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United States Securities and Exchange Commission
Washington, D.C. 20549
FORM 10-K
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED December 31, 2003
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
Commission File No. 000-50343
INTEGRATED ALARM SERVICES GROUP, INC.
(Exact name of Registrant as specified in its charter)
Delaware 42-1578199
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
99 Pine Street, 3rd Floor, Albany, New York 12207
(Address of principal executive offices) (zip code)
(518) 426-1515 (Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
NONE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. |X|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes |_| No |X|
The aggregate market value of common stock held by non-affiliates of the
registrant as of June 30, 2003 was $0.
The number of shares outstanding of the registrant's common stock as of
February 28, 2004 was 24,641,822 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrants proxy statement on Schedule 14A to be furnished to
stockholders in connection with its Annual Meeting of Stockholders are
incorporated by reference in Part III of the Form 10-K. Such proxy statement is
expected to be filed with the Commission by April 29, 2004.
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Integrated Alarm Services Group, Inc.
FORM 10-K
For The Fiscal Year Ended December 31, 2003
INDEX
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Page
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Part I
Item 1 Business 2
Item 2 Properties 13
Item 3 Legal Proceedings 13
Item 4 Submission of Matters to a Vote of Security Holders 14
Part II
Item 5 Market for Registrant's Common Stock and Related
Stockholder Matters 14
Item 6 Selected Financial Data 15
Item 7 Management's Discussion and Analysis of Financial
Condition and Results of Operations 16
Item 7A Quantitative and Qualitative Disclosures about
Market Risk 28
Item 8 Financial Statements and Supplementary Data 28
Item 9 Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 28
Item 9A Controls and Procedures 28
Part III
Item 10 Directors and Executive Officers of the Registrant 29
Item 11 Executive Compensation 30
Item 12 Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters 30
Item 13 Certain Relationships and Related Transactions 30
Item 14 Principal Accountant Fees and Services 30
Part IV
Item 15 Exhibits, Financial Statement Schedules, and Reports on
Form 8-K 31
Signatures
PART I
Item 1. Business
We provide an integrated solution to independent security alarm dealers, which
we refer to as "Dealers", to assist them in competing in the residential and
commercial security alarm market. Our services include wholesale alarm
monitoring and financing solutions, including purchasing Dealers' alarm
monitoring contracts for our own portfolio and providing loans to Dealers
collateralized by alarm monitoring contracts. We also provide support for our
Dealers including billing, collection, marketing and access to equipment
discount programs. We believe our package of services allows Dealers to compete
against self-monitoring national providers in the security alarm market by
giving them access to technical sophistication, financing, back office and other
services that they would not otherwise have, while allowing them to remain the
local and visible contact with their customer, the end-user of the alarm.
We believe we are the largest wholesale alarm monitoring company in the United
States, monitoring approximately 410,000 alarm systems on behalf of
approximately 5,000 Dealers. Our alarm monitoring service is provided through
three state-of-the-art, redundant alarm monitoring centers located in New
Jersey, Minnesota and California. We are also a significant provider of capital
to Dealers. Since 1993, we have provided financing to Dealers in the form of
loans or alarm monitoring contract purchases of approximately $424 million in
the aggregate. We currently hold and monitor approximately 119,000 alarm
monitoring contract equivalents in our own portfolio. In addition, we hold
approximately 4,000 contracts as collateral against loans we have made to
Dealers.
Our Industry
Overview
The security alarm industry is characterized by a large number of privately
owned companies involved in security alarm sales, leasing, installation, repair
and monitoring. In 2001, approximately 10,000 such Dealers were active in the
United States. Based on information from Security Distributing and Marketing
magazine ("SDM"), approximately 75% of this market is served by smaller
companies not included in the 100 largest companies. The top 100 companies
include large self-monitoring national providers such as ADT, a subsidiary of
Tyco International, Inc., and Brinks Home Security, Inc., a subsidiary of The
Brink's Company.
Our target market is the portion of the market served by the roughly 10,000
Dealers outside of the top 100, or approximately 75% of the overall alarm
monitoring market.
The growth in the security alarm industry has been fueled by several factors. We
believe the aging of the population and the increase in two-career families have
both contributed to an increased focus on the security of the home. Many
insurance companies offer discounts to home and business owners who install
electronic security alarm systems. In fact, many commercial enterprises are
required by insurance underwriters to have monitored alarm systems. According to
a study conducted by two professors of economics at Temple University, homes
without security systems are between 2.2 and 3.1 times (depending on home value)
as likely to be broken into than homes with security systems. In addition, they
reported losses due to burglary average $400 less in residences with security
systems than in those without security systems. These factors and others,
including a heightened awareness of overall security needs, have resulted in an
increasing number of homes in North America with monitored security systems.
According to The Freedonia Group, Inc., the current penetration of alarm systems
in existing homes in North America is 18% and is expected to exceed 20% by 2006.
Additionally, we believe that many new homes have pre-installed security alarm
systems. We also anticipate that historic growth rates in this industry will be
surpassed as technology continues to lower the cost of remote monitoring and
increases the potential applications of monitoring call centers. Such new
applications include personal monitoring for the elderly or health impaired and
using global positioning systems ("GPS") to monitor the location of equipment
and other assets. In connection with this asset tracking initiative, many
commercial users of GPS are adding a safety and security element for their human
resources.
The performance of the security alarm industry has been impacted by the
significant amount of consolidation that occurred in the mid-to-late nineties.
Self-monitoring national providers such as ADT (acquired by Tyco in 1997) and
Protection One, private regional providers, as well as new entrants into the
market such as Ameritech (a telephone company that has since exited the
business) acquired a large number of independent Dealers (with and without
monitoring call centers) and wholesale monitoring stations. During this period
of consolidation, purchase multiples of recurring monthly revenue ranged from
approximately 35 to 68 times. This growth was largely financed with debt. Most
of these acquirers experienced service disruptions in connection with the
integration of these newly-acquired customer accounts, which increased customer
attrition. Further, many acquirers were facing and continue to face financial
pressures to service the debt used to effect these acquisitions. Consequently,
although the industry is still fragmented, acquisition activity and purchase
multiples of recurring monthly revenue have declined. We believe that the
combination of these higher service-related attrition levels and debt service
requirements, as well as the credit environment generally, presents us with a
unique opportunity to grow our business. We believe that we will be able to
complete acquisitions at purchase multiples of recurring monthly revenue
substantially lower than those which existed industry-wide in the mid- to-late
nineties. Further, we expect that such acquisitions will be completed without
compromising our account underwriting and due diligence criteria.
2
Dealer Operations
The primary sources of revenue for Dealers are the sale and installation of
security alarm systems and the monthly subscription of the monitoring service.
Typically, upon installation, the end-user enters into an annual alarm
monitoring contract. Under an alarm monitoring contract, the Dealer agrees to
monitor, or contract with another company to monitor, the security alarm from a
remote location and to take certain pre-determined actions, such as calling the
police, an ambulance service, or fire department, when a security system is
triggered and an alarm signal is received. After its initial term, most alarm
monitoring contracts are subject to automatic renewal on an annual basis unless
the Dealer or end-user notifies the other party within a defined time period
that the alarm monitoring contract will not be renewed. The average life of
alarm monitoring contracts typically ranges from 8 to 12 years.
Most Dealers do not have the capability to monitor alarms internally, and
outsource the monitoring and/or administrative aspects of the business to an
outside wholesale alarm monitoring company. We believe that Dealers look for a
partner, such as us, who offers a wide array of services, including state-of-
the-art monitoring service, billing and collection capabilities, and marketing
support, all at a reasonable cost.
Financing support is often just as important as monitoring support since many
Dealers are constrained by the working capital requirements required to build
their business. In many cases, the cost of the installed equipment to the
end-user is at or below the Dealer's cost. In these cases, much of the Dealer's
capital and financial return comes from future monthly payments under the alarm
monitoring contracts. As a result, Dealers often need or desire to monetize
these alarm monitoring contracts and will, consequently, sell or borrow against
their alarm monitoring contracts.
Although there is a well-developed market for the purchase and sale of alarm
monitoring contracts and several specialty finance companies have been willing
to lend against alarm monitoring contracts held by Dealers, many Dealers have
not had access to traditional credit lending markets. Several characteristics of
the industry, including the lack of standardization among individual alarm
monitoring contracts and the under-capitalization of most Dealers, make it
difficult for traditional lenders to comfortably lend against the value of
individual alarm monitoring contracts. Further, the ability to provide or
control monitoring service is critical to maximizing the value of the alarm
monitoring contract since service issues are the primary reasons why end-users
do not renew alarm monitoring contracts. Traditional lenders and many specialty
lenders do not have this capability.
When acquiring alarm monitoring contracts from Dealers, purchasers typically pay
a multiple of the "recurring monthly revenue". According to Barnes and
Associates, a financial services provider to the security alarm industry, the
average recurring monthly revenue purchase multiple for portfolios with less
than $50,000 in recurring monthly revenue was 32.7 times in 2001, 31.1 times in
2002 and 30.9 times in 2003. For example, assuming a monthly security alarm
monitoring cost to the end-user of $30.00, the acquisition price of the alarm
monitoring contract would be approximately $950.00.
Our Services
Our two primary business activities are acquiring and managing portfolios of
alarm monitoring contracts and monitoring security alarms. We also offer
administrative services, such as billing and collection, to our Dealers as well
as new and emerging products and services. Our acquisition and financing
solutions provide capital to Dealers, allowing them to compete with larger
competitors on the initial price of equipment and installation to the end- user.
We also provide Dealers with access to technical sophistication and back office
services that they may not otherwise have (or be able to profitably operate),
while allowing them to maintain visible contact with their local customers, the
end-users of the alarm. Our alarm monitoring contract acquisition and financing
solutions and monitoring services complement one another and drive growth in
other areas of our business.
We generally require Dealers to whom we provide alarm monitoring contract
financing to use our monitoring services for all of the alarm monitoring
contracts they continue to own. We typically also require these Dealers to use
our billing and collection services, enabling us to gain an additional level of
control over the reliability of the alarm monitoring contracts' cash flows. This
places us in a unique position to minimize alarm monitoring contract attrition
because we can control the quality of the monitoring, billing and collection
and, to a significant extent, Dealer interaction with the end-user.
Alarm Monitoring Contract Acquisition and Financing Services
Generally, Dealers have had limited access to traditional credit providers.
Several characteristics of the industry, including the lack of standardization
among many individual alarm monitoring contracts, the under capitalization of
Dealers, and their inability to provide monitoring services directly, has
historically made lenders hesitant to provide financing to Dealers. When
providing financing to Dealers, we obtain a security interest in the underlying
alarm monitoring contracts. The payment terms are generally between 36 and 72
months, at interest rates based on prevailing overall interest rates and market
conditions.
3
We believe that we are uniquely positioned to maximize the value of alarm
monitoring contracts through the depth of our knowledge of the security alarm
industry and the integrated nature of the services we provide. We have the
ability to exercise greater control over alarm monitoring contract attrition
than most capital providers because we have direct influence over the quality of
the monitoring, interaction with the end-user and billing and collection.
Consequently, we are able to deploy more capital and achieve higher returns.
With respect to purchased alarm monitoring contracts, we typically acquire them
from the Dealers that originally sold and installed the security alarm systems
giving rise to the alarm monitoring contracts. We structure the payment terms
and pricing of both our alarm monitoring contract purchases and loans to provide
us with a competitive internal rate of return. In a typical transaction, the
Dealer will sell its alarm monitoring contracts for a purchase price that is a
multiple of the recurring monthly revenue. The multiple paid in any actual
transaction is impacted by several factors including average recurring monthly
revenue, the amount of the homeowner's investment in the alarm system,
geographic diversity of the accounts and our own due diligence of the Dealer.
Generally, Dealers that sell or borrow against their alarm monitoring contracts
do so on either a flow basis (as such alarm monitoring contracts are generated)
or a bulk basis (where the Dealer has accumulated a portfolio of alarm
monitoring contracts, and desires to sell or finance, all, or a portion, of
those alarm monitoring contracts at the same time). We purchase alarm monitoring
contracts on both a flow and a bulk basis. Typically, the price paid for a flow
alarm monitoring contract is less than that paid in a bulk purchase because very
often the bulk purchases are comprised of seasoned, performing alarm monitoring
contracts. In either instance, we typically require Dealers to replace any
cancelled alarm monitoring contracts and lost revenues for the first year after
we purchase an alarm monitoring contract. Such replacement must be in cash or
acceptable alarm monitoring contracts. We also hold back a portion of the
purchase proceeds to secure this Dealer obligation.
Since alarm monitoring contract quality is a key driver of our profitability,
underwriting discipline is critical. We maintain a very strict underwriting
discipline. For example, we do not typically purchase alarm monitoring contracts
that were generated by Dealers offering "zero-down" on equipment purchases and
installation, unless the contracts have been outstanding for a minimum of 12
months and exhibit acceptable payment patterns as well as acceptable responses
to quality control calls, since the lack of such costs does not create an
investment stake in the service by the end-user. Further, end-users attracted to
"zero-down" promotions are often of lower credit standing and therefore, may be
more likely to default.
Credit quality of the end-user is also a key consideration when purchasing alarm
monitoring contracts on a flow basis. We require credit rating scores on all
alarm monitoring contracts that we acquire on a flow basis. We typically reject
those alarm monitoring contracts with Beacon Scores (a credit rating employing a
methodology developed by Fair, Isaac and Co., primarily used by Equifax in the
US and Canada) of less than 625 and typically accept alarm monitoring contracts
with a Beacon Score of 640 or more (provided they satisfy all of our other due
diligence criteria). Alarm monitoring contracts with a Beacon Score between 625
and 640 are further scrutinized through an additional review of the end-user's
credit status. We do not conduct a credit review of the end-user for bulk
purchases because of the seasoned performance characteristics of such alarm
monitoring contracts.
Our due diligence process begins with an examination of the Dealer in much the
same way as a bank reviews a mortgage applicant. We perform judgment and lien
searches, review tax filings (corporate and personal), and obtain credit scores,
certificates of good standing and proof of licensure from the state(s) in which
the Dealer does business. In addition, we pre-approve each Dealer's standard
end-user alarm monitoring contract and with respect to flow purchases obtain a
credit rating for each end-user. We also require that the selling Dealers carry
errors and omissions insurance with at least $1 million of coverage and provide
us with a personal guarantee of the dealer recourse obligation. When we purchase
on a flow basis, we also generally contact the end-user to ensure that they
understand the alarm monitoring contract and know how to use the alarm system.
When purchasing alarm monitoring contracts on a bulk basis, we contact a
significant random sample. In all cases, we verify that the alarm system
generates a live signal to our monitoring call centers.
We include certain additional safeguards in our purchase and loan agreements. We
generally bill end-users directly and require that the receipts be deposited
into a segregated lock-box account for our benefit. A lock-box account is
established through a remittance processing agreement between a third party
service provider and us pursuant to which payments made under the end-user alarm
monitoring contracts are forwarded to the third party and placed in a segregated
account. The contents of the lock-box are remitted daily to an accumulation
account from which disbursements are made first to our lenders, as required, and
to us. The Dealers have no right in, or any right to withdraw any amounts held
in the accumulation account. For loans, we also take physical possession of the
original alarm monitoring contracts and file financing statements to perfect our
security interest.
While some of our monitoring competitors also claim to offer alarm monitoring
contract acquisition and financing alternatives to Dealers, many act merely as
an intermediary. In contrast, we operate as a principal and either lend directly
to the Dealers or acquire alarm monitoring contracts for our own portfolio. We
are not aware of any other monitoring competitor in the industry that acts as a
principal for loans to Dealers.
A key element of our alarm monitoring contract acquisition and financing
business is that we are uniquely able to mitigate attrition of the alarm
monitoring contracts we acquire. In addition to the alarm monitoring contract
acquisition and finance process described above, we generally require that
Dealers use us to monitor all of their alarm monitoring contracts, not just
those that have been acquired or financed. This monitoring requirement enables
us to ensure the quality of the monitoring services. Monitoring problems are a
primary cause of alarm monitoring contract cancellation and we believe that we
are the only participant in the industry that has the ability to control every
aspect of its acquired alarm monitoring contracts.
4
Monitoring Services
We provide monitoring to Dealers on alarm monitoring contracts that they have
entered into with an end-user. Dealers typically pay us a fixed monthly
monitoring fee for each account that we monitor on their behalf. The cost of the
monthly monitoring fee is either based on a published list price or is
negotiated between us and the Dealer. The charges are billed to the Dealer on a
monthly, quarterly, semi-annual or annual basis in accordance with the contract
agreement. The collection of payments by the Dealer from their end users have no
effect on the prices charged or collected by us from the Dealer. We currently
monitor approximately 547,000 end-user accounts. Generally, when an alarm is
activated, a signal is sent from the alarm system through a phone line, radio
transmitter, or wireless service to a receiver located at one of our three
monitoring facilities. This signal is immediately routed through our automated
system and an operator personally handles each call. When the operator receives
the alarm condition, his or her computer will simultaneously display a series of
instructions on how to handle the alarm. These instructions are prepared by the
Dealer and the end-user in advance and are customized to the particular
logistics of the geographic area as well as the individual needs of the
end-user.
In many instances, the operator will call a phone number specified by the
end-user and ask for a code word. If the operator is unable to contact the
end-user or an incorrect code word is given, the operator will dispatch the
appropriate authority to the scene of the alarm. In the instance of a fire
alarm, the operator is typically instructed to dispatch emergency vehicles
without making an attempt to contact the end-user. In any event, after
dispatching the appropriate authority, the operator will then call any other
individuals specified in the end-user's instructions and will provide notice to
the Dealer servicing the end-user of the event. The Dealer can then provide
follow-up support with the local end-user.
In a typical week, our operators respond to approximately 84,000 alarm
activations. We have consistently met a response time, measured by us as the
time between when an alarm signal arrives in our monitoring call centers and our
first response to that alarm, of 30 seconds, which we believe is among the best
response times in the industry.
We own and operate three redundant monitoring call centers, which operate with
state-of-the-art equipment and a highly trained staff. Our monitoring call
centers are located in Manasquan, New Jersey, Minneapolis, Minnesota and Santa
Fe Springs, California, and are linked via advanced software that creates a
real-time queuing process. Having three facilities located strategically
throughout the United States allows us to efficiently allocate alarm responses
based on time-of-day or specific event drivers that may cause one area of the
country to have a higher volume of alarms than others. As a result, alarm
signals, which would otherwise wait for available operators during peak periods,
are routed to our other monitoring call centers where they are more quickly
processed. For instance, a large number of alarms at our New Jersey facility
resulting from bad weather in the Northeast would result in the transfer of a
portion of these calls to our California facility.
All of our monitoring call centers are Underwriters Laboratories ("UL") listed.
To obtain and maintain a UL listing, a monitoring call center must be located in
a building meeting UL's structural requirements, have back-up and
uninterruptible power supply, have secure and redundant telephone lines and
redundant computer systems that meet UL criteria. Access to the facility must
also be strictly controlled.
Alarm monitoring offerings vary widely with the specific needs of the end-user
and encompass many types of monitored alarms including burglary, hold-up, panic,
fire, two-way voice communication, industrial process control, medical emergency
and environmental alert. We monitor all of these types of alarms from our
existing monitoring call centers. Our monitoring call centers are also capable
of supporting a full range of add-on services such as remote video monitoring,
network intrusion detection, cellular transmission, private radio access,
personal emergency response systems and GPS monitoring and emergency dispatch
services using GPS technology.
Historically, our monitoring services business has grown by adding new Dealer
relationships generated by both direct marketing and sales activities and by
cross-selling to those Dealers to whom we have provided financing. Additionally,
over the last three years we have acquired four wholesale alarm monitoring
companies and we expect to acquire additional monitoring call centers in the
future, subject to the availability of suitable acquisition opportunities.
We continually monitor the efficiency of each of our monitoring call centers. We
recently consolidated seven monitoring call centers into the three call centers
that we operate today, taking advantage of new technologies that enable us to
monitor large geographic areas very effectively from a single location. This
consolidation has allowed us to increase efficiency and productivity, and
decrease duplicative expenses. However, we intend to always maintain at least
one fully redundant facility.
5
Other Services
Billing and Collection
We create paper invoices and mail them to end-users serviced by our Dealers.
Additionally we may provide collection services for accounts receivable. We
generally charge on a per account basis. In instances where we provide the
billing and collection function in addition to alarm monitoring contract
acquisition and financing, we gain an additional level of assurance that timely
payments will be made on the alarm monitoring contracts that we have purchased
or lent against. It also enables us to minimize billing errors, which are also a
cause of alarm monitoring contract attrition. By offering billing and collection
services to our Dealers, we enable Dealers to focus their efforts on sales and
installation, rather than administration of alarm monitoring contracts.
Guardian Name Brand Program
We offer a name brand program under the Guardian name that is designed to assist
our Dealers in the selling of more security systems by utilizing the brand
awareness of the Guardian name and the many marketing and sales tools that we
provide. The Guardian program is operated and administered by us on an exclusive
basis and each system that is sold and installed under the Guardian brand is
required to be monitored by us. Under the program, a Dealer is provided with all
the marketing material, monitoring agreements and equipment necessary for the
installation of the systems as well as other sales and administrative materials
under the Guardian name. In addition, we act as the exclusive financing company
for the program should the Dealer wish to borrow against or sell alarm
monitoring contracts that are generated from sales under the Guardian brand.
Equipment Discount Program
We provide our Dealers with access to discounts on equipment. For example, we
have entered into a relationship with Alarm Device Manufacturing Company
(ADEMCO), which is the largest security alarm equipment manufacturer and
provider in the world. Our understanding with ADEMCO is that any Dealer who uses
our monitoring services will automatically receive preferential pricing for all
equipment purchased from ADEMCO. This program can represent significant savings
to our Dealers. To be eligible for this program, we require that the Dealer (i)
be an existing customer of ours, (ii) connect all of their new end-users to our
monitoring call center, and (iii) maintain a current standing with regard to
their monitoring charges.
We are currently in discussions with other major manufacturers of alarm
equipment to institute a similar type of discount program for their equipment.
This will give our Dealers a choice of using different types and brands of
equipment while enjoying similar reduced pricing plans.
Sales and Marketing
Our sales and marketing activities are conducted through a network of 75
in-house professionals.
Sales activities are structured by product area (monitoring services, financial
products and new product applications) and geography. Although sales personnel
are focused on one product area, each professional is trained to sell all
products and services. There are six professionals in our wholesale sales force.
Our retail segment has 69 employees involved in sales activities related to
servicing commercial and residential customers. We also maintain two
telemarketing departments (one for monitoring and financial services and related
products and one for new product offerings) that support the sales force.
Our marketing department is comprised of four professionals. This team is
responsible for the production and distribution of print advertising materials
and direct mail marketing pieces. The team also issues corporate communications
to employees, customers, strategic partners and other interested parties through
regular press releases and announcements of new products and services. The group
is also responsible for business development activities including the
identification and procurement of new products and services that Dealers can
sell to their customers.
We believe that this multi-faceted approach to sales and marketing activities is
an important ingredient to the successful ongoing growth in all our business
areas.
Growth Initiatives
Our growth initiatives are focused on four elements: prudently increasing the
number of alarm monitoring contracts that we either purchase from Dealers or
finance; increasing the number of Dealers (and therefore the number of
end-users) to whom we provide wholesale alarm monitoring services; cross-selling
our various services to Dealers and their end-users and leveraging our alarm
monitoring infrastructure across new safety and security applications.
6
Acquisition of Additional Alarm Monitoring Contracts
We intend to expand our acquisition and financing of alarm monitoring contracts
through purchasing alarm monitoring contracts on both a flow business and bulk
purchase basis. We have in 2003, acquired two businesses that not only had a
significant number of contracts but also installed and serviced commercial and
residential monitoring systems.
Our alarm monitoring flow business includes the purchase of newly created alarm
monitoring contracts on a recurring, or as originated, basis from our Dealers.
We have engaged in flow business with over 75 Dealers, and are actively seeking
to increase the number of Dealers with whom we conduct flow business.
Bulk purchases occur when we buy existing portfolios of alarm monitoring
contracts with demonstrated payment histories of at least six months. Bulk
purchases typically range in size from 10,000 to 20,000 alarm monitoring
contracts. These alarm monitoring contracts are typically purchased from Dealers
on a non-recurring basis. The bulk purchases are less predictable in terms of
the timing of account acquisitions, but are generally more predictable in terms
of performance than flow business because the actual historical performance of
individual alarm monitoring contracts is known. Many of the bulk purchases made
by us are made from Dealers who are existing monitoring customers. We expect
that as we increase our penetration of Dealers who use our wholesale alarm
monitoring services, acquire other wholesale alarm monitoring companies and call
centers (see below, "Building Additional Wholesale Monitoring Relationships with
Dealers.") and continue to build Dealer relationships, we will experience
increased opportunities to purchase alarm monitoring contracts on both a flow
and a bulk basis.
In a typical alarm monitoring contract acquisition, we retain the selling Dealer
to service the underlying alarm system, which helps us maintain strong
relationships with the Dealers and encourages the Dealer to sell additional
alarm monitoring contracts to us as new installations are completed.
The impact of the acquired contracts on revenue and profitability will be
affected by the attrition rates of acquired portfolios, as well as the variable
expenses relating to such acquisitions including billing, collection and
servicing.
Building Additional Wholesale Monitoring Relationships with Dealers
In the past, we have grown both internally and by acquiring monitoring call
centers, including the acquisitions of Criticom and Monital.
Our internal growth is driven by the value that we provide to our Dealers. We
provide quality, reliable alarm monitoring services to our Dealers' end-users.
Our Dealer branding program, warranty program, equipment discount programs,
billing and collection services and financing programs are also important
factors that enable us to attract additional Dealers.
Historically, we have also added Dealer relationships through the acquisition of
monitoring companies and the integration of their call centers into our
operations. We plan to grow our business through opportunistic acquisitions of
monitoring call centers in order to capture the associated Dealer relationships.
The impact to profitability of any such acquisition will be dependent upon our
ability to efficiently integrate the acquired business and cost structure into
our existing platforms.
Cross-Selling Opportunities
We have initiated a comprehensive cross-selling program of our primary services
to Dealers. For those Dealers to whom we provide wholesale monitoring services,
we will encourage them to use us as the purchaser when they wish to sell alarm
monitoring contracts, or as a financing source should they wish to borrow funds
against the value of their alarm monitoring contracts. The ability to be a
consistent, readily available provider of financing solutions positions us to be
the preferred provider of our products and services to Dealers.
Dealers have access to a network of local end-users, which allows us to offer
additional services to the Dealers' end-users such as two-way voice
communication, extended warranty coverage and personal emergency response
service. Through an existing strategic marketing partnership, we also give our
Dealers the ability to offer GPS tracking services for any kind of movable
asset.
Since we generally do not participate in the sales and installation market and
provide monitoring services on a transparent basis, Dealers are comfortable that
we will not interfere with their customer relationships, and value our
relationships which provide them with new revenue opportunities that they can
market to their end-users.
7
The cost of effectively marketing new products and services to end-users through
Dealers may be greater than anticipated, which could negatively affect
profitability.
New Business Opportunities
We believe there are substantial opportunities for us to expand our traditional
security alarm monitoring services into new monitoring applications, including
commercial and personal vehicular security monitoring and dispatch, telemedicine
(monitoring medical behaviors and events of individuals) and personal emergency
response services ("PERS"). The Freedonia Group estimates that the market for
vehicular security monitoring services alone was valued at $630 million in 2001
and is projected to be $5.8 billion by 2006. Criticom focuses on these
opportunities and has already begun and/or completed the following projects that
utilize GPS technology to monitor vehicles and their contents.
We are the exclusive provider of GPS monitoring and emergency dispatch service
on systems installed by Minorplanet Systems USA, Inc., of Richardson, Texas,
including over 26,000 vehicles for Minorplanet fleet customers such as SBC
Communications, Ameritech, Southern New England Telephone Co. and Nevada Bell.
The exclusive agreement that we have with Minorplanet will expire in May 2005.
In June 2000, we partnered with Security Trac, LLC, of New York City, which
supplies GPS services linked to our monitoring and emergency dispatch service to
New York City taxis and livery vehicles. Security Trac has installed over 621
units in taxis to date. There are over 80,000 taxis, liveries and vehicles for
hire in New York City.
In September 2002, we co-developed an end-user interface for a leading overnight
shipping company that will allow it to track vehicles that transport high value
assets and, should the driver be involved in an emergency situation, have an
emergency signal transmitted to us using GPS technology for emergency dispatch
service. We are currently in the test phase of this initiative.
We are the first choice provider of Public Safety Answering Point (PSAP)
monitoring services to all customers of Signature Agency, a GE Financial
Assurance Company.
We are the exclusive provider of remote convenience features for vehicles and
monitoring for stolen cars utilizing GPS technology provided by Directed
Electronics, Inc. of Vista, CA. Directed Electronics distributes its vehicle
security systems to customers such as Best Buy, Circuit City and local
automotive aftermarket retailers. This exclusive agreement we have with Directed
Electronics will expire in April of 2006.
The development and implementation of the infrastructure for these new services
is complete, primarily because we are equipped to receive most types of
electronic signals regardless of the source of the signal (i.e., residential
alarm equipment, satellite transmissions and other emergency communication
devices). Consequently, the remaining costs associated with these new
initiatives relate primarily to marketing, administration and operations. In
connection with our acquisition of Criticom, we acquired a 5.03% interest in
Royal Thoughts LLC, for which we received a right of first refusal to provide
monitoring services for any new technology developed by Royal Thoughts.
The timing and economic impact of introducing new services to undeveloped market
segments is difficult to forecast. These activities accounted for approximately
2% of our revenues in 2003.
Risks Related to Our Business
Significant attrition of Dealers or non-renewal of end-user alarm monitoring
contracts could materially adversely effect our results of operations. We
experience attrition of Dealer customer relationships and alarm monitoring
contracts as a result of several factors including relocation of end-users,
adverse financial and economic conditions and competition from other alarm
service companies. In addition, we may lose or experience non-renewal of certain
alarm monitoring contracts of Dealers, particularly acquired Dealer customer
relationships and alarm monitoring contracts, if we do not service those alarm
monitoring contracts adequately or do not successfully integrate new alarm
monitoring contracts into our operations. A significant increase in attrition or
the non-renewal of alarm monitoring contracts could have a material adverse
effect on our revenues and earnings. To the extent that actual attrition exceeds
our expectations, our revenues, profitability, cash flow and earnings would be
adversely effected. Attrition for acquired Dealer customer relationships and
alarm monitoring contracts may be greater in the future than the attrition rate
assumed or historically incurred by us. In addition, because some Dealer
customer relationships and acquired alarm monitoring contracts are prepaid on an
annual, semi-annual or quarterly basis, attrition may not become evident for
some time after an acquisition is consummated.
8
We face significant competition in the security alarm industry, which could make
it more difficult for us to succeed in securing relationships with Dealers and
reduce the number of alarm monitoring contracts we are able to acquire. We are
dependent on entering into and maintaining relationships with Dealers who will
either sell their alarm monitoring contracts directly to us, borrow from us, or
enter into alarm monitoring contracts for us to provide monitoring services for
the alarm monitoring contracts retained by them. While we do not typically
compete directly with many of the larger companies in the industry because we do
not primarily sell and install security systems, we are nonetheless impacted by
the competitive challenge these entrants present to Dealers.
There is the potential that larger companies in the industry may generate alarm
monitoring contracts offering "zero down" on equipment purchases and
installation. The independent Dealer may have to offer the same "zero down" deal
in order to effectively compete. Since the end-users attracted to "zero- down"
promotions are often of lower credit standing and thereby are more likely to
default, we will only purchase these contracts if they have been outstanding for
periods longer than 12 months and exhibit acceptable payment patterns as well as
acceptable responses to quality control calls, thus potentially limiting the
available alarm monitoring contracts which meet our due diligence standards.
We also compete with several companies that have alarm monitoring contract
acquisition and loan programs for Dealers and some of those competitors may be
larger and better capitalized than we are. Some of these companies may be able
to pay higher multiples of recurring monthly revenue for the portfolios they
acquire than we can. We may be required to offer higher prices for such
acquisitions than we have in the past, thus making these acquisitions less
financially advantageous. There is also the potential for other entities such as
banks or finance companies to become more active as a source of competition for
the Dealer finance portions of our business.
We may not be able to obtain all of the benefits of the security alarm
monitoring contracts we purchase. A principal element of our business strategy
is to acquire portfolios of alarm monitoring contracts. Acquisitions of end-
user alarm monitoring contracts involve a number of risks, including the
possibility that we will not be able to realize the recurring monthly revenue
stream we contemplated at the time of acquisition because of higher than
expected attrition rates or fraud. Although we complete an extensive due
diligence process prior to acquiring alarm monitoring contracts and obtain
representations and warranties from the seller, we may not be able to detect
fraud on the part of the seller, including the possibility that the seller has
misrepresented the historical attrition rates of the sold contracts or has sold
or pledged the contracts to a third party. If the sale of alarm monitoring
contracts involves fraud or the representations and warranties are otherwise
inaccurate, we may not be able to recover from the seller damages in the amount
sufficient to fully compensate us for any resulting losses. In such event, we
may incur significant costs in litigating ownership or breach of acquisition
contract terms.
We may pursue acquisitions of alarm monitoring call centers that by their nature
present risks and may not be successful. An element of our business strategy is
to acquire additional alarm monitoring call centers. The following are some of
the risks associated with these acquisitions:
o We may be unable to achieve anticipated revenues, earnings or cash flow
because of higher than expected attrition rates or other reasons.
o We may be unable to integrate acquired call centers successfully and
realize anticipated economic, operational and other benefits in a timely
manner. If we are unable to integrate acquired call centers successfully,
we could incur substantial costs and delays or other operational,
technical or financial problems.
o If we are not successful in integrating acquired call centers, we could
have increased attrition of end-users because of service-related problems.
o Acquisitions could disrupt our ongoing business, distract management,
divert resources and make it difficult to maintain our current business
standards, controls and procedures.
We also face competition in identifying and purchasing suitable alarm monitoring
call centers. We would be competing with other firms, many of which have greater
financial and other resources than we do. Should this competition increase, it
will be more difficult to acquire additional alarm monitoring call centers.
Our ability to continue to grow our business is dependent upon our ability to
obtain additional financing. We intend to continue to pursue growth through the
acquisition of end-user alarm monitoring contracts and wholesale monitoring
businesses. We will be required to seek additional funding from third party
lenders and/or from the possible sale of additional securities, which may lead
to higher leverage or the dilution of then existing stockholders. Any inability
to obtain funding through third party financing is likely to adversely effect
our ability to continue or increase our acquisition activities. Third party
funding may not be available to us on attractive terms or at all.
Rising interest rates could negatively effect our profitability. The interest
rate of our financing is generally tied to prevailing market rates. In the event
that interest rates rise, the spread between our cost of capital and the amount
that we can charge Dealers who borrow from us may decrease, which will
negatively effect our profitability.
9
We could face liability for our failure to respond adequately to alarm
activations. The nature of the services we provide potentially exposes us to
risks of liability for employee acts or omissions or system failures. In an
attempt to reduce this risk, our alarm monitoring agreements and other
agreements pursuant to which we sell our products and services contain
provisions limiting liability to end-users and Dealers. However, in the event of
litigation with respect to such matters, there can be no assurance that these
limitations will continue to be enforced. In addition, the costs of such
litigation could have an adverse effect on us.
We may face additional costs and potential liability as a result of "false
alarm" ordinances. Significant concern has arisen in certain municipalities
about the high incidence of false alarms. This concern could cause a decrease in
the likelihood or timeliness of police response to alarm activations and thereby
decrease the propensity of consumers to purchase or maintain alarm monitoring
services.
A number of local governmental authorities have considered or adopted various
measures aimed at reducing the number of false alarms. Such measures include
subjecting alarm monitoring companies to fines or penalties for transmitting
false alarms, licensing individual alarm systems and the revocation of such
licenses following a specified number of false alarms, imposing fines on alarm
end-users for false alarms, imposing limitations on the number of times the
police will respond to alarms at a particular location after a specified number
of false alarms and requiring sufficient further verification of an alarm signal
before the police will respond. Enactment of such measures could increase our
costs and thus adversely effect our future results of operations.
Future government or other organization regulations and standards could have an
adverse effect on our operations. Our operations are subject to a variety of
laws, regulations and licensing requirements of federal, state and local
authorities. In certain jurisdictions, we are required to obtain licenses or
permits, to comply with standards governing employee selection and training and
to meet certain standards in the conduct of our business. The loss of such
licenses, or the imposition of conditions to the granting or retention of such
licenses, could have an adverse effect on us. We believe that we are in material
compliance with applicable laws and licensing requirements. In the event that
these laws, regulations and/or licensing requirements change, it could require
us to modify our operations or to utilize resources to maintain compliance with
such rules and regulations. There can be no assurance as to what new regulations
will be enacted and what effect they may have on us.
The loss of our Underwriters Laboratories listing could negatively impact our
competitive position. All of our monitoring call centers are Underwriters
Laboratories(R) ("UL") listed. To obtain and maintain a UL listing, an alarm
monitoring call center must be located in a building meeting UL's structural
requirements, have back-up and uninterruptible power supply, have secure
telephone lines and maintain redundant computer systems. UL conducts periodic
reviews of monitoring call centers to ensure compliance with their regulations.
Non-compliance could result in a suspension of our UL listing. The loss of our
UL listing could negatively impact our competitive position.
We rely on technology which may become obsolete. Our monitoring services depend
upon the technology (hardware and software) of security alarm systems. We may be
required to upgrade or implement new technology which could require significant
capital expenditures. There can be no assurance that we will be able to
successfully implement new technologies or adapt existing technologies to
changing market demands. If we are unable to adapt in a timely manner in
response to changing market conditions or customer requirements, such inability
could adversely effect our business.
In the event that adequate insurance is not available or our insurance is not
deemed to cover a claim we could face liability. We carry insurance of various
types, including general liability and errors and omissions insurance. Our loss
experience and that of other security service companies may effect the
availability and cost of such insurance. Certain of our insurance policies and
the laws of some states may limit or prohibit insurance coverage for punitive or
certain other types of damages, or liability arising from gross negligence. To
the extent that insurance was not available, or a particular claim was not
covered or exceeded our coverage, we could be exposed to material costs.
Any conflict of interest between us and various affiliates of our senior
management could hurt our business or prospects. There is a possibility that
conflicts of interest will arise between some affiliates of our senior
management and us in various areas relating to our past and ongoing
relationships. Potential factors that may create a conflict of interest include:
Timothy M. McGinn, our CEO, is a Director of McGinn, Smith & Co., Inc., and
David L. Smith, one of our Directors, is President and a Director of McGinn,
Smith & Co., Inc. For the period January 1, 2000 to January 31, 2003, McGinn,
Smith & Co., Inc. has acted as either a placement agent or investment banker in
connection with various financings, as well as an investment banker in
connection with certain acquisitions. McGinn, Smith & Co., Inc., an NASD
registered broker dealer, received commissions and/or investment banking fees of
$4.5 million for acting in such capacity. Subject to our policy on interested
party transactions, McGinn, Smith & Co., Inc. may in the future act as an
underwriter to us. Our policy provides that any future transactions with
affiliates, including without limitation, our officers, directors or principal
stockholders will be on terms no less favorable than we could have obtained from
unaffiliated third parties. Any such transactions will be approved by a majority
of the independent and disinterested members of our board of directors.
10
We are dependent upon our senior management. The success of our business is
largely dependent upon the active participation of our executive officers, who
have extensive experience in the industry. As a result, we have entered into
employment agreements with each of our executive officers. The loss of the
services of one or more of such officers for any reason may have an adverse
effect on our business.
Stockholders should not expect dividends. We do not intend to pay any cash
dividends in the foreseeable future.
Employees
As of December 31, 2003, we had a workforce of 573 employees. Of our total
workforce, 80 are engaged in finance, administration and management, 6 are
engaged in new product applications and services, 300 are engaged in the
monitoring business, 75 are engaged in sales and marketing, and 112 are engaged
in service and installation of monitoring systems. None of our employees are
represented by a collective bargaining agreement, nor have we experienced work
stoppages. We believe that our relations with our employees are good.
Competition
The security alarm industry is highly competitive and fragmented. While we
generally do not compete directly with many of the large companies in the
industry such as ADT, a subsidiary of Tyco International, Inc., Brinks Home
Security, Inc., a subsidiary of the Brink's Company, Protection One, Inc. and
Honeywell International Inc. because we do not primarily sell and install
security systems, we are nonetheless impacted by the competitive challenge these
companies present to Dealers. While all of these companies provide monitoring
services, some of these companies, may from time to time, purchase portfolios of
monitoring contracts.
We compete with several companies that have alarm monitoring contract
acquisition and loan programs for Dealers and some of these competitors may be
better capitalized than us. There is also the potential for other entities such
as banks or finance companies to gain a better understanding of the industry and
become more active as a source of competition for alarm monitoring contract
acquisition and financing portions of our business. Further, we compete with
participants that primarily provide alarm monitoring contract acquisition and
financing services such as Security Alarm Financing Enterprises, Inc., Financial
Security Services, Inc., and Monitronics International, Inc.
History
We were formed as King Central in 1985 in the State of New Jersey. In 1986,
Thomas Few, Sr. our Vice Chairman, President and Chief Operating Officer joined
King Central as Executive Vice President and Chief Operating Officer and
acquired 20% of King Central's capital stock. In January 1998, as part of a
reorganization of King Central, Mr. Few, Sr.'s ownership was increased to 80%
and the remaining 20% was acquired by Timothy M. McGinn, our Chief Executive
Officer, and David L. Smith, a Director. At that time, we changed our name to KC
Acquisition.
In September 2002, KC Acquisition acquired all of the capital stock of Criticom
in exchange for $1.0 million and 155,911 shares of our common stock. An
additional 68,182 shares of our common stock has or will be issued to the
sellers based upon Criticom's financial performance in 2003. Criticom provides
wholesale alarm monitoring services to Dealers. In addition, it provides Global
Positioning System monitoring and asset tracking services to various customers.
Curtis Quady, an Executive Vice President, was the President, Chief Executive
Officer and principal stockholder of Criticom.
In connection with the acquisition of Criticom, we acquired a 5.03% interest in
Royal Thoughts, LLC. The purchase price was approximately $3.5 million net of
cash acquired of $0.6 million as well as a note for $0.7 million. In connection
with our purchase, we received a right of first refusal to provide any
monitoring services for new technology developed by Royal Thoughts.
M&S Partners, a New York general partnership equally owned by Mr. McGinn and Mr.
Smith began to acquire portfolios of alarm monitoring contracts from Dealers in
1992. Each contract was ultimately placed by M&S Partners with one of 41
leveraged trusts of which Mr. McGinn, Mr. Few, Sr. and Mr. Smith were the
beneficiaries. M&S Partners also acquired alarm monitoring contracts through
three limited liability companies (Guardian Group, LLC, Palisades Group, LLC and
Payne Security Group, LLC) which were owned by TJF Enterprises, LLC, which is
owned by Mr. Few, Sr., and First Integrated Capital Corporation, which is
majority owned by Mr. McGinn and Mr. Smith. They bundled those alarm monitoring
contracts and sold them as Trust Certificates collateralized by the underlying
alarm monitoring contracts and their recurring monthly revenue. We do not expect
to engage in securitizing alarm monitoring contracts in the future.
11
Between March and November 2002, IASI, a company that was controlled by Mr.
McGinn, Mr. Smith and Mr. Few, Sr., offered the holders of the trust
certificates the right to exchange such certificates for promissory notes of
IASI. Upon completion of the exchanges, all but eleven of the trusts were
liquidated and their assets were transferred to IASI. The trust certificates of
the remaining trusts were repaid with the proceeds of the offering and the
assets of the trusts were transferred to us. In January 2003, IASI entered into
a merger with a wholly owned subsidiary of ours and became our wholly owned
subsidiary. In connection with the acquisition of IASI, we issued an aggregate
of 772,192 shares of our common stock.
Palisades Group, LLC was the owner of approximately 38% of the alarm monitoring
contracts underlying the trusts. In January 2003, Palisades exchanged all of its
ownership interests for our stock and distributed such stock to its members, TJF
Enterprises, LLC and First Integrated Capital Corporation. In connection with
the acquisition of Palisades, we issued an aggregate of 25,000 shares of our
common stock. This acquisition was accounted for under the purchase method of
accounting. It is anticipated that Palisades will be liquidated concurrent with
this offering. In January 2003, Payne Security Group, LLC and Guardian Group,
LLC were acquired by us and became our wholly owned subsidiaries. In connection
with the acquisition of Payne Security Group, LLC, we issued an aggregate of
50,250 shares to TJF Enterprises, LLC, and First Integrated Capital Corporation.
In connection with the acquisition of Guardian Group, LLC, we issued an
aggregate of 16,750 shares to TJF Enterprises, LLC, and First Integrated Capital
Corporation.
Morlyn Financial Group, LLC was founded in May 2000 to assist Dealers who were
interested in selling their alarm monitoring contracts to IASI. Morlyn
originates alarm monitoring contracts for acquisition and provides due
diligence, billing and other related services. In connection with the
acquisition of Morlyn, in January 2003, we issued an aggregate of 17,000 shares
of our common stock to Messrs. McGinn, Few Sr., and Smith.
In June 1999, KC Acquisition acquired all of the assets and assumed certain
liabilities of Criticom CA, Inc., a monitoring call center in Santa Fe Springs,
California, in exchange for approximately $3.2 million. In May 2000, KC
Acquisition acquired 99.2% of the capital stock of Monital Signal Corporation in
exchange for approximately $10.7 million. Monital, located in Manasquan, New
Jersey, was KC Acquisition's largest competitor in the Northeast, United States.
In October 2001, KC Acquisition acquired Custom Design Security, an independent
wholesale alarm monitoring company which services the Western and Central
Regions of Florida, in exchange for approximately $1.2 million. In January 2002,
KC Acquisition acquired certain assets of RTC Alarm Monitoring Services, a large
alarm monitoring call center in California, in exchange for $5.1 million.
In January 2003, we effected a migratory merger into KC Alarm Services Group,
Inc., a Delaware corporation. The sole purpose of the migratory merger was to
change our jurisdiction of incorporation from New Jersey to Delaware. Subsequent
to the migratory merger, we assumed all of the assets and liabilities of
Integrated Alarm Services Group, Inc., a pre-existing, Delaware company whose
only activity was the sale of $5.5 million of convertible debentures. The
pre-existing Integrated Alarm Services Group, Inc. was then dissolved and we
changed our name to Integrated Alarm Services Group, Inc.
Risk Management
We carry insurance of various types, including general liability and errors and
omissions insurance. Our errors and omissions coverage is $5 million per
occurrence. Our loss experience and the loss experience of other companies in
the security industry may effect the cost and availability of such insurance.
Since 1998 we have had no uninsured losses. Certain of our insurance policies
and the laws of some states may limit or prohibit insurance coverage for
punitive or other types of damages, or liability arising from gross negligence
or wanton behavior. See "Risk Factors--Risk of Liability from Operations."
The nature of the services we provide potentially exposes us to greater risks of
liability for employee acts or omissions or systems failure than may be inherent
in other businesses. Our agreements with Dealers and end-users contain
provisions limiting our liability to end-users and Dealers in an attempt to
reduce this risk. However, in the event of litigation with respect to such
matters, there can be no assurance that these limitations will continue to be
enforced. In addition, the costs of such litigation could have an adverse effect
on us.
Regulatory Matters
A number of local governmental authorities have adopted or are considering
various measures aimed at reducing the number of false alarms. Such measures
include: (i) subjecting alarm monitoring companies to fines or penalties for
transmitting false alarms, (ii) licensing individual alarm systems and the
revocation of such licenses following a specified number of false alarms, (iii)
imposing fines on end-users for false alarms, (iv) imposing limitations on the
number of times the police will respond to alarms at a particular location after
a specified number of false alarms, and (v) requiring further verification of an
alarm signal before the police will respond.
Our operations are subject to a variety of other laws, regulations and licensing
requirements of federal, state and local authorities. In certain jurisdictions,
we are required to obtain licenses or permits to comply with standards governing
employee selection and training and to meet certain standards in the conduct of
our business. Many jurisdictions also require certain of our employees to obtain
licenses or permits.
12
The alarm industry is also subject to requirements imposed by various insurance,
approval, listing and standards organizations. Depending upon the type of
end-user served, the type of service provided and the requirements of the
relevant local governmental jurisdiction, adherence to the requirements and
standards of such organizations is mandatory in some instances and voluntary in
others.
Our alarm monitoring business utilizes radio frequencies to transmit alarm
signals. The Federal Communications Commission and state public utilities
commissions regulate the operation and utilization of radio frequencies.
Item 2. Properties
In September 2003, the Company entered into a five year lease for office space
for its headquarters in Albany, NY. The lease is for approximately 21,000 square
feet. The lease period is November 15, 2003 through November 14, 2008. The lease
has a five year renewal option. Annual rents will be $190,000 for year one and
two and $225,000 for years three through five.
We also have offices and our East Coast call monitoring center in Manasquan, New
Jersey. The facility is 7,200 square feet. We own the premises, free of any
encumbrances.
Morlyn's executive offices are located in Oakland, New Jersey. The offices are
4,705 square feet. The lease expires in March 2006 and provides for a monthly
rental of $6,665.
Our call monitoring center in California is located in Santa Fe Springs. The
facility is 6,551 square feet. The premises are leased pursuant to a two-year
lease expiring in March 2005, at a monthly rental rate of approximately $5,600
per month.
We also have a call monitoring center in Minneapolis, Minnesota. The facility is
13,478 square feet. The lease expires in 2010, and provides for a net monthly
rental rate of $6,360.
As a result of the acquisition of PSI and AHS, we acquired two sales, service
and administration offices as well as seven sales and service branch offices
located in California, New Mexico, Arizona and Nevada. The leases expire at
various dates through 2007 and currently have a monthly rental rate of $58,807.
Item 3. Legal Proceedings
In March of 2003, Protection One Alarm Monitoring, Inc., a company engaged in
the business of providing security and other alarm monitoring services to
residential and commercial customers, brought an action against us in the
Superior Court of New Jersey, Camden County for unspecified damages in
connection with our purchase of certain alarm monitoring contracts from B&D
Advertising Corporation ("B&D"). B&D had previously sold alarm monitoring
contracts to Protection One. As part of such sales, B&D agreed not to solicit
any customers whose contracts had been purchased and to keep certain information
confidential. Protection One claims that our subsequent purchase of contracts
from B&D constitutes tortuous interference, that we utilized confidential
information belonging to Protection One and that Protection One had an interest
in some of the contracts that we purchased from B&D. We plan to vigorously
defend this claim. We believe the resolution of this matter will not have a
material adverse effect on our financial condition, results of operations or
cash flows.
In May 2003, a former employee of McGinn, Smith & Co., Inc., brought an action
against us, as well as McGinn, Smith & Co., Inc. and M&S Partners for wrongful
termination. The suit brought in the Supreme Court of the State of New York
seeks damages of $10,000,000. McGinn, Smith & Co., Inc. and M&S Partners have
fully indemnified us from any damages or legal expenses that we may incur as a
result of the suit. This employee of McGinn, Smith & Co., Inc., was never our
employee and we plan to vigorously defend this claim. We believe the resolution
of this matter will not have a material adverse effect on our financial
condition, results of operations or cash flows.
On December 9, 2003, a complaint was filed against the Company in the United
States District Court in the southern District of New York entitled Ian Meyers
v. Integrated Alarm Services Group, Inc., et al. The Plaintiff alleges, among
other things, that the Company and its professionals engaged in transactions
with the Company that were designed to defraud plaintiff out of funds he was
entitled to pursuant to Plaintiff's agreement with First Integrated Capital
Corp. ("FICC"), his employer, and a company in which he had an equity interest.
FICC was also an affiliate of the Company that sold a portfolio of alarm
contracts to the Company. In particular, plaintiff alleges that the Company and
certain of its principals removed valuable revenue-generating assets from FICC
and transferred the FICC contracts to the Company for less than fair value.
Plaintiff is seeking damages in the amount of $3,000,000. A mediation conference
before the court has been scheduled for April 22, 2004. The Company believes
that the suit is without merit and intends to vigorously defend itself. We
believe the resolution of this matter will not have a material adverse effect on
our financial condition, results of operations or cash flows.
13
We from time to time experience routine litigation in the normal course of our
business. We do not believe that any pending litigation will have a material
adverse effect on our financial condition, results of operations or cash flows.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of stockholders during the fourth quarter of
the fiscal year ended December 31, 2003, through the solicitation of proxies or
otherwise.
Part II
Item 5. Market for Registrant's Common Stock and Related Stockholder Matters
The Company's common stock is traded in the NASDAQ National Market System under
the symbol IASG. The Company's common stock was first traded on the NASDAQ
during the third quarter of 2003. Quarterly high and low bid information for the
third and fourth quarter of 2003 as reported by NASDAQ for normal trading hours
(4 pm EST closing) are set forth below:
2003
----
High Low
---- ---
Quarter
-------
3rd $9.99 $7.75
4th 9.50 6.95
These over the counter market quotations reflect inter-dealer prices, without
retail mark-up, mark-down or commission and may not necessarily represent actual
transactions.
No dividends have been paid on the common shares to date and none are
anticipated for the foreseeable future.
As of December 31, 2003 there were 24,607,731 common shares issued and
outstanding held by 17 shareholders of record, not including persons or entities
where stock is held in nominee or "street" name through various brokerage firms
or banks.
The Company filed a Registration Statement (333-101159) with the Securities and
Exchange Commission on June 27, 2003 to register 25,300,000 shares of common
stock for sale at an aggregate offering price of approximately $278,300,000. The
offering commenced on July 23, 2003 and terminated on August 22, 2003. Upon
completion, the managing underwriter, Friedman, Billings, Ramsey & Co., Inc.,
successfully sold 22,982,729 shares at $9.25 per share for an aggregate offering
price of approximately $212,590,243. Concurrently with the offering, 792,793
shares of common stock were registered on behalf of certain holders of
convertible promissory notes. All of the shares of common stock were sold by us
and none of the selling security holders' shares were underwritten in the
offering.
Initial Public Offering Proceeds
Common stock issued $ 212,590,243
--------------
Underwriter commissions (7%) 14,881,317
Expenses paid to underwriter 573,230
Other expenses 1,279,186
--------------
Total expenses 16,733,733
--------------
Net Offering Proceeds $ 195,856,510
==============
Use of Proceeds (through December 31, 2003)
Repayment of debt $ 91,910,820
Acquisition of contracts and businesses 68,137,570
New dealer loans 3,073,316
Working capital 2,243,553
--------------
Total uses $ 165,365,259
==============
Temporary Investments as of December 31, 2003
Cash and cash equivalents $ 30,491,251
--------------
Total temporary investments $ 30,491,251
==============
14
Item 6. Selected Financial Data
The following selected financial data have been derived from the Consolidated
Financial Statements of the Company.
Year ended December 31
1999 2000 2001 2002 2003
------------- ------------- ------------- ------------- -------------
Statement of operations data (1):
Revenue $ 12,721,583 $ 18,774,517 $ 20,569,037 $ 23,495,607 $ 40,867,598
Total operating expenses, inclusive of
cost of revenue 13,337,323 19,455,562 19,691,838 24,267,532 44,517,078
------------- ------------- ------------- ------------- -------------
Income (loss) from operations (615,740) (681,045) 877,199 (771,925) (3,649,480)
Other (expense), net (2,475,054) (3,824,867) (3,914,509) (5,556,730) (14,828,508)
------------- ------------- ------------- ------------- -------------
Income (loss) before income taxes (3,090,794) (4,505,912) (3,037,310) (6,328,655) (18,477,988)
Income tax expense (benefit) -- (4,793,725) (703,784) (681,443) 3,526,572
------------- ------------- ------------- ------------- -------------
Net income (loss) $ (3,090,794) $ 287,813 $ (2,333,526) $ (5,647,212) $ (22,004,560)
============= ============= ============= ============= =============
Basic and diluted income (loss) per share $ (5.58) $ 0.52 $ (4.21) $ (9.53) $ (1.95)
============= ============= ============= ============= =============
Shares used computing basic and diluted
income (loss) per common share (2) (4) (5) 553,808 553,808 553,808 592,785 11,263,455
Pro forma income tax to give effect as
if a C corporation (3):
Loss before income tax expense (benefit) (4,505,912) (3,037,310) (6,328,655) (18,477,988)
Income tax expense (benefit) (1,519,990) (955,569) (2,871,573) (89,916)
------------- ------------- ------------- -------------
Net income (loss) $ (2,985,922) $ (2,081,741) $ (3,457,082) $ (18,388,072)
============= ============= ============= =============
Net income (loss) per share $ (5.39) $ (3.76) $ (5.83) $ (1.63)
============= ============= ============= =============
Balance sheet data:
Cash, cash equivalents and short-term
investments $ 717,586 $ 1,151,337 $ 1,224,035 $ 3,442,082 $ 35,435,817
Total assets 24,350,032 38,113,543 36,830,768 45,627,797 241,036,330
Long-term debt 22,319,837 35,599,770 37,122,449 45,061,363 65,742,612
Capital lease obligations 258,021 145,355 32,549 507,858 885,366
Total stockholders' equity (deficit) (7,025,866) (7,067,197) (9,345,667) (11,562,881) 153,402,730
Working capital (deficit) (3,975,589) (5,240,872) (7,798,161) (8,076,758) 4,769,173
Other financial data:
Cash provided by (used in) operating activities (32,010) (1,331,125) 1,012,251 2,691,844 (4,238,641)
Cash provided by (used in) investing activities (3,878,468) (11,086,367) (1,705,428) (8,863,018) (57,984,339)
Cash provided (used in) financing activities 3,520,347 12,851,242 765,875 5,389,221 97,216,715
(1) Results of operations for acquired companies are included from the
date of acquisition. As a result comparability of periods presented has been
effected by our acquisitions. For more information about our acquisition
history, see "Business", Management's Discussion and Analysis of Financial
Condition and Results of Operations" and Note 11 to our consolidated financial
statements.
(2) On January 8, 2003, our Board of Directors approved a 6,033-for-one
stock split, as a result, share data has been retroactively restated for all
periods presented.
(3) To give effect to the conversion of KC Acquisition from an S
corporation to a C corporation for federal income tax purposes. The tax
provision was prepared as if we had a combined federal and state effective tax
rate of 40% and giving effect for permanent differences.
(4) On April 17, 2003, the Company's Board of Directors approved a one
for two reverse common stock split, as a result, share data has been
retroactively restated for all periods presented.
(5) During July 2003, the Company successfully completed its IPO and
issued a total of 22,982,729 shares of common stock and received net proceeds of
$195,856,512.
15
Equity Compensation Plan Information
- --------------------------- -------------------------- -------------------------------------- -----------------------------------
Plan category Number of Securities to Weighted-average exercise price of Number of securities remaining
be issued upon exercise outstanding options, warrants and available for future issuance
of outstanding options, rights under equity compensation plans
warrants and rights (excluding securities reflected
in column (a))
- --------------------------- -------------------------- -------------------------------------- -----------------------------------
Equity compensation plans 48,000 $9.25 102,000
approved by security
holders
- --------------------------- -------------------------- -------------------------------------- -----------------------------------
Equity compensation plans -0- -0- -0-
not approved by security
holders
- --------------------------- -------------------------- -------------------------------------- -----------------------------------
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations
The following discussion and analysis of our financial condition and results of
operations should be read together with the financial statements and the related
notes included in another part of this prospectus. This discussion contains
forward-looking statements that involve risks and uncertainties.
Overview
We provide an integrated solution to independent security alarm Dealers, to
assist them in competing in the residential and commercial security alarm
market. Our services include wholesale alarm monitoring and financing solutions,
including purchasing Dealers' alarm monitoring contracts for our own portfolio
and providing loans to Dealers collateralized by those alarm monitoring
contracts. We also provide support for our Dealers including billing,
collection, marketing and access to equipment discount programs. We believe our
package of services allows Dealers to compete against self- monitoring national
providers in the security alarm market by giving them access to technical
sophistication, financing, back office and other services that they would not
otherwise have, while allowing them to remain the local and visible contact with
their customer, the end-user of the alarm.
We believe we are the largest wholesale alarm monitoring company in the United
States, monitoring approximately 410,000 alarm systems on behalf of
approximately 5,000 Dealers. Our alarm monitoring service is provided through
three state-of-the-art alarm monitoring centers located in New Jersey, Minnesota
and California. Our operators respond to approximately 365,000 alarm activations
per month. We are also one of the largest providers of capital to Dealers. Since
1993, we have provided financing to the alarm industry in the form of loans or
the purchase of alarm monitoring contracts of approximately $424 million in the
aggregate. We currently hold and monitor approximately 119,000 alarm monitoring
contract equivalents in our own portfolio.
Our revenues are derived primarily from our portfolio of customer accounts and
providing alarm monitoring services to Dealers for the benefit of the end-user
of the alarm system. We typically enter into contracts with our Dealers to
provide alarm monitoring services for periods ranging from one to five years.
The majority of monitoring contracts entered into by end-users with our Dealers
generally permit cancellation with notice of 30-60 days before the end of the
original, or any renewal, contract term. Some alarm monitoring contracts with
Dealers have longer, more definitive terms. However, essentially all alarm
monitoring contracts may be broken for non-performance. Our alarm monitoring
contracts with Dealers may require the Dealer to place its entire portfolio of
end-user alarm monitoring contracts in our monitoring facilities. Our revenues
will fluctuate based upon changes in the net number of end-user alarm monitoring
contracts and the timing of connections and disconnections that any one Dealer
has with us. Our revenues will also fluctuate based upon the number of Dealers
that are added or lost during any particular period. We may gain or lose Dealers
based upon the quality, range or price of the services we provide relative to
what is provided by our competitors and the effectiveness of our sales and
marketing efforts. Our revenues may also be affected by the application of
various pricing strategies we may choose to use with our Dealers.
In addition to our organic revenue growth, our revenues will increase because of
acquisitions of customer accounts and wholesale alarm monitoring businesses
(i.e. call centers or central stations) we may make during any particular
period. Our recurring monthly revenues derived from acquired businesses are also
subject to the standard risks associated with any acquisition and subsequent
integration. We may suffer attrition because of differences in, among other
things, the application of policies and procedures, or disruption caused by any
conversion or consolidation activity.
The cost of services is primarily a function of labor, telecommunication, data
processing and technical support costs. Labor costs are driven in part by the
number and productivity of operators, supervisors and management within our call
centers that provide alarm monitoring services on behalf of our Dealer
customers. Labor costs are also a function of the quality of our data
processing, customer service and quality management functions. Labor costs also
reflect the number of technical staff required to maintain and develop our
state-of-the-art monitoring systems. Telecommunication costs reflect, among
other things, the number of signals processed, the time required to process any
particular signal, the number and type of lines, the design and functionality of
our telecommunications network and the negotiated rate with our chosen
telecommunication providers. We are constantly evaluating how to improve the
quality of our services while lowering the cost of providing those services. We
estimate that we presently have sufficient capacity to provide alarm monitoring
services to approximately 750,000 end-users.
16
Our operating expenses are primarily comprised of general and administrative,
selling and marketing and depreciation and amortization expenses. General and
administrative expenses are comprised primarily of office staff and officer
salaries, rent and professional fees. Fluctuations in general and administrative
expenses generally reflect net increases in staff associated with acquisitions,
changes in professional fees primarily associated with acquisition activity and
audits of our books and records and merit compensation increases. Selling and
marketing expenses are primarily driven by the size of our sales force,
commissions based upon successful selling activities, travel and advertising.
Depreciation and amortization expenses are primarily a function of the
acquisition of Dealer relationships and alarm monitoring contracts.
Streamlining of Operations
We have completed the consolidation of two alarm monitoring facilities to
improve operating efficiencies. During 2001, we commenced the process of
consolidating our Van Nuys, California alarm monitoring facility into our alarm
monitoring facility in Santa Fe Springs, California and consolidating our
Hackensack, New Jersey alarm monitoring facility into our alarm monitoring
facility in Manasquan, New Jersey. The consolidations were completed in August
2002. The Manasquan facility now monitors approximately 270,000 accounts. The
Santa Fe Springs facility now monitors approximately 155,000 accounts. We have
identified approximately $2.0 million in annualized expense reductions that we
have realized from the consolidations. The major expense categories where we
have realized savings include telecommunications, operator salaries and rent
expenses. The savings are related to the acquisitions of Monital, Custom Design
Security and RTC Alarm Monitoring Services.
Acquisitions
In December 2003, we acquired all of the capital stock of Lane Security Inc.
("Lane Security") for approximately $43,035,000 in cash, net of holdbacks for
severance payments and attrition of customer contracts. The principal operating
unit of Lane Security is Protection Service Industries, L.P. ("PSI") whose
assets include customer accounts with recurring monthly revenue ("RMR") of
approximately $1,760,000 at December 31, 2003. PSI installs and services
commercial and residential alarm systems in the western United States. The
acquisition was accounted for under the purchase method of accounting.
On November 21, 2003, we acquired all of the outstanding stock of American Home
Security, Inc. (AHS) and certain assets of Emergency Response Network, Inc.
(ERN), (collectively referred to as the acquirees) for approximately $15.0
million inclusive of direct acquisition costs. The acquirees install and service
residential alarm monitoring systems in the Nevada area. The acquisition has
been accounted for as a purchase and the results of the acquirees are included
in the Company's results of operations from the date of acquisition (November
21, 2003). In addition, the former owner of AHS will receive additional
consideration of up to 130,000 shares of Company common stock and up to 140,000
Company stock options, if AHS achieves certain earnings levels in 2004.
Furthermore, the Company entered into a three year employment agreement with the
former owner of AHS. The agreement provides for annual compensation of $420,000
and an annual bonus commencing in 2004 equal to 19% of the amount by which AHS's
pre-tax income (as defined in the agreement) for such year exceeds $1,250,000.
The Company has the option to make a one-time payment up to 125% of AHS' pre-tax
income to the employee under a bonus buy-out provision as defined in the
agreement, at which time the Company would have no further annual bonus
obligation to the employee. The employee for calendar years 2006-2009 has the
right to elect a bonus buy-out. Furthermore, the bonus buy-out shall
automatically trigger upon the expiration of the employment term, and under
other circumstances as defined in the agreement. The agreement also provides
that during the employment term, the employee on an annual basis, will be
granted options to acquire Company common stock if AHS achieves certain earnings
levels. The contingent consideration which includes Company common stock and
stock options issuable upon the achievement of certain earnings levels, may
result in future charges to earnings.
In January 2003, we acquired all of the capital stock of Integrated Alarm
Services, Inc. and affiliates in exchange for an aggregate of 864,192 shares of
our common stock of which 525,452 shares were issued to minority interests for
an estimated total fair value of $11,559,944. The acquisition was accounted for
under the purchase method of accounting.
Prior to the acquisition of Integrated Alarm Services, Inc., Messrs. McGinn and
Smith controlled 41 trusts and three limited liability companies which were
principally created to acquire alarm monitoring contracts. Approximately 62% of
the trust certificates of the 41 trusts were exchanged for promissory notes of
Integrated Alarm Services, Inc. and some of these notes were repaid with
proceeds from the offering. Approximately 38% of the trust certificates were not
exchanged and were subsequently repaid out of the proceeds of the offering. An
additional $9.5 million of bank debt relating to these contract acquisitions was
also repaid with proceeds from the offering. Messrs. McGinn and Smith were
residual beneficiaries of these trusts but have contributed their residual
benefits in the trusts to us. The three limited liability companies, Palisades
Group, LLC, Payne Security Group, LLC and Guardian Group, LLC were acquired by
us in January 2003 and are now our wholly owned subsidiaries.
17
On September 26, 2002, we acquired 100% of Criticom, a Minnesota based alarm
monitoring call center that supports digital alarm monitoring as well as GPS
technology, for approximately $4.3 million, net of cash acquired of $0.6
million. The total consideration consisted of $1.0 million in cash and 155,911
shares of our common stock as well as a note totaling $0.7 million. The former
shareholders of Criticom may receive up to 68,182 additional shares of the
Company's common stock based upon the future performance of Criticom. In 2003,
Criticom achieved its performance targets, as a result, the former shareholders
of Criticom will receive 68,182 shares of Company common stock with an aggregate
value of $630,684. The purchase of Criticom added approximately 400 Dealer
relationships that service 80,000 end-user alarm monitoring contracts with
approximately $0.4 million in recurring monthly revenue.
In connection with the Criticom transaction, IASG also acquired a 5.03% interest
in Royal Thoughts, LLC, a Minnesota limited liability company engaged in the
development of new monitoring applications and monitoring technologies for
emerging markets. In connection with our investment in Royal Thoughts, we
obtained a right of first refusal to monitor signals that stem from Royal
Thoughts' intellectual property and designs.
In January 2002, we acquired certain assets of RTC Alarm, a wholesale security
system alarm monitoring business located in Roseville, California. The total
purchase price was $5.1 million, which included Dealer relationships ($4.4
million), accounts receivable ($0.2 million) and property & equipment ($0.5
million). The purchase was financed with debt totaling $5.8 million, which
funded the purchase price, along with providing a $0.425 million working capital
infusion for us, $0.1 million in restricted cash and financing fees totaling
$0.175 million. The acquisition initially added 270 Dealers to our Dealer count.
As of January 2003, 225 Dealers remain. We pursued a cause of action against the
seller for certain contractual misrepresentations regarding the attrition rates
related to certain Dealer alarm monitoring contracts and received a settlement
in 2003 for $375,000.
In October 2001, we acquired certain assets of Custom Design, a wholesale
security alarm monitoring business located in Sarasota, Florida for $1.2
million, which included Dealer relationships ($1.0 million), accounts receivable
($0.1 million) and property & equipment ($0.1 million). This acquisition was
financed with debt totaling $1.425 million. The sellers received $1.2 million,
while we retained the balance for working capital ($0.1 million), financing fees
($0.075 million) and an attrition reserve fund ($0.05 million). The Custom
Design acquisition initially added 94 Dealers to our Dealer count. As of January
2003, 76 Dealers remain.
A related party placed the debt incurred for the RTC Alarm and the Custom Design
acquisitions and assumed in the acquisition of Criticom. The results of
operations are included in our financial statements from the date of
acquisition.
As a result of this activity, as of December 31, 2003, we have customer
contracts of $73,571,131, dealer relationships of $23,113,617 and goodwill of
$85,515,985.
Operations
In December 2001, we commenced a consolidation process of our monitoring
facilities and a systems conversion for a material percentage of our Dealer and
end-user base. The disruption caused by these activities negatively impacted our
revenues and profitability. We have completed the consolidation of our central
stations. Key expenses such as payroll and telephone line costs have been
reduced. We believe our costs per subscriber will decline as additional
subscriber accounts are added.
Our recurring monthly revenue may include amounts billable to customers or
Dealers with past due balances which we believe are collectible. We seek to
preserve the revenue stream associated with each end-user alarm monitoring
contract, primarily to maximize our return on the investment we made to generate
each alarm monitoring contract or Dealer relationship. As a result, we actively
work to collect amounts owed to us and to retain the end-user at the same time.
In some instances, we may allow more than six months to collect past due
amounts, while evaluating the ongoing customer or Dealer relationship. After we
have made every reasonable effort to collect past due balances, we will
disconnect the customer and include the loss in attrition calculations.
Customer creation and marketing
Our current customer acquisition strategy relies on both internally generated
sales and acquiring Dealer relationships and alarm monitoring contract rights to
monitor security systems. We currently have a salaried and commissioned sales
force that operates in four regions covering the 48 contiguous states. The
internal sales program generated in the wholesale segment 99,106, 84,616, and
64,472 new monitoring contracts in 2001, 2002 and 2003, respectively.
Attrition
End-user attrition has a direct impact on our results of operations since it
affects our revenues, amortization expense and cash flow. We define attrition in
the wholesale alarm monitoring business as the number of end-user accounts lost,
expressed as a percentage, for a given period. In some instances, we use
estimates to derive attrition data. We monitor end-user attrition each month,
each quarter and each year. In periods of end-user account growth, end-user
attrition may be understated and in periods of end- user account decline,
end-user attrition may be overstated. Our actual attrition experience shows that
the relationship period with any individual Dealer or end-user can vary
significantly. Dealers discontinue service with us for a variety of reasons,
including but not limited to, the sale of their alarm monitoring contracts,
performance issues and receipt of lower pricing from competitors. End-users may
discontinue service with the Dealer and therefore with us for a variety of
reasons, including, but not limited to, relocation, service issues and cost. A
portion of Dealer and end-user relationships, whether acquired or originated via
our sales force, can be expected to discontinue service every year. Any
significant change in the pattern of our historical attrition experience would
have a material effect on our results of operations, financial position or cash
flows.
18
For the years ended December 31, 2001, 2002 and 2003, our trailing annual
end-user account growth rates in the wholesale monitoring segment, including
acquisitions were 14.0%, 24.7% and 12.3%, respectively. For the years ended
December 31, 2001, 2002 and 2003, our trailing annual end-user account growth
rates in the wholesale monitoring segment, excluding acquisitions, were 10.6%,
(6.1%) and (3.2%), respectively. For the years ended December 31, 2001, 2002 and
2003, our trailing annual end-user attrition rates in the wholesale monitoring
segment, calculated as end-user losses divided by the sum of beginning
end-users, end- users added and end-users acquired, was 13.9%, 18.2%,and 12.7%
respectively. Included in these totals for 2003 are approximately 137,000
contracts that are owned by our retail monitoring segment.
2001 2002 2003
------- ------- -------
Beginning balance, January 1,................... 342,345 390,216 486,650
End-users added, excluding acquisitions......... 99,106 84,616 64,472
End-users acquired.............................. 11,557 120,192 75,375
End-user losses................................. 62,792 108,374 79,848
------- ------- -------
Ending Balance, December 31,.................... 390,216 486,650 546,649
======= ======= =======
We engaged Standard & Poor's Corporate Value Consulting to perform attrition
analyses of certain identified customer relationship groups. As a result of the
study, we identified our end-user attrition rates in the retail customer
contract segment to be 17.2% and 15.4% for the years ending December 31, 2000
and 2001, respectively. In 2000, the majority of the alarm monitoring contracts
we acquired were by foreclosure from Dealers to whom we had made loans. As a
result, our attrition rate was adversely affected in 2000, with carryover into
2001. The Standard & Poor's study presents data for accounts acquired by bulk
purchase, which represents the majority of our end-user alarm monitoring
contracts, which suggests that the maximum expected amortizable life of alarm
monitoring contracts purchased in bulk is approximately 18 years.
We intend to employ, for prospective contracts purchased in bulk subsequent to
January 31, 2003, an amortization methodology which is the total of the charges
calculated by a straight line, 18 year life; together with charges incurred as a
result of actual account attrition.
For contracts previously purchased in bulk by IASI and acquired upon purchase of
IASI on January 31, 2003, we employ an amortization methodology which uses 150%
declining balance over a life of 8 years.
As a result of recent acquisitions, our portfolio of customer accounts has had
substantial growth during the fourth quarter of fiscal 2003. The RMR (recurring
monthly revenue) of active customer accounts of the Company at December 31, 2003
($3,579,513) is more than three times what it was at September 30, 2003
($1,169,039). As a result of this growth, it is more meaningful to present
attrition rates as if the portfolio's purchased had been owned by us as of
September 30, 2003.
The annualized attrition rates, based upon customer accounts cancelled or
becoming significantly delinquent, during the fourth quarter are as follows:
Portfolio Attrition Rate Active RMR at December 31, 2003
- ---------------------- -------------- -------------------------------
Legacy and flow 18.4% $ 1,085,712
Residential since IPO 12.0% 1,485,768
Commercial since IPO 6.8% 1,008,033
-----------
Total 12.5% $ 3,579,513
-----------
Attrition for acquired Dealer customer relationships and alarm monitoring
contracts may be greater in the future than the attrition rate assumed or
historically incurred by us. In addition, because some Dealer customer
relationships and acquired alarm monitoring contracts are prepaid on an annual,
semi-annual or quarterly basis, attrition may not become evident for some time
after an acquisition is consummated.
19
Critical Accounting Policies
Our discussion and analysis of results of operations, financial condition and
cash flows are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States of America (GAAP). The preparation of these consolidated financial
statements requires us to make estimates and judgments that effect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosure of
contingent assets and liabilities. We evaluate our estimates on an on-going
basis, including those related to accounts receivable and notes receivable
reserves, Dealer relationships, customer contracts, goodwill, income taxes, and
contingencies and litigation. We base our estimates on historical experience and
on various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different
assumptions or conditions.
Note 2 of the "Notes to Financial Statements" includes a summary of the
significant accounting policies and methods used in the preparation of our
financial statements. The following is a brief description of the more
significant accounting policies and methods we use.
Revenue recognition
All of our revenue is recognized on an accrual basis. Accounts receivable
consists primarily of amounts due from Dealers and end- users located in the
United States. Credit is extended based upon an evaluation of the Dealer's and
end-users' financial condition and credit history. Receivables that are deemed
not collectible have been provided for in our allowance for doubtful accounts.
If the Dealers financial condition were to deteriorate, resulting in their
inability to make payments, additional allowances may be required.
Notes receivable
IASI makes loans to Dealers, which are collateralized by the Dealers' portfolio
of end-user alarm monitoring contracts. Loans to Dealers are carried at the
lower of the principal amount outstanding or the net realizable value of the
portfolio underlying the loan. Loans are generally considered nonperforming if
they are 120 days in arrears of contractual terms.
Management periodically evaluates the loan portfolio to assess the
collectibility of Dealer notes and adequacy of allowance for loan losses.
Management reviews certain criteria in assessing the adequacy of the allowance
for loan losses including IASI's past loan loss experience, known and inherent
risks in the portfolio, adverse situations that may affect the borrower's
ability to repay, the estimated value of any underlying collateral and current
economic conditions. Loan impairment is identified when a portfolio's cash flow
is materially below the minimum necessary to service the loan. In most cases,
loans will be foreclosed and valued at the lower of cost (loan carrying value)
or fair value of end-user contracts using recent transaction prices and industry
benchmarks.
Notes receivable consists of loans to Dealers which are collateralized by a
portfolio of individual end-user monitoring contracts. If a Dealer becomes
delinquent, the Company generally forecloses on and takes ownership of the
portfolio of end-user monitoring contracts.
Deferred installation costs and revenues
The direct incremental costs associated with installing monitoring systems and
the related revenue from those sales are deferred and recognized over the
expected life of the customer relationship.
Deferred issuance costs
Debt issuance costs represents direct costs incurred in connection with
obtaining financing with related parties and banks. Debt issuance costs are
being amortized over the life of the related obligations using the effective
interest method.
Intangible assets
Alarm monitoring services for Dealers' end-users are outsourced to us. We
acquire such Dealer relationships from our internally generated sales efforts
and from other monitoring companies. Acquired dealer relationships are recorded
at cost which management believes approximates fair value. End-user alarm
monitoring contracts are acquired from the Dealers' pre-existing portfolios of
contracts or assumed upon the foreclosure on Dealers' loans.
Acquired end-user alarm monitoring contracts are recorded at cost which
management believes approximates fair value. End-user alarm monitoring contracts
assumed as a result of foreclosure on Dealer loans are recorded at the lower of
cost (loan carrying value) or the fair value of such contracts using recent
transaction prices and industry benchmarks at the time of foreclosure.
End-user alarm monitoring contracts are amortized over the term that such
end-users are expected to remain a customer of the Company. The Company, on an
ongoing basis, conducts comprehensive reviews of its amortization policy for
end-user contracts and, when deemed appropriate, uses an independent appraisal
firm to assist in performing an attrition study.
The Company's amortization methods for end-user contracts below consider the
average estimated life and historical and projected attrition rates determined
from actual experience and a recent attrition study and consists of the
following portfolios:
20
Acquired as a result of the IASI merger:
Existing at January 31, 2003 Accelerated method Period
- ----------------------------------- ----------------------------- --------
Existing portfolio accounts (bulk) 150% Declining balance 8 years
Dealer acquired new accounts (flow) 160% Declining balance 8 years
Contracts assumed from dealers 160% Declining balance 4 years
Acquired subsequent to the IASI merger:
Acquired after January 31, 2003
- -----------------------------------
Existing portfolio accounts (bulk) Straight-line plus attrition 18 years
Dealer acquired new accounts (flow) 200% Declining balance 12 years
Contracts assumed from dealers 200% Declining balance 8 years
Dealer relationships and customer (end-user) contracts are amortized using
methods and lives which are management's estimates, based upon all information
available (including industry data, attrition studies, current portfolio
trends), of the life (attrition pattern) of the underlying contracts and
relationships. If actual results vary negatively (primarily attrition) from
management assumptions, amortization will be accelerated which will negatively
impact results from operations. If amortization is not accelerated or conditions
deteriorate dramatically, the asset could become impaired. For existing
portfolio accounts purchased subsequent to January 31, 2003, the Company will
amortize such accounts using a straight-line method over an 18 year period plus
actual attrition. This methodology may cause significant variations in
amortization expense in future periods.
Dealer relationships and end-user alarm monitoring contracts are tested for
impairment on a periodic basis or as circumstances warrant. Recoverability of
Dealer relationship costs and end-user alarm monitoring contracts are highly
dependent on our ability to maintain our Dealers. Factors we consider important
that could trigger an impairment review include higher levels of attrition of
Dealers and/or end-user alarm monitoring contracts and continuing recurring
losses.
In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets, which supersedes SFAS No. 121, "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
of," and the accounting and reporting provisions of APB No. 30. SFAS No. 144
addresses financial accounting and reporting for the impairment or disposal of
long-lived assets and is effective for fiscal years beginning after December 15,
2001, and interim periods within those fiscal years. SFAS No. 144 requires that
the assets be reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of the assets to be held and used is measured by a
comparison of the carrying amount of the assets with the future net cash flows
expected to be generated. Cash flows of dealer relationships and retail customer
contracts are analyzed at the same group level (acquisition by acquisition and
portfolio grouping, respectively) that they are identified for amortization, the
lowest level for which independent cash flows are identifiable. All other
long-lived assets are evaluated for impairment at the company level, using one
asset grouping. If such assets are considered to be impaired, the impairment to
be recognized is measured by the amount by which the carrying amount of the
assets exceeds their fair values. We have not identified any such impairment
losses.
Goodwill was being amortized on a straight-line basis over its estimated useful
life of 15 years through December 31, 2001. Effective January 1, 2002, we
adopted SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS 142 changed
the accounting for goodwill from an amortization method to an impairment-only
approach. An initial transition impairment test of goodwill was required as of
January 1, 2002. We completed this initial transition impairment test during the
second quarter of 2002, which did not result in any impairment charges. An
impairment test is performed annually in the third quarter. To date, no
impairment charges were required. A significant triggering event may occur in
future periods that will require an interim assessment of goodwill and could
result in a future impairment charge to earnings.
Income taxes
As part of the process of preparing our combined financial statements, we will
be required to estimate our income taxes in each of the jurisdictions in which
we operate. This process will involve estimates of our actual current tax
exposure together with assessing temporary differences resulting from differing
treatment of items, such as depreciation and amortization, for tax and
accounting purposes.
21
Litigation
In March 2003, Protection One Alarm Monitoring, Inc., a company engaged in the
business of providing security and other alarm monitoring services to
residential and commercial customers, brought an action against us in the
Superior Court of New Jersey, Camden County for unspecified damages in
connection with our purchase of certain alarm monitoring contracts from B&D
Advertising Corporation ("B&D"). B&D had previously sold alarm monitoring
contracts to Protection One. As part of such sales, B&D agreed not to solicit
any customers whose contracts had been purchased and to keep certain information
confidential. Protection One claims that our subsequent purchase of contracts
from B&D constitutes tortious interference, that we utilized confidential
information belonging to Protection One and that Protection One had an interest
in some of the contracts that we purchased from B&D. We plan to vigorously
defend this claim. We believe the resolution of this matter will not have a
material adverse effect on our financial condition, results of operations or
cash flows.
In May 2003, a former employee of McGinn, Smith & Co., Inc., brought an action
against us, as well as McGinn, Smith & Co., Inc. and M&S Partners for wrongful
termination. The suit brought in the Supreme Court of the State of New York
seeks damages of $10,000,000. McGinn, Smith & Co., Inc. and M&S Partners have
fully indemnified us from any damages or legal expenses that we may incur as a
result of the suit. This employee of McGinn, Smith & Co., Inc. was never our
employee and we plan to vigorously defend this claim. We believe the resolution
of this matter will not have a material adverse effect on our financial
condition, results of operations or cash flows.
On December 9, 2003, a complaint was filed against the Company in the United
States District Court in the southern District of New York entitled Ian Meyers
v. Integrated Alarm Services Group, Inc., et al. The Plaintiff alleges, among
other things, that the Company and its professionals engaged in transactions
with the Company that were designed to defraud plaintiff out of funds he was
entitled to pursuant to Plaintiff's agreement with First Integrated Capital
Corp. ("FICC"), his employer, and a company in which he had an equity interest.
FICC was also an affiliate of the Company that sold a portfolio of alarm
contracts to the Company. In particular plaintiff alleges that the Company and
certain of its principals removed valuable revenue-generating assets from FICC
and transferred the FICC contracts to the Company for less than fair value.
Plaintiff is seeking damages in the amount of $3,000,000. A mediation conference
before the court has been scheduled for April 22, 2004. The Company believes
that the suit is without merit and intends to vigorously defend itself. We
believe the resolution of this matter will not have a material adverse effect on
our financial condition, results of operations or cash flows.
We from time to time experience routine litigation in the normal course of our
business. We do not believe that any pending litigation will have a material
adverse effect on our financial condition, results of operations or cash flows.
Results of Operations--IASG
The following table sets forth, for the periods indicated, selected statements
of operations data for IASG:
Years Ended December 31,
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