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INTERFACE SECURITY SYSTEMS HOLDINGS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) General Interface Security Systems Holdings, Inc. ("Holdings") is primarily owned by SunTx Capital Partners, L.P. and its affiliates ("SunTx Capital Partners"), which owns approximately 88% of the voting power of Holdings' parent company, Interface Master Holdings, Inc. ("Master Holdings"), on a fully diluted basis. We own 100% of the outstanding membership interests of our principal operating subsidiary, Interface Security Systems, L.L.C. ("Interface Systems"). In the third quarter of 2013, we acquired all of the remaining noncontrolling interest in The Greater Alarm Company, Inc. ("GAC") and we merged Westec Acquisition Corp. ("Westec") and GAC into Interface Systems. Collectively, Holdings and Interface Systems are referred to herein as the "Company," "we," "our," or "us". Overview We are a leading national provider of physical security and secured managed network services to primarily large, commercial multi-site customers and believe that we provide the most comprehensive Internet protocol ("IP") technologyenabled managed security solution in the market. Our physical security solutions include alarm / event monitoring, interactive video surveillance, managed access control and fire / life safety systems. Our secured network services include secure managed broadband ("SMB"), payment card industry ("PCI") compliance, managed digital voice and other ancillary services. Our comprehensive service offering is designed to meet the needs of commercial enterprises that require a universal and secure IP security platform capable of servicing all of their locations. We combine a complete suite of customized physical and network security services into a fullyintegrated bundle, enabling our customers to consolidate services from multiple vendors into a single service provider, significantly enhancing the quality and breadth of their security and reducing their costs. Our physical security platform is delivered utilizing state-of-the-art IP technology, which enables our alarm / event monitoring to be faster, more reliable and less expensive than digital dialer systems. In addition, our experienced engineering team is able to program the routers on these IP systems to optimize our alarm monitoring and interactive video surveillance services by proactively managing bandwidth in our customers' networks to insure continuity of all critical business systems. Our proprietary video surveillance technology allows for remote eventbased monitoring from our central command center ("C3") where highly trained specialists can monitor real-time events taking place at a customer premise through both live video and audio and take appropriate action. We believe our proprietary video surveillance technology provides the most cost efficient system in the market allowing operators to simultaneously monitor events at multiple customer locations. The unique features of this system include video verification, rapid response, video escorts and snapshot audits. These services, along with our other ancillary IP security applications, are customconfigured through a private, secured network to meet the requirements of our customer's existing software system and infrastructure. We are able to continuously monitor the health of each customer's network remotely through our Security Operations Center ("SOC") / Network Operations Center ("NOC"). We supply and install all of the required hardware and software equipment for our bundled service offering, which enables us to enter into long term (on average four years or more) contracts with our customers. We have also taken the quality of service and level of urgency that is critical to the life safety / emergency response sector and applied it to monitoring SMB. As a result, we believe we provide the highest quality of customer service in the secured network service space. Our diverse customer base includes large multi-site commercial enterprises in the luxury retail, dining, quick-service restaurant ("QSR") and hospitality vertical sectors, including Dollar General, Subway, Family Dollar, Michaels Stores, McDonald's, Sterling Jewelers, Zales, Tumi, Panda Express, Sunoco and Edward Jones. As of June 30, 2014, our top ten customers accounted for 46.4% of our total recurring monthly revenue ("RMR") with an average length of relationship of seven years. As of June 30, 2014, we serviced 75,748 total customer sites across our customer base through our 16 regional service centers and employee field technicians in most of the largest markets in the U.S. The scope and breadth of our services, combined with our significant equipment investment, software system configuration and long term contracts make our customer relationships stable and "sticky." In addition, we have established a sales and installation infrastructure capable of managing largescale national deployments, which we can leverage to add new customers without significantly incurring additional infrastructure costs. We also have mutuallybeneficial channel partnership agreements in place with companies such as Cisco and Verizon Wireless to expand our national sales footprint at minimal incremental cost. As a result of our infrastructure, partnerships and focus on large, commercial multi-site customers, our costs to create customers are lower than the industry average 16 -------------------------------------------------------------------------------- Table of Contents and we achieve higher than industry average revenue per user ("ARPU"). We have demonstrated the ability to manage largescale deployments across customer locations nationwide in a short period of time, as highlighted by our rollout of over 10,000 store locations for Dollar General in 2010 and 2011 ("Dollar General Deployment"). Recent Events Revolving Credit Facility On May 16, 2014, we entered into a waiver, consent and second amendment to our $45.0 million revolving credit facility (the "Revolving Credit Facility") with the lender, which (i) amended the Revolving Credit Facility to permit, and in which the lender consented to, certain events in connection with certain reorganization transactions; (ii) amended the Revolving Credit Facility to provide that a ''change of control'' in the indenture governing the notes to be issued pursuant to an offering of 12.50% / 14.50% Senior Contingent Cash Pay Notes due 2018 by Master Holdings (the "Master Holdings Notes") will constitute a ''change in control'' under the Revolving Credit Facility; and (iii) waived any defaults in connection with our prior going concern qualification. Corporate Reorganization On May 30, 2014, we completed a corporate reorganization with Master Holdings in connection with the closing of a $115.0 million offering of the Master Holdings Notes. The Master Holdings Notes are not guaranteed by any of Master Holdings' subsidiaries, including Holdings and Interface Systems. Master Holdings' subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to make any funds available to Master Holdings, whether by dividend, distribution, loan or other payments. Pursuant to the reorganization, each of SunTx Capital Partners and certain of its affiliates, Michael T. Shaw, Michael J. McLeod, Kenneth Obermeyer and certain other stockholders of Holdings exchanged all of their shares of each class of common stock of Holdings and each class of preferred stock of Holdings for an equal number of shares of common stock and preferred stock of Master Holdings with substantially similar terms as the shares of Holdings. In addition, Master Holdings used $71.6 million of the proceeds of the offering to purchase shares of Class A common stock and Class B common stock of Holdings. Holdings and Interface Systems intend to use the consideration from the sale of shares of Holdings common stock to Master Holdings to make cash interest payments on the Senior Secured Notes and for general corporate purposes, including to fund growth initiatives. Immediately following the consummation of these transactions, Master Holdings owned approximately 99% of each class of common stock of Holdings and at least 99% of each class of Holdings' preferred stock. Subsequent to these transactions, the remaining stockholders of Holdings exchanged all of their shares of each class of common stock and preferred stock of Holdings for an equal number of shares of common stock and preferred stock of Master Holdings. As a result, Master Holdings now owns 100% of the common stock and preferred stock of Holdings. Registration Rights Agreement In connection with the issuance of the Senior Secured Notes, we entered into a registration rights agreement with the initial purchasers of the Senior Secured Notes. A registration statement on Form S-4 was filed pursuant to our obligations under this registration rights agreement on July 9, 2014 (the "Registration Statement"). The Registration Statement was declared effective on July 30, 2014 and the exchange offer is scheduled to expire on August 27, 2014, unless otherwise extended, which is prior to the required deadline in the registration rights agreement. Factors Affecting Operating Results We conduct our business and report financial and operating information in one operating segment. Our operations comprise a single business segment. For the three and six months ended June 30, 2014, approximately 80.6% and 79.8%, respectively, of our revenue is derived from customers who sign long-term monitoring and maintenance contracts. These long-term contracts, typically between 36 and 60 months in duration, provide stable and predictable RMR. The amount of RMR that we generate from any single customer depends on the type of services being provided. We offer a wide range of physical and network security IP-based managed services. The balance of our revenue is generated through up-front fees for the installation of new systems and repair of existing systems. The generation of new customers requires significant upfront investments in subscriber system assets, field labor, sales costs and related general and administrative costs. As a result of our infrastructure, partnerships and focus on large, commercial multi-site customers, we believe we have a lower than industry average creation cost to acquire a new customer ("creation cost"), which in turn provides high margin RMR and higher than industry ARPU generated from our monitoring and managed services. 17 -------------------------------------------------------------------------------- Table of Contents We market our services through direct sales channels and in partnerships with select vertical marketing organizations. We are working to establish additional channel partnerships with these vertical marketing organizations that we believe will generate new business in 2014 and beyond. We primarily focus on industry verticals where there is a significant base of national accounts with multi-site operations, both company operated and franchised. Our focus on large, established national customers helps reduce our exposure to attrition as a result of locations closing, or customers going out of business. Our operating results are impacted by the following key factors: RMR, number of customer additions, creation costs, ARPU, average net attrition rate, the costs to monitor and service our customers, the level of general and administrative expenses and the availability and cost of capital required to generate new customers. Average net attrition rate has a direct impact on the number of customers who we monitor and service and on our financial results, including revenue, operating income and cash flows. A portion of the customer base can be expected to cancel its service every year. We focus our investment decisions on generating new customers and servicing our existing customers in the most cost-effective manner, while maintaining a high level of customer service to minimize attrition. These decisions are based on the projected cash flows and associated margins generated over the expected life of the customer relationship. Average net attrition rate is defined as the aggregate amount of canceled or reduced RMR during a period divided by the average total RMR during the measurement period. Customers are considered canceled when they terminate in accordance with the terms of their contract or are terminated by us. Certain customer re-signs and relocations are excluded from the attrition calculation. If a customer relocates and continues its service, we consider this as a cancellation but do not include such cancellation in our average net attrition rate calculation. Further, if a customer discontinues its service at a site and a new customer enters into a contract for service at the same site, we refer to this as a re-sign. We consider re-signs as cancellations, but do not include them in our average net attrition rate calculation. Our ability to increase customers and customer revenue depends on a number of factors, both external and internal. External factors include the overall macroeconomic environment and the level of product and price competition from other companies in the markets we serve. Some of our current competitors have longer operating histories, greater name recognition and substantially greater financial and marketing resources than us. In the future, other companies may also choose to begin offering bundled services similar to ours. Internal factors affecting customer and customer revenue growth include our ability to maintain consistently high levels of customer satisfaction and invest in technologies to further enhance the attractiveness and value proposition of our solutions to current and potential customers. We will need to recruit, train and retain personnel and maintain the level of our investment in sales and marketing efforts. We believe maintaining competitive compensation structures, differentiated bundled product offerings and establishing a strong brand are critical to attracting and retaining high-quality personnel and competing effectively in the markets we serve. Successfully growing our ARPU also depends on our ability to continue expanding our technology platform by offering additional value added services demanded by the market and crossselling these additional services through our bundled service offering. Therefore, we continually evaluate the viability of additional service offerings that could further benefit from our existing technology platform. As of June 30, 2014, approximately 36.8% of our commercial customer sites subscribed to more than one service as a bundled service offering. ARPU increased to $97.55 as of June 30, 2014 from $81.12 at December 31, 2013, an increase of 20.3%, primarily due to the sale of the Transferred Assets. We focus on managing the costs associated with monitoring and service without jeopardizing our service quality. We believe our ability to retain customers over the long-term relies on our ability to maintain our consistent superior service levels. 18 -------------------------------------------------------------------------------- Table of Contents The table below presents our RMR and average net attrition data for the three and six months ended June 30, 2014 and 2013, respectively: Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Beginning RMR $ 7,440,556 $ 8,049,926 $ 8,411,787 $ 7,814,849 New and Acquired RMR 143,365 366,761 330,511 801,420 Sold RMR - - (918,387 ) - Canceled RMR (194,993 ) (210,145 ) (434,983 ) (409,727 ) Ending RMR $ 7,388,928 $ 8,206,542 $ 7,388,928 $ 8,206,542 End of period total customer sites 75,748 105,526 75,748 105,526 Average net attrition rate 9.8 % 9.0 % 11.0 % 8.9 % We track customer growth by measuring new RMR added and total RMR as of the end of the period. Ending RMR for the six months ended June 30, 2014 was $7.4 million compared to $8.2 million for the same period ended June 30, 2013. We sold $0.9 million of RMR in January 2014 related to the Transferred Assets. New and acquired RMR added was $0.3 million and canceled RMR was $0.4 million for the six months ended June 30, 2014 as compared to $0.8 million of new and acquired RMR and $0.4 million of canceled RMR for the six months ended June 30, 2013. The direct cost associated with creating new RMR are fixed costs that include sales engineering, marketing, sales overhead and operational overhead. The creation cost of new RMR in 2014 is higher than in 2013 due to the allocation of fixed direct cost over lower new RMR during the period. The decrease in organic RMR growth reflects lower Contracted Backlog as of December 31, 2013 and a decrease in installation services and product installations due to lower sales activity during the six months ended June 30, 2014 compared to the six months ended June 30, 2013. We currently maintain a Contracted Backlog and sales pipeline that we believe will generate a steady, significant flow of new RMR in 2014 and beyond. In April 2014, we converted approximately $2.4 million of our sales pipeline to Contracted Backlog. As of June 30, 2014, our Contracted Backlog was $2.9 million with over half of the Contracted Backlog to be installed in 2014. How We Generate Revenue Our primary source of revenue is recurring services revenue, generated through monitoring, maintenance and installation services provided to our customers in accordance with their customer contracts. Monitoring services for our customers are billed in advance, primarily monthly, pursuant to the terms of customer contracts. Revenue is recognized ratably over the contract term. At the end of each monthly period, the portion of monitoring fees related to services not yet provided are deferred and recognized in the period that these services are provided. Installation revenue represents upfront one-time charges billed to customers at the time of installation. Revenue on installation contracts is recognized upon completion and delivery of the installation in transactions where equipment is sold. For transactions in which we retain ownership of the security system, any amounts collectible up-front are deferred and amortized over the longer of the average customer life or the initial term of the contract. Service and maintenance revenue represents our service and other revenue associated with selling customers additional equipment, and for maintenance and repair. Service revenue is billed, and the associated revenue recognized, when the services are performed. Maintenance revenue is billed and revenue is recognized ratably over the contract term. The remainder of our revenue is generated through products revenue and other services. Costs and Expenses Cost of Services and Products. Cost of services and products represent the cost of providing services and products to our customers. Cost of services includes costs associated with installation, service calls for customers who have maintenance contracts, costs of monitoring, central station expense, selling and marketing expense and the maintenance / repair of existing systems. Cost of products includes direct materials utilized in the installation of new systems along with wire, disposable stock and costs to deliver products. 19 -------------------------------------------------------------------------------- Table of Contents General and administrative expenses. General and administrative expenses consist of accounting and finance, legal, collections, human resources, executive management, telephone, insurance, executive travel and other expenses related to the corporate administration of the Company. It also captures administrative labor, telecommunications, insurance and real estate lease expenses related to our regional service centers throughout the United States. Amortization. Amortization expenses consist of amortization from intangible assets primarily related to acquired alarm monitoring contracts. Depreciation. Depreciation expenses consist of depreciation from property and equipment and equipment leased under capital leases. Critical Accounting Policies and Estimates The preparation of the consolidated financial statements in conformity with generally accepted accounting principles in the United States ("GAAP") requires management to use judgment in making estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities and the reported amounts of revenue and expenses. We believe that our accounting policies for revenue recognition, accounts receivable and allowances, goodwill and indefinite-lived intangible assets, long-lived assets and intangible assets and income taxes are based on, among other things, judgments and assumptions made by management that include inherent risks and uncertainties. During the six months ended June 30, 2014, there have been no significant changes to these policies or in the underlying accounting assumptions and estimates used in the above critical accounting policies. Critical accounting policies are detailed in the Company's Registration Statement. 20 -------------------------------------------------------------------------------- Table of Contents Results of Operations The following table sets forth our results of operations for the periods indicated (dollars in thousands). Three Months Ended June 30, 2014 Compared to Three Months Ended June 30, 2013 Three Months Ended June 30, Percent 2014 2013 Change Revenue Services $ 24,793 $ 27,282 (9.1)% Products 2,634 4,463 (41.0)% Total revenue 27,427 31,745 (13.6)% Cost and Expenses Cost of services 20,324 22,690 (10.4)% Cost of products 2,294 4,373 (47.5)% General and administrative expenses 5,715 5,714 * Amortization 2,211 2,457 (10.0)% Depreciation 2,381 2,517 (5.4)% Loss (gain) on sale of long-lived assets 154 (2 ) * Total costs and expenses 33,079 37,749 (12.4)% Loss from operations (5,652 ) (6,004 ) (5.9)% Interest expense 6,049 5,923 2.1% Interest income - 3 * Loss before provision for income taxes (11,701 ) (11,924 ) (1.9)% Provision for income taxes 1,200 171 * Net loss (12,901 ) (12,095 ) 6.7% Net loss attributable to noncontrolling interest - (10 ) * Net loss attributable to Interface Security Systems Holdings, Inc. (12,901 ) (12,085 ) 6.8% Redeemable Class A Preferred stock dividend (1,834 ) (2,562 ) (28.4)% Redeemable Class C Preferred stock dividend (655 ) (915 ) (28.4)% Convertible and redeemable Class E Preferred stock dividend (190 ) (580 ) (67.2)% Convertible and redeemable Class F Preferred stock dividend - (146 ) * Redeemable Class G Preferred stock dividend - (200 ) * Net loss attributable to common stockholders $ (15,580 ) $ (16,488 ) (5.5)% ________________________ *Not meaningful Revenue Total revenue decreased $4.3 million, or 13.6%, to $27.4 million for the three months ended June 30, 2014 as compared with the three months ended June 30, 2013. Services revenue decreased $2.5 million, or 9.1%, to $24.8 million for the three months ended June 30, 2014 as compared with the three months ended June 30, 2013. The decrease was due primarily to a $2.8 million decline attributable to the Transferred Assets and a decrease of $0.8 million in installation services and recognized deferred revenue offset by an increase of approximately $1.1 million of services revenue from RMR growth during 2013. Products revenue decreased $1.8 million, or 41.0%, to $2.6 million for the three months ended June 30, 2014 as compared with the three months ended June 30, 2013 due primarily to a $1.9 million decrease in product installations related to a decline in installation sales during three months ended June 30, 2014 as well as a decrease of $0.3 million related to the Transferred Assets. 21 -------------------------------------------------------------------------------- Table of Contents Cost and Expenses Total cost and expenses decreased $4.7 million, or 12.4%, to $33.1 million for the three months ended June 30, 2014 as compared with the three months ended June 30, 2013. Cost of services decreased $2.4 million, or 10.4%, to $20.3 million for the three months ended June 30, 2014 as compared with the three months ended June 30, 2013. The decrease in costs of services is due to a $1.6 million decline related to the Transferred Assets, lower RMR associated with SMB services resulting in $0.1 million of lower service operating costs and a reduction of $1.5 million in service and installation wages and commissions due to less RMR and installation products installed for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013. The decrease was partially offset by a $0.8 million increase in service materials related to maintenance agreements. Cost of products decreased $2.1 million, or 47.5%, to $2.3 million for the three months ended June 30, 2014 as compared with the three months ended June 30, 2013. The decrease in cost of products is related to a decrease in installation materials cost of $1.4 million as a result of a lower product sales, $0.6 million less of service materials costs related to time and material contracts and $0.1 million related to the Transferred Assets during the three months ended June 30, 2014. General and administrative expenses remained flat at $5.7 million for the three months ended June 30, 2014 as compared with the three months ended June 30, 2013. Transferred Assets resulted in a decrease of approximately $0.3 million offset by a $0.1 million increase in professional services and a $0.1 million increase in computer system expense. Amortization expense decreased $0.2 million, or 10.0%, to $2.2 million for the three months ended June 30, 2014 as compared with the three months ended June 30, 2013. The decrease was primarily due to the end of life of acquired alarm monitoring accounts as of June 30, 2014. Depreciation expense decreased $0.1 million, or 5.4%, to $2.4 million for the three months ended June 30, 2014 as compared with the three months ended June 30, 2013. The decrease was due primarily to the sale of the Transferred Assets in January 2004. Interest Expense Interest expense increased $0.1 million, or 2.1%, to $6.0 million for the three months ended June 30, 2014 as compared with the three months ended June 30, 2013. The increase was due primarily to the additional debt borrowed during the six months ended June 30, 2013 under our Revolving Credit Facility to fund growth. Provision for Income Taxes Provision for income taxes increased $1.0 million to $1.2 million for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013. The increase was due primarily to the impact of the gain on sale of the Transferred Assets has on the projected annual loss for 2014. The effective tax rate increased from 1.53% at December 31, 2013 to 10.25% at June 30, 2014. The tax provision in future periods will vary based on current and future temporary differences, as well as future operating results. Net Loss Net loss increased $0.8 million, or 6.7%, to $12.9 million for the three months ended June 30, 2013 compared to the three months ended June 30, 2014 primarily as a result of the factors described above. 22 -------------------------------------------------------------------------------- Table of Contents Six Months Ended June 30, 2014 Compared to Six Months Ended June 30, 2013 Six Months Ended June 30, Percent 2014 2013 Change Revenue Services $ 50,498 $ 53,662 (5.9)% Products 5,649 8,328 (32.2)% Total revenue 56,147 61,990 (9.4)% Cost and Expenses Cost of services 40,078 42,367 (5.4)% Cost of products 6,066 7,736 (21.6)% General and administrative expenses 13,815 11,915 15.9% Amortization 4,583 4,920 (6.8)% Depreciation 4,831 4,879 (1.0)% Loss on extinguishment of debt - 707 * Loss (gain) on sale of long-lived assets 633 (11 ) * Gain on sale of Transferred Assets (39,715 ) - * Total costs and expenses 30,291 72,513 (58.2)% Income (loss) from operations 25,856 (10,523 ) * Interest expense 12,182 11,802 3.2% Interest income 4 7 (42.9)% Income (loss) before provision for income taxes 13,678 (22,318 ) * Provision for income taxes (1,111 ) 342 * Net income (loss) 14,789 (22,660 ) * Net loss attributable to noncontrolling interest - (20 ) * Net income (loss) attributable to Interface Security Systems Holdings, Inc. 14,789 (22,640 ) * Redeemable Class A Preferred stock dividend (4,564 ) (5,035 ) (9.4)% Redeemable Class C Preferred stock dividend (1,630 ) (1,798 ) (9.3)% Convertible and redeemable Class E Preferred stock dividend (502 ) (1,140 ) (56.0)% Convertible and redeemable Class F Preferred stock dividend (14 ) (286 ) (95.1)% Redeemable Class G Preferred stock dividend (19 ) (393 ) (95.2)% Net income (loss) attributable to common stockholders $ 8,060 $ (31,292 ) * ________________________ *Not meaningful Revenue Total revenue decreased $5.8 million, or 9.4%, to $56.1 million for the six months ended June 30, 2014 as compared with the six months ended June 30, 2013. Services revenue decreased $3.2 million, or 5.9%, to $50.5 for the six months ended June 30, 2014 as compared with the six months ended June 30, 2013. The decrease was due primarily to a $5.3 million decline attributable to the Transferred Assets and a decrease of $1.5 million in installation services offset by an increase of approximately $4.3 million of services revenue from RMR growth during 2013. Products revenue decreased $2.7 million, or 32.2%, to $5.6 for the six months ended June 30, 2014 as compared with the six months ended June 30, 2013 due primarily to a $0.5 million decrease in product installations from the sale of Transferred Assets and a decrease in service product revenue of $2.2 million. 23 -------------------------------------------------------------------------------- Table of Contents Cost and Expenses Total cost and expenses decreased $42.2 million, or 58.2%, to $30.3 million for the six months ended June 30, 2014 as compared with the six months ended June 30, 2013. Cost of services decreased $2.3 million, or 5.4%, to $40.1 million for the six months ended June 30, 2014 as compared with the six months ended June 30, 2013. The decrease in costs of services is due to a $3.2 million decrease in costs associated with the sale of the Transferred Assets partially offset by a $0.8 million increase in service materials related to maintenance agreements. Cost of products decreased $1.7 million, or 21.6%, to $6.1 million for the six months ended June 30, 2014 as compared with the six months ended June 30, 2013. The decrease in cost of products is related to a decrease in product materials attributable to the Transferred Assets of approximately $0.2 million, a decrease in installation materials cost of $1.2 million as a result of lower product sales during the period and $0.3 million less service materials costs related to time and material contracts during the six months ended June 30, 2014. General and administrative expenses increased $1.9 million, or 15.9%, to $13.8 million for the six months ended June 30, 2014 as compared with the six months ended June 30, 2013. The increase for the six months ended June 30, 2014 was due primarily to $1.9 million of transaction costs related to the Transferred Assets and registering the Senior Secured Notes. The Company also realized a decrease in expenses of $0.5 million related to the Transferred Assets offset by an increase in legal and professional fees of $0.2 million. Amortization expense decreased $0.3 million, or 6.8%, to $4.6 million for the six months ended June 30, 2014 as compared with the six months ended June 30, 2013. The decrease was primarily due to the end of life of acquired alarm monitoring accounts as of June 30, 2014. Depreciation expense remained relatively flat at $4.8 million for the six months ended June 30, 2014 and $4.9 million for the six months ended June 30, 2013. Interest Expense Interest expense increased $0.4 million, or 3.2%, to $12.2 million for the six months ended June 30, 2014 as compared with the six months ended June 30, 2013. The increase was due primarily to the additional debt borrowed under our Revolving Credit Facility (as defined below) to fund growth during the six months ended June 30, 2014 compared to 2013. Provision for Income Taxes Provision for income taxes decreased $1.5 million to a net tax benefit of $1.1 million for the six months ended June 30, 2014 as compared with the six months ended June 30, 2013. The decrease was due primarily to the impact of the gain on sale of the Transferred Assets has on the projected annual loss for 2014. The effective tax rate fell from 1.53% at December 31, 2013 to (8.13)% at June 30, 2014. The tax provision in future periods will vary based on current and future temporary differences, as well as future operating results. Net Income (Loss) Net loss increased $37.4 million to net income of $14.8 million for the six months ended June 30, 2014 as compared from a net loss of $22.7 million for the six months ended June 30, 2013. The increase is primarily related to the $39.7 million gain on the sale of the Transferred Assets and the other factors described above. Non-GAAP Financial Measures We use certain financial measures, including EBITDA and Adjusted EBITDA, as supplemental measures of our operating performance that are not required by, or presented in accordance with, GAAP. They are not measurements of our financial performance under GAAP and should not be considered as alternatives to net income, operating income or any other performance measures derived in accordance with GAAP or as an alternative to cash flows from operating activities as a measure of our liquidity. These measures are used in the internal management of our business, along with the most directly comparable GAAP financial measures, in evaluating our operating 24 -------------------------------------------------------------------------------- Table of Contents performance. In addition, our presentation of Adjusted EBITDA is consistent with the equivalent measurements that are contained in our Revolving Credit Facility and the indenture governing the Senior Secured Notes. EBITDA represents net income (loss) attributable to Interface Security Systems Holdings, Inc. before interest expense, interest income, income taxes, depreciation, amortization and net loss attributable to noncontrolling interest. Adjusted EBITDA represents EBITDA as further adjusted for gain or loss of sale of long-lived assets, gain on sale of Transferred Assets, loss on extinguishment of debt, sales and installation costs, net of sales and installation revenue, related to organic RMR growth, plus 50% of non-capitalized corporate and service center administrative costs related to organic RMR growth, less capitalized subscriber system assets. Our calculation of Adjusted EBITDA does not include any adjustments for expenses related to the sale of the Transferred Assets, the merger of The Greater Alarm Company, Inc. and Westec Acquisition Corp. into Interface Security Systems, L.L.C. in September 2013, financing of the Revolving Credit Facility or costs of preparing for the initial registration of the Senior Secured Notes. These expenses for the three months ended June 30, 2014 and 2013 were $0.3 million and $0.1 million, respectively, and $2.2 million and $0.2 million for the six months ended June 30, 2014 and 2013, respectively. Our measurement of EBITDA and Adjusted EBITDA may not be comparable to similarly titled measures of other companies and are not measures of performance calculated in accordance with GAAP. We have included information concerning EBITDA and Adjusted EBITDA because we believe that such information is used by certain investors as supplemental measures of a company's historical ability to service debt. We believe these measures are frequently used by securities analysts, investors and other interested parties in the evaluation of high yield issuers, many of which present EBITDA and Adjusted EBITDA when reporting their results. Our presentation of EBITDA and Adjusted EBITDA should not be construed as an inference that our future results will be unaffected by unusual or nonrecurring items. EBITDA and Adjusted EBITDA have limitations as analytical tools, and you should not consider them in isolation, or as a substitute for analysis of, our operating results or cash flows as reported under GAAP. Some of these limitations are: • they do not reflect our cash expenditures, or future requirements, for capital expenditures or contractual commitments; • they do not reflect changes in, or cash requirements for, our working capital needs; • they do not reflect the significant interest expense, or the cash requirements necessary to service interest or principal payments, on our debt; • although depreciation is a non-cash charge, the assets being depreciated will often have to be replaced in the future, and EBITDA and Adjusted EBITDA do not reflect any cash requirements for such replacements; • they are not adjusted for all non-cash income or expense items that are reflected in our statements of cash flows; and • other companies in our industry may calculate these measures differently than we do, limiting their usefulness as comparative measures. Because of these limitations, EBITDA and Adjusted EBITDA should not be considered as measures of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our GAAP results and using EBITDA and Adjusted EBITDA only for supplemental purposes. Please see our consolidated financial statements contained elsewhere in this report. 25 -------------------------------------------------------------------------------- Table of Contents The following table sets forth a reconciliation of net income (loss) attributable to Interface Security Systems Holdings, Inc. to EBITDA and EBITDA to Adjusted EBITDA for the periods indicated (in thousands): Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Net income (loss) attributable to Interface Security Systems Holdings, Inc. $ (12,901 ) $ (12,085 ) $ 14,789 $ (22,640 ) Net loss attributable to noncontrolling interest - (10 ) - (20 ) Provision for income taxes 1,200 171 (1,111 ) 342 Interest expense 6,049 5,923 12,182 11,802 Interest income - (3 ) (4 ) (7 ) Depreciation 2,381 2,517 4,831 4,879 Amortization 2,211 2,457 4,583 4,920 EBITDA (1,060 ) (1,030 ) 35,270 (724 ) (Gain) loss on sale of long-lived assets 154 (2 ) 633 (11 ) Gain on sale of Transferred Assets - - (39,715 ) - Loss on extinguishment of debt - - - 707 Sales and installation expense (a) 11,016 17,849 23,223 34,466 50% of overhead expenses (b) 2,816 2,795 6,804 5,833 Capitalized expenditures, subscriber system assets (c) (1,452 ) (4,096 ) (3,134 ) (8,601 ) Sales and installation revenue (d) (3,709 ) (6,395 ) (8,111 ) (13,140 ) Adjusted EBITDA $ 7,765 $ 9,121 $ 14,970 $ 18,530 (a) Reflects sales and installation costs related to organic RMR growth. Certain other industry participants purchase customers through customer contract purchases, and as a result, may capitalize the full cost to purchase these customer contracts, as compared to our organic generation of new customers, were majority of our customer creation costs is expensed. (b) Reflects 50% of the corporate and service center administrative costs related to organic RMR growth and is not capitalized. Corporate and service center administrative cost includes expenses and the related overhead to support the RMR and installation growth. Other industry participants customarily allocate 50% of their overhead cost to RMR and sales growth. (c) Reflects sales and installation cost related to organic RMR growth, including those costs associated with accounts payable that are capitalized as subscriber systems assets. Since the full amount of sales and installation expense is added as an adjustment in (a) above, the capitalized portion of the sales and installation cost is deducted from the Adjusted EBITDA calculation. (d) Reflects revenue received for the installation of subscriber systems related to organic RMR growth to match certain costs incurred in connection with the installations as described in (a) above. Adjusted EBITDA decreased $1.4 million for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013. The decrease was driven by lost service margins of $1.3 million from the Transferred Assets. Adjusted EBITDA decreased $3.6 million for the six months ended June 30, 2014 as compared to the six months ended June 30, 2013. The decrease was driven by an increase in general and administrative expense of $1.9 million related to an increase in costs incurred in connection with the sale of the Transferred Assets and the costs associated with preparing for the initial registration of the Senior Secured Notes. The lost services margins from the Transferred Assets contributed to a $2.1 million decrease in Adjusted EBITDA compared to the six months ended June 30, 2013 offset by increased margins from new RMR created during 2013. 26 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Overview of Our Contractual Obligations and Liquidity Our primary source of liquidity is our cash on hand and the Revolving Credit Facility. As of June 30, 2014, we had cash on hand of $64.4 million and $4.8 million of available borrowing capacity under our Revolving Credit Facility. We had working capital of $61.1 million as of June 30, 2014 and negative working capital of $13.2 million (excluding assets and liabilities held for sale) as of December 31, 2013 and used $22.3 million and $8.9 million of cash to fund our operations for the six months ended June 30, 2014 and 2013, respectively. If we were to cease our internal growth strategy and no longer invest in creating new RMR, we believe we would generate future positive cash flows that could be used to provide the Company with sufficient liquidity to start to pay down our outstanding debt. The following table provides a summary of cash flow data (in thousands): Six Months Ended June 30, 2014 2013 Net cash used in operating activities $ (22,291 ) $ (8,894 ) Net cash provided by (used in) investing activities 36,692 (9,141 ) Net cash provided by financing activities 49,634 16,674 Cash Flows from Operating Activities Net cash used in operating activities increased by $13.4 million from $8.9 million for the six months ended June 30, 2013 to $22.3 million for the six months ended June 30, 2014. This use of cash was primarily due to an increase in inventory of $2.6 million and prepaid services of $1.3 million associated with future RMR growth. The timing of payments for accounts payable and accrued expenses and an increase in net loss (excluding the gain on sale of Transferred Assets) of approximately $2.3 million. Cash Flows from Investing Activities Our investing activities mainly consist of capital expenditures for subscriber system assets. Capital expenditures primarily consist of periodic additions to property and equipment to support the growth in our business. Net cash from investing activities increased $45.8 million from $9.1 million of net cash used in investing activities for the six months ended June 30, 2013 to $36.7 million of net cash provided by investing activities for the six months ended June 30, 2014. The increase is primarily related to proceeds of approximately $40.7 million for the sale of the Transferred Assets, net of change in restricted cash, and a decrease of $5.1 million in subscriber system assets as a result of lower RMR during the period. Cash Flows from Financing Activities Our cash flows from financing activities are mainly used to fund the portion of upfront costs associated with generating new customers that are not covered through our operating cash flows and acquisitions. During the six months ended June 30, 2014, our net cash provided by financing activities was $49.6 million compared to $16.7 million of cash provided by financing activities during the six months ended June 30, 2013. The increase is primarily related to the $71.6 million of cash received during the six months ended June 30, 2014 from Master Holdings as consideration for its purchase of shares of common stock of Holdings. We also redeemed all of the issued and outstanding shares of our Class G and Class F Preferred Stock and a portion of its Class E Preferred Stock and paid a cash dividend in an aggregate amount of approximately $27.3 million to the stockholders as permitted under the indenture governing the Senior Secured Notes. This was offset by $5.5 million in draws on our Revolving Credit Facility to fund new RMR installations and working capital needs. Net cash provided by financing activities for the six months ended June 30, 2013 reflect the issuance of $230.0 million of Senior Secured Notes that were used to repay outstanding debt and fees. 27 -------------------------------------------------------------------------------- Table of Contents Current Indebtedness Senior Secured Notes. On January 18, 2013, Holdings and Interface Systems issued $230.0 million aggregate principal amount of the Senior Secured Notes the proceeds of which were used to repay our then-existing indebtedness, which consisted of our prior revolving credit facility, our prior senior subordinated debt and the subordinated promissory note, for general corporate purposes and to pay related fees and expenses. The Senior Secured Notes are secured by second priority liens on substantially all of our and any guarantor's assets, subject to certain exceptions. The obligations under the Senior Secured Notes will be fully and unconditionally guaranteed, jointly and severally, on a senior secured basis by each of our future domestic restricted subsidiaries. The Senior Secured Notes bear interest at a fixed rate of 9¼% per annum with interest payable semi-annually on July 15 and January 15 of each year, and mature on January 15, 2018. The Senior Secured Notes do not require us to make mandatory redemption or sinking fund payments; however, under certain circumstances related to a change of control or assets sales, we may be required to offer to purchase the Senior Secured Notes. Revolving Credit Facility. Interface Systems, as borrower, and Holdings, as guarantor, entered into the $45.0 million Revolving Credit Facility on January 18, 2013, as amended on September 30, 2013 and May 16, 2014. The Revolving Credit Facility has an available borrowing capacity equal to the lesser of $45.0 million and 5 times eligible RMR. The Revolving Credit Facility matures on January 15, 2018. The Revolving Credit Facility includes a $1.0 million sub-limit for the issuance of letters of credit, and the amount outstanding reduces the amount of available borrowing. As of June 30, 2014 and December 31, 2013, we had $0.1 million and $0.1 million in letters of credit outstanding. Borrowings under the Revolving Credit Facility bear interest at a floating rate per year equal to the higher of (A) the rate (adjusted for statutory reserve requirements for Eurocurrency liabilities) at which Eurodollar deposits are offered for a period equal to one, two, three, or six months, as quoted on Reuters Screen LIBOR01 Page (or any successor / similar page or service) as of 11:00 a.m., London time, on the day that is two London banking days preceding the applicable interest determination date and (B) 0.50%, plus 3.25% (3.75% as of June 30, 2014). The Revolving Credit Facility is subject to certain customary fees and expenses of the lenders and agents. The Revolving Credit Facility provides that, upon the occurrence of certain events of default, our obligations thereunder may be accelerated and any lending commitments terminated. Such events of default include payment defaults to the lenders, material inaccuracies of representations and warranties, covenant defaults, crossdefaults to other material indebtedness, voluntary and involuntary bankruptcy proceedings, material money judgments, certain change of control events and other customary events of default. The Revolving Credit Facility is secured by a first priority perfected lien on all of the same assets that secure our Senior Secured Notes. On June 30, 2014, our available borrowing capacity was $36.9 million, of which $32.0 million was drawn and $4.8 million was available for borrowing. We expect that new RMR growth during 2014 will provide additional borrowing capacity availability under the Revolving Credit Facility. Restrictive Covenants. The indenture governing the Senior Secured Notes and the credit agreement governing our Revolving Credit Facility contain a number of covenants imposing significant restrictions on our business. These restrictions may affect our ability to operate our business and may limit our ability to take advantage of potential business opportunities as they arise. The restrictions these covenants place on us include limitations on our and any restricted subsidiaries' ability to (subject to certain exceptions): • transfer or sell assets or use asset sale proceeds; • incur or guarantee additional debt or issue redeemable or preferred equity securities; • pay dividends, redeem equity or subordinated debt or make other restricted payments; • make certain investments; • create or incur liens on assets; • incur or permit dividend or other payment restrictions affecting any restricted subsidiaries; • enter into transactions with affiliates; • merge, consolidate or transfer all or substantially all assets; and • engage in a business other than a business that is the same or similar to our current business and reasonably related businesses. 28-------------------------------------------------------------------------------- Table of Contents In addition, the credit agreement governing the Revolving Credit Facility contains financial covenants including a covenant not to exceed a revolving facility usage to eligible RMR ratio of 5.0 to 1.0, a covenant to maintain a minimum fixed charge coverage of at least 1.25 to 1.0 and a covenant not to exceed 13.0% gross attrition at any time. As of June 30, 2014, we were in compliance with the applicable restrictive covenants under our debt agreements, and we expect to remain in compliance for at least the next twelve months. Recently Issued Accounting Standards In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), ("ASU 2014-09"). ASU 2014-09 outlines a new, single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. This new revenue recognition model provides a five-step analysis in determining when and how revenue is recognized. The new model will require revenue recognition to depict the transfer of promised goods or services to customers in an amount that reflects the consideration a company expects to receive in exchange for those goods or services. The pronouncement is effective for fiscal years, and interim periods within those years, beginning after December 15, 2016, and early adoption is not permitted. We are currently assessing the impact that adopting this new accounting guidance will have on our consolidated financial statements and footnote disclosures. Off-Balance Sheet Arrangements Other than off-balance sheet arrangements in connection with operating leases, we had no off-balance sheet arrangements as of June 30, 2014. Contractual Obligations Since March 31, 2014, there have been no material changes to our contractual obligations as discussed in the Registration Statement. Item 3. Quantitative and Qualitative Disclosures About Market Risk. We are subject to market risk from interest rate fluctuations on our outstanding borrowings under the Revolving Credit Facility. The Revolving Credit Facility bears interest at a floating rate per year equal to the higher of (A) the rate (adjusted for statutory reserve requirements for Eurocurrency liabilities) at which Eurodollar deposits are offered for a period equal to one, two, three, or six months, as quoted on Reuters Screen LIBOR01 Page (or any successor / similar page or service) as of 11:00 a.m., London time, on the day that is two London banking days preceding the applicable interest determination date and (B) 0.50%, plus 3.25% (3.75% as of June 30, 2014). As a result, we will be exposed to fluctuations in interest rates to the extent of our borrowings under the Revolving Credit Facility. A hypothetical 10% increase in the interest rates we pay on our borrowings under the Revolving Credit Facility as of June 30, 2014 would result in an increase of approximately $3.2 million per year. The hypothetical changes and assumptions may be different from what actually occurs in the future. |