Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended December 31, 2005

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from              to             

 

Commission File Number 333-110025

 


 

Monitronics International, Inc.

(Exact name of registrant as specified in its charter)

 


 

Texas   74-2719343

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

 

2350 Valley View Lane

Dallas, Texas 75234

(Address of principal executive offices)

(Zip Code)

 

(972) 243-7443

(Registrant’s telephone number, including area code)

 


 

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 whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

            Large accelerated filer ¨             Accelerated filer ¨             Non-accelerated filer x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

 

Title of Each Class


 

Outstanding at January 31, 2006


Class A Common Stock, par value $.01 per share   31,090,317
Class B Common Stock, par value $.01 per share   None

 



Table of Contents
          Page

Part I Financial Information

    

Item 1.

  

Financial Statements

   3
    

Balance Sheets as of December 31, 2005 and June 30, 2005

   3
    

Statements of Operations for the three and six months ended December 31, 2005 and 2004

   4
    

Statements of Cash Flows for the six months ended December 31, 2005 and 2004

   5
    

Statement of Shareholders’ Net Capital as of June 30, 2005 and December 31, 2005

   6
    

Notes to Financial Statements

   7

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   13

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

   19

Item 4.

  

Controls and Procedures

   20

Part II Other Information

    

Item 1.

  

Legal Proceedings

   20

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

   20

Item 3.

  

Defaults Upon Senior Securities

   20

Item 4.

  

Submission of Matters to a Vote of Security Holders

   21

Item 5.

  

Other Information

   21

Item 6.

  

Exhibits

   21

Signatures

   22

 

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

 

MONITRONICS INTERNATIONAL, INC.

BALANCE SHEETS

(In thousands, except share data)

 

     December 31,
2005


    June 30,
2005


 
     (Unaudited)        
Assets  

Current assets:

                

Cash and cash equivalents

   $ 1,771     $ 190  

Accounts receivable, net

     7,230       6,392  

Federal income tax receivable

     8,343       8,427  

Prepaid expenses and other current assets

     1,121       1,124  
    


 


Total current assets

     18,465       16,133  

Property and equipment, net

     8,434       7,215  

Subscriber accounts, net of accumulated amortization of $399,212 as of December 31, 2005 and $361,727 as of June 30, 2005

     479,193       471,212  

Deferred financing costs, net

     11,030       12,418  

Goodwill

     14,795       14,795  
    


 


Total assets

   $ 531,917     $ 521,773  
    


 


Liabilities and Shareholders’ Net Capital  

Current liabilities:

                

Accounts payable

   $ 2,326     $ 2,554  

Accrued expenses

     2,854       2,413  

Purchase holdbacks

     9,540       7,855  

Deferred revenue

     5,140       5,865  

Interest payable

     7,003       7,370  

Taxes payable

     84       33  

Current portion of long-term debt

     3,656       1,804  
    


 


Total current liabilities

     30,603       27,894  

Long-term debt, less current portion

     483,722       425,809  

Redeemable preferred stock, net

     —         13,342  

Commitments and contingencies

                

Shareholders’ net capital:

                

Class A common stock, $.01 par value:

                

Authorized shares – 80,000,000

                

Issued and outstanding shares – 31,090,317 shares as of December 31, 2005 and June 30, 2005

     311       311  

Class B common stock, $.01 par value:

                

Authorized shares – 700,000

                

Issued and outstanding shares – none

     —         —    

Additional paid-in capital

     124,807       156,677  

Treasury stock, at cost, 843,194 shares as of December 31, 2005 and June 30, 2005

     (8,913 )     (8,913 )

Accumulated deficit

     (98,613 )     (93,347 )
    


 


Total shareholders’ net capital

     17,592       54,728  
    


 


Total liabilities and shareholders’ net capital

   $ 531,917     $ 521,773  
    


 


 

See accompanying notes.

 

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MONITRONICS INTERNATIONAL, INC.

STATEMENTS OF OPERATIONS

(Unaudited)

 

    

Three Months Ended

December 31,


   

Six Months Ended

December 31,


 
     2005

    2004

    2005

    2004

 
     (In thousands)  

Revenue

   $ 46,739     $ 41,445     $ 91,811     $ 81,991  

Cost of services

     5,704       4,656       11,212       9,462  
    


 


 


 


Gross profit

     41,035       36,789       80,599       72,529  

Operating expenses:

                                

Sales, general and administrative

     9,153       7,513       17,894       15,073  

Depreciation

     546       532       1,163       1,039  

Amortization

     22,143       19,462       43,626       38,303  
    


 


 


 


       31,842       27,507       62,683       54,415  
    


 


 


 


Operating income

     9,193       9,282       17,916       18,114  

Other expense:

                                

Interest expense

     12,245       10,327       23,164       20,159  
    


 


 


 


       12,245       10,327       23,164       20,159  
    


 


 


 


Loss before income taxes

     (3,052 )     (1,045 )     (5,248 )     (2,045 )

Provision (benefit) from income taxes

     5       (461 )     18       (646 )
    


 


 


 


Net loss

   $ (3,057 )   $ (584 )   $ (5,266 )   $ (1,399 )
    


 


 


 


Preferred dividends accrued

     —         —         —         (878 )

Accretion of redeemable convertible preferred stock redemption value

     —         —         —         (18 )
    


 


 


 


Net loss attributed to common stock shareholders

   $ (3,057 )   $ (584 )   $ (5,266 )   $ (2,295 )
    


 


 


 


 

See accompanying notes.

 

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MONITRONICS INTERNATIONAL, INC.

STATEMENTS OF CASH FLOWS

(Unaudited)

 

    

Six Months Ended

December 31,


 
     2005

    2004

 
     (In thousands)  
Operating Activities                 

Net loss

   $ (5,266 )   $ (1,399 )

Adjustments to reconcile net loss to net cash provided by operating activities:

                

Depreciation and amortization

     44,789       39,342  

Amortization of deferred financing costs

     1,388       1,459  

Deferred income taxes

     —         (1,031 )

Provision for bad debt

     1,900       1,850  

Non-cash interest expense for redeemable preferred stock

     700       —    

Non-cash interest accretion

     329       317  

Non-cash expense related to put option

     248       409  

Changes in current assets and liabilities:

                

Accounts receivable (excluding provision for bad debt)

     (2,738 )     (2,593 )

Prepaid expenses and other current assets

     3       (212 )

Accounts payable

     (228 )     1,013  

Accrued expenses

     441       (773 )

Accrued interest

     (367 )     (120 )

Deferred revenue

     (725 )     (157 )

Income taxes payable and receivable

     135       1,581  
    


 


Net cash provided by operating activities

     40,609       39,686  
Investing Activities                 

Purchases of property and equipment

     (2,420 )     (1,555 )

Net proceeds from sale of land

     40       —    

Purchases of subscriber accounts (net of holdbacks)

     (49,922 )     (54,599 )
    


 


Net cash used in investing activities

     (52,302 )     (56,154 )
Financing Activities                 

Payment of deferred financing and issuance costs

     —         (1,324 )

Purchase of treasury stock

     —         (345 )

Proceeds from credit facility

     42,050       46,050  

Payments of credit facility

     (28,776 )     (23,725 )

Redemption of preferred stock

     —         (5,610 )
    


 


Net cash provided by financing activities

     13,274       15,046  
    


 


Increase (decrease) in cash and cash equivalents

     1,581       (1,422 )

Cash and cash equivalents at beginning of period

     190       1,645  
    


 


Cash and cash equivalents at end of period

   $ 1,771     $ 223  
    


 


Significant cash transactions during the period for:

                

Interest paid

   $ 20,850     $ 18,047  
    


 


Non-cash investing and financing activities:

                

Recapitalization:

                

Issuance of common stock

   $ —       $ 158,090  
    


 


Issuance of new Series A preferred stock

   $ —       $ 13,342  
    


 


Retirement of Series A, B, C, C-1 and D-1 preferred stock

   $ —       $ (171,432 )
    


 


Accrued preferred stock dividends

   $ —       $ 878  
    


 


Dividend election on redeemable preferred stock (see Note 4 - Redeemable Preferred Stock)

   $ 45,212     $ —    
    


 


 

See accompanying notes.

 

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MONITRONICS INTERNATIONAL, INC.

STATEMENT OF SHAREHOLDERS’ NET CAPITAL

(In thousands, except for shares)

 

    

Class A

Common Stock


  

Additional
Paid-in Capital


              

Accumulated

Deficit


   

Total

Shareholders’

Net Capital


 
          Treasury Stock, at
Cost


     
     Shares

   Amount

     Shares

   Amount

     

Balance at June 30, 2005

   31,090,317    $ 311    $ 156,677     843,194    $ (8,913 )   $ (93,347 )   $ 54,728  

Reclass redeemable preferred stock to long-term debt related to dividend election (see Note 4)

   —        —        (31,870 )   —        —         —         (31,870 )

Net loss

   —        —        —       —        —         (5,266 )     (5,266 )
    
  

  


 
  


 


 


Balance at December 31, 2005

   31,090,317    $ 311    $ 124,807     843,194    $ (8,913 )   $ (98,613 )   $ 17,592  
    
  

  


 
  


 


 


 

See accompanying notes.

 

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Table of Contents

Monitronics International, Inc.

Notes to Financial Statements

(Unaudited)

 

1. Description of Business and Summary of Significant Accounting Policies

 

Description of Business

 

Monitronics International, Inc. (the “Company”) provides security alarm monitoring and related services to residential and business subscribers throughout the United States. The Company monitors signals arising from burglaries, fires, and other events through security systems installed by independent dealers at subscribers’ premises.

 

The accompanying interim unaudited financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles. In the opinion of management, the accompanying interim unaudited financial statements contain all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the results of operations for the interim periods.

 

Stock Compensation

 

The Company accounts for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”) and related interpretations, and complies with the disclosure provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”). Under APB 25, compensation cost is recognized over the vesting period based on the difference, if any, on the date of grant between the fair market value of the Company’s common stock and the exercise price of the stock option granted. Generally, the Company grants options with an exercise price at least equal to or above the fair market value of the Company’s common stock on the date of the grant and, as a result, generally does not record compensation cost.

 

The following table illustrates the effect on net loss if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation (in thousands):

 

    

Three Months Ended

December 31,


   

Six Months Ended

December 31,


 
     2005

    2004

    2005

    2004

 

Net loss as reported

   $ (3,057 )   $ (584 )   $ (5,266 )   $ (1,399 )

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net value of related tax effects

     (19 )     (37 )     (47 )     (40 )
    


 


 


 


Pro forma net loss

   $ (3,076 )   $ (621 )   $ (5,313 )   $ (1,439 )
    


 


 


 


 

Recent Accounting Pronouncements

 

On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), Share-Based Payment (“SFAS 123(R)”), which is a revision of SFAS 123. SFAS 123(R) supercedes APB 25, and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure will no longer be an alternative. SFAS 123(R) is effective no later than the beginning of the first fiscal year beginning after December 15, 2005. The Company will adopt SFAS 123(R) on or before July 1, 2006. The adoption of SFAS 123(R)’s fair value method may have a significant impact on the Company’s results of operations, although it will have no impact on the Company’s overall financial position. The Company will implement SFAS 123(R) using the “prospective” method.

 

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Table of Contents

Monitronics International, Inc.

Notes to Financial Statements (continued)

(Unaudited)

 

2. Long-Term Debt

 

Long-term debt consists of the following (in thousands):

 

     December 31,
2005


   June 30,
2005


Revolving credit line and term loan payable

   $ 259,963    $ 246,687

Senior subordinated notes payable

     160,000      160,000

Subordinated notes payable

     21,744      21,470

Investor put option (see Note 3 (Related Party Transactions))

     468      220

Redeemable Preferred Stock (see Note 4 (Redeemable Preferred Stock))

     45,912      —  
    

  

       488,087      428,377

Less: discount

     709      764

Less: current portion

     3,656      1,804
    

  

     $ 483,722    $ 425,809
    

  

 

On August 25, 2003, the Company entered into its existing credit facility agreement comprised of a $175.0 million term loan that matures in fiscal year 2010 and a $145.0 million revolving credit facility that matures in fiscal year 2009. Payments under the term loan are payable in quarterly installments from December 31, 2003 through June 30, 2009. The quarterly payment is calculated based upon the amount of the original facility multiplied by 0.25% for the quarters ended December 31, 2003 through September 30, 2006, 1.25% for the quarters ended December 31, 2006 through September 30, 2007 and 3.00% for the quarters ended December 31, 2007 through June 30, 2009 with the remaining balance due at maturity. As of December 31, 2005, the Company had $88.9 million in borrowings outstanding under the $145 million revolving credit line and had $171.1 million in borrowings outstanding under the term loan. Further, the Company had $56.1 million in availability under the revolving credit line, of which $22.6 million was immediately available as calculated under the covenants in the Company’s credit facility, and is charged a commitment fee of 0.5% on the average daily unused portion. The revolving credit line bears interest at a rate of either prime plus 2.25% or LIBOR plus 3.25%. The term loan bears interest at a rate of either prime plus 2.75% or LIBOR plus 3.75%. For the six months ended December 31, 2005, borrowings under the credit facility had a weighted average interest rate of 7.5%. Interest incurred on borrowings is payable monthly in arrears.

 

On March 28, 2005, the Company amended certain provisions of its credit facility resulting in the elimination of mandatory reductions to the revolving credit facility, a 75 basis point reduction in the variable interest rate for the Company’s revolving credit line and the term loan, and a 25 basis point reduction in commitment fees at the Company’s current borrowing level.

 

On August 25, 2003, the Company also issued $160.0 million of senior subordinated notes (the “Senior Subordinated Notes”) at a discount of $0.94 million. The Senior Subordinated Notes accrue interest at 11.75% per annum and mature on September 1, 2010. Interest payments are to be made semi-annually in cash in arrears on March 1 and September 1 of each year beginning on March 1, 2004. On December 16, 2004, the Company completed an exchange offer in which it exchanged new notes that were registered under the Securities Act of 1933 for the Senior Subordinated Notes. In accordance with the registration rights agreement associated with these notes, the Company incurred special interest on the Senior Subordinated Notes in the amount of $470,000 in connection with the exchange offer.

 

Proceeds from the issuance of the Senior Subordinated Notes and borrowings under the credit facility in August 2003 were used primarily to repay the Company’s prior credit facility and its $12 million senior subordinated notes payable, to repurchase $20.5 million principal amount of its subordinated notes at a repurchase price of approximately $23.2 million and to pay debt issuance costs. As part of the August 2003 refinancing, the terms of the then-remaining $20.5 million principal amount of the subordinated notes were amended, and the maturity date was extended to March 1, 2010. Interest on the subordinated notes originally accrued at 13.5% per annum with

 

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Table of Contents

Monitronics International, Inc.

Notes to Financial Statements (continued)

(Unaudited)

 

interest payable semi-annually at a rate of 12% per annum with the remaining 1.5% interest per annum added to the outstanding principal amount of the subordinated notes. The 1.5% interest rate increased to 2.5% per annum on December 15, 2003 when the subordinated notes were not repurchased by that date, and the increased rate was applied retroactively to August 25, 2003.

 

The credit facility and subordinated notes have certain financial tests which must be met on a quarterly basis, including maximum total senior debt and total debt to quarterly annualized net operating income, minimum interest coverage ratio, minimum fixed charge coverage ratio and an annual capital expenditure limit. Indebtedness under the credit facility is secured by all of the assets of the Company. As of December 31, 2005, the Company was in compliance with all required financial tests.

 

On August 18, 2003, the Company entered into an agreement with the Hull Family Limited Partnership (the “Partnership”) and Mr. James R. Hull, the Company’s president and chief executive officer, as amended on September 23, 2004, that allowed for the put of $500,000 in value of Class A common stock to the Company in each fiscal year beginning in fiscal 2005 and ending June 30, 2009. On November 5, 2005, the Company was notified that the second of five option exercises would be completed where the Partnership would sell the Company $500,000 worth of Class A common stock. The fair value of the remaining investor put option was $0.5 million at December 31, 2005. See Note 3 (Related Party Transactions) to these financial statements.

 

Scheduled maturities (as defined) of long-term debt at December 31, 2005, utilizing the required payment schedule of the Senior Subordinated Notes, subordinated notes, credit facility, fair value of the investor put option, and the redeemable preferred stock (See Note 4 – Redeemable Preferred Stock) are as follows for fiscal years below (in thousands):

 

2006

   $ 875

2007

     7,156

2008

     64,006

2009

     110,056

2010

     145,994

Thereafter

     160,000
    

     $ 488,087
    

 

3. Related Party Transactions

 

Concurrently with the Senior Subordinated Notes offering, the Company entered into an agreement with James R. Hull, the Company’s president and chief executive officer, and the Hull Family Limited Partnership (the “Partnership”) pursuant to which the Company paid Mr. Hull a $2 million transaction fee in cash at the closing of the refinancing on August 25, 2003. This fee was capitalized as deferred financing costs. On November 7, 2003, the Partnership exercised its right to require the Company to purchase 400,000 shares of Class A common stock at a purchase price of $1 million in cash. Based on the fair value of the Company’s stock, no expense was recorded related to the repurchase of the Partnership’s shares. The agreement also gives the Partnership and Mr. Hull a written investor put option to sell up to a combined total of $500,000 in value of Class A common stock to the Company in each of the five fiscal years ending June 30, 2009 at purchase prices per share that are based on a multiple of the Company’s consolidated cash flow. Based on the fair value of the Company’s stock at the time of the agreement, the Company recorded no liability in connection with this agreement. On November 5, 2005, the Company was notified that the second of five option exercises would be completed where the Partnership would sell the Company 71,633 shares of Class A common stock for $500,000. As of December 31, 2005, the outstanding liability for the put option was $0.5 million. The Company will prospectively adjust its liability and related SG&A expense as the fair value of the put option changes.

 

On July 14, 2004, the Company completed a series of transactions which it refers to as the “recapitalization.” In the recapitalization, the Company redeemed approximately $5.6 million of the Series C and C-1 preferred stock held by Windward Capital Partners II, L.P. and Windward Capital LP II, LLC (the “Windward entities”) and then issued shares of a new Series A preferred or Class A common stock to its preferred shareholders in exchange for all of their preferred stock, Class A common stock and warrants to purchase Class A common stock. The preferred

 

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Table of Contents

Monitronics International, Inc.

Notes to Financial Statements (continued)

(Unaudited)

 

shareholders determined the number of shares to be received in the exchange based on the liquidation preference of, and accrued but unpaid dividends on, the existing preferred shares as of July 14, 2004 for the shares held by the Windward entities and as of June 30, 2003 for the remaining preferred shares. The Company’s preferred shareholders agreed to value the Class A common stock and new Series A preferred stock received in the exchange at $6.00 per share. The valuation was based on a negotiation amongst the Company’s preferred shareholders and the agreement of New York Life Capital Partners II, L.P. and PPM America Private Equity Fund L.P. to subsequently purchase the shares of Class A common stock received by the Windward entities in the exchange for $6.00 per share. No independent third party valuations or appraisal opinions were obtained by the preferred shareholders or board of directors during the negotiation process. The Company’s lenders and preferred shareholders consented to the recapitalization as required under the terms of the Company’s applicable agreements.

 

The Company’s preferred shareholders also negotiated the terms of the new Series A preferred stock issued to Austin Ventures III-A, L.P., Austin Ventures III-B, L.P., Austin Ventures V, L.P. and Austin Ventures V Affiliates Fund, L.P. The Company’s board of directors and the holders of at least two-thirds of the outstanding shares of Class A common stock, Series A preferred stock, Series B preferred stock, Series C preferred stock, Series C-1 preferred stock and Series D-1 preferred stock, each voting as a separate class as required by the Company’s articles of incorporation, approved the amendment and restatement of the Company’s articles of incorporation to create the new Series A preferred stock. On November 4, 2005, the holders of the Company’s Series A preferred stock notified it of their election for the Series A preferred stock to begin accruing dividends as permitted under the Company’s Company’s articles of incorporation (the “Dividend Election”). As a result of the Dividend Election, the Company must redeem the Series A preferred stock on June 30, 2008 (See Note 4 – Redeemable Preferred Stock).

 

4. Redeemable Preferred Stock

 

As of June 30, 2005, there were 8,247,075 shares of Series A preferred stock authorized of which 8,175,075 shares were issued and outstanding. On November 4, 2005, the holders of the Company’s Series A preferred stock notified it of their election for the Series A preferred stock to begin accruing dividends as permitted under the Company’s articles of incorporation. As a result of the Dividend Election, the Company must redeem the Series A preferred stock on June 30, 2008. The terms of the Series A preferred stock following the Dividend Election are described below.

 

Accounting Treatment

 

As a result of the Dividend Election made on November 4, 2005, the Company recorded the Series A preferred stock as a debt instrument by reclassifying, from additional paid-in capital to a long-term liability, the amount necessary to adjust the Series A preferred stock to its fair value as of the date of the Dividend Election. The Company obtained an independent valuation of the Series A preferred stock to determine the fair value of the Series A preferred stock. On November 4, 2005, the fair value of the of the Series A preferred stock was $45.2 million. The fair value of the liability will be accreted to the redemption amount of $57.9 million to be paid at June 30, 2008 using the interest rate implicit at the Dividend Election date. As of December 31, 2005, the Company reported a liability for the Series A preferred stock of $45.9 million consisting of $45.2 million as of November 4, 2005, which was the fair value of the Series A Preferred stock, plus accrued interest of $0.7 million. The liquidation preference of the Series A preferred stock as of December 31, 2005 is $45.8 million as calculated per the Company’s articles of incorporation (see Liquidation Preference below).

 

Series A Preferred Stock Dividend Preferences

 

Dividends will accrue on the Company’s Series A preferred stock at an annual rate of 8% until the first anniversary of the Dividend Election, and thereafter will increase by an additional 2% per annum on each subsequent anniversary of the Dividend Election date up to a maximum annual rate of 16%. If the Company fails to redeem the Series A preferred stock on June 30, 2008, the maximum dividend rate shall be increased from 16% to the greater of 24% and the maximum rate permitted by law.

 

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Monitronics International, Inc.

Notes to Financial Statements (continued)

(Unaudited)

 

The dividend rate will also increase by an additional 3% per annum above the then-applicable rate and by an additional 1% per annum at the end of each 90-day period thereafter (up to a maximum annual rate of 24%) following covenant defaults (as defined below) or if the Company issues senior securities or incurs certain indebtedness that causes the Company’s leverage ratio to exceed an initial multiple of 5.1 times annualized EBITDA (see Liquidation Preference below) until such noncompliance is cured. If the Company’s leverage ratio exceeds an initial multiple of 4.8 times annualized EBITDA other than as a result of its issuance of additional senior securities or indebtedness that triggers the increased dividends described in the preceding sentence, the dividend rate will increase by an additional 2% per annum (up to a maximum annual rate of 24%). The initial multiples are subject to increases to reflect subsequent debt or equity issuances.

 

Dividends are payable solely in cash when and as declared by the Company’s board of directors and only if sufficient cash is available to make the dividend payment. The Company may not pay dividends if a default exists or the payment of dividends would create a default under its credit facility or the indenture relating to the Senior Subordinated Notes.

 

Voting Rights

 

If the Company undertakes any of the actions described hereunder without first obtaining the consent of the holders of a majority of the then-outstanding shares of Series A preferred stock (referred to as a covenant or leverage default), the Liquidation Value will be recalculated at that time using the formula provided in the terms of the Series A preferred stock included in the Company’s articles of incorporation (see Liquidation Preference below).

 

Except as provided below or otherwise required by law, holders of Series A preferred stock will have no voting rights. On matters specifically requiring the vote of the Series A preferred stock voting as a separate class, holders of Series A preferred stock will be entitled to one vote per share of Series A preferred stock held by the holders. The holders of a majority of the outstanding shares of Series A preferred stock, voting as a separate class, must approve:

 

    Any change in the nature of the Company’s business;

 

    The issuance of securities that rank senior to, or pari passu with, the Series A preferred stock, or the incurrence of certain indebtedness, subject to limited exceptions;

 

    The issuance of additional Series A preferred stock other than to holders who received Series A preferred stock in the recapitalization or their permitted transferees;

 

    A redemption or repurchase of company securities that rank junior to, or pari passu or senior to, the Series A preferred stock, subject to limited exceptions;

 

    The declaration or payment of dividends or distributions on any company security that ranks junior to, or pari passu or senior to, the Series A preferred stock, subject to limited exceptions;

 

    The Company’s entry into agreements that prohibit it from performing its obligations in respect of the Series A preferred stock or which prohibit the exercise of the right of the holders of Series A preferred stock to require a sale of the company or other voting rights;

 

    Acquisitions in excess of $100 million;

 

    Amendment of the Company’s articles of incorporation or bylaws to increase the authorized shares of Series A preferred stock or adversely affect or otherwise impair the rights or relative preferences or priorities of the Series A preferred stock, other than to establish or amend senior securities otherwise permitted to be issued;

 

    The Company’s entry into or amendment of agreements with affiliates, subject to limited exceptions; or

 

    The Company’s establishment, acquisition of or ownership of any equity securities of ABRY or its affiliates.

 

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Monitronics International, Inc.

Notes to Financial Statements (continued)

(Unaudited)

 

Conversion Rights

 

Following the November 4, 2005 Dividend Election, the Company’s Series A preferred stock is no longer convertible into Class A common stock.

 

Redemption Rights

 

The Company must redeem the Series A preferred stock upon the closing of a qualified public offering at a per share price equal to the Liquidation Value (as defined below) plus accrued and unpaid dividends (the “Redemption Price”). The Company must also redeem the Series A preferred stock at the Redemption Price per share on June 30, 2008 (the “Mandatory Redemption Date”). If the Company has not redeemed the Series A preferred stock on the Mandatory Redemption Date, the holders of a majority of the outstanding Series A preferred stock may elect to initiate the sale or liquidation of the Company. The Company may redeem the Series A preferred stock at its option at any time prior to the Mandatory Redemption Date.

 

Notwithstanding the foregoing mandatory and optional redemption provisions, the Company cannot redeem the Series A preferred stock while the Senior Subordinated Notes are outstanding or if prohibited under its credit facility.

 

Liquidation Preference

 

The Series A preferred stock will have a liquidation preference per share based on the Liquidation Value (as defined below) plus accrued and unpaid dividends. As of December 31, 2005, the Series A preferred stock had an aggregate liquidation preference of $45.8 million consisting of a Liquidation Value of $45.2 million as of November 4, 2005, which was the fair value of the Series A preferred stock, plus accrued and unpaid dividends of $0.6 million.

 

If the Company undertakes any of the actions described under “Voting Rights” above without first obtaining the consent of the holders of a majority of the then-outstanding shares of Series A preferred stock (referred to as a covenant or leverage default), the Liquidation Value will be recalculated at that time using the formula provided in the terms of the Series A preferred stock included in the Company’s articles of incorporation. The Series A preferred stock will then have a new Liquidation Value equal to the amount that would be received by the holders of the Series A preferred stock upon a liquidation of the Company assuming liquidation proceeds equal to (a) the sum of (i) annualized EBITDA for the most recently completed fiscal quarter multiplied by 5.5 as adjusted according to the terms of the Series A preferred stock depending on the type of covenant or leverage default, plus (ii) company cash in excess of $2.0 million, less (b) company debt (as defined in the articles of incorporation) (the “Liquidation Value”).

 

5. Income Taxes

 

The Company provides a valuation allowance for its deferred tax assets when it is more likely than not that some portion or all of its deferred tax assets will not be realized. In June 2005, the Company established a valuation allowance to fully reserve its net deferred tax assets. The primary reason the valuation allowance was established was due to the history of cumulative losses in the three-year period ending June 30, 2005. Management also considered possible tax planning strategies. During the three and six months ended December 31, 2005, the Company continued to fully reserve its net deferred tax assets and therefore there is no provision or benefit for income taxes, except for state income tax expense, for the three and six months ended December 31, 2005, compared to a $0.5 million and $0.6 million benefit for the three and six months ended December 31, 2004, respectively. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income (including reversals of deferred tax liabilities) during the periods in which those temporary differences will become deductible.

 

6. Commitments and Contingencies

 

In December 2004, a lawsuit was served on the Company in Gatan, et al., vs. Alarm One, Inc., et al., a case then pending in the Superior Court for Alameda County, California, and which was originally filed against Alarm One, Inc. and others in 2003. The Company was served with a complaint seeking certification of a class of persons whose Alarm One contracts were assigned to the Company between March 1, 2000 and December 13, 2004. The operative complaint in this matter alleges claims by two named plaintiffs against the Company, as the claims filed by the two original named plaintiffs against Alarm One, Inc. have now been settled out of this case by Alarm One, Inc., and neither of the original named plaintiffs had contracts which were assigned to the Company. The complaint alleges that the Company has violated various California consumer protection statutes, including the California Home Solicitation Act, the California Unruh Act, the California Consumers Legal Remedies Act, and the California Unfair Competition Law, as well as breached the contracts, by failing to comply with various statute requirements or improperly enforcing the contracts in light of the various statute requirements. The new named plaintiffs seek damages, or alternatively, rescission or reformation of the contracts assigned to the Company, as well as compensatory damages, attorneys’ fees, costs and expenses, punitive damages, and certain injunctive relief. Plaintiffs moved for class certification of their claims against the Company on December 1, 2005, and no class has been certified as yet. The Company believes it acted properly and lawfully in its dealings with its customers, and that most if not all of the claims asserted in the case have already been addressed by the prior settlement by Alarm One, Inc., or alternatively are the sole responsibility of Alarm One, Inc., and not the Company. As a result, the Company intends to vigorously defend and contest any and all issues or threatened claims in this matter. Management is currently unable to determine the outcome of the claims or to estimate the amount of potential loss. In accordance with SFAS No. 5, Accounting for Contingencies, the Company has not established a loss accrual associated with this claim.

 

The Company is party to various legal proceedings and claims that have arisen in the ordinary course of its business. In the opinion of management, the amount of ultimate liability with respect to these actions is not expected to have a material impact on the financial position or results of operations of the Company.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

We are a leading national provider of security alarm monitoring services. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements, and the related notes to those financial statements, included in Part I - Item 1 of this Quarterly Report on Form 10-Q.

 

Forward-Looking Statements

 

Certain statements contained or incorporated by reference in this Quarterly Report on Form 10-Q including, without limitation, statements containing the words “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “plan,” “foresee,” “believe” or “continue” or the negatives of these terms or variations of them or similar terminology, are forward-looking statements within the meaning of the federal securities laws. Such forward-looking statements involve known and unknown risks, uncertainties and other matters which may cause actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Factors, risks and uncertainties that could cause actual outcomes and results to be materially different from those projected include, among others, the following:

 

    our high degree of leverage;

 

    our anticipated growth strategies;

 

    anticipated trends and conditions in our business, including trends in the market;

 

    our ability to acquire and integrate additional accounts;

 

    our expected rate of subscriber attrition;

 

    our ability to continue to control costs and maintain quality;

 

    our ability to compete;

 

    the impact of “false alarm” ordinances on our results of operations; and

 

    our ability to obtain additional funds to grow our business.

 

We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. They can be affected by inaccurate assumptions we might make or by known or unknown risks, uncertainties and assumptions. Reference is hereby made to the disclosures contained under the heading “Risk Factors” in “Part II - Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on September 23, 2005. In light of these risks, uncertainties and assumptions, the forward-looking statements may not occur and actual results could differ materially from those anticipated or implied in the forward-looking statements. When you consider these forward-looking statements, you should keep in mind these risk factors and other cautionary statements.

 

Our forward-looking statements speak only as of the date made. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless the securities laws require us to do so.

 

Overview

 

Nearly all of our revenues are derived from monthly recurring revenues under security alarm monitoring contracts purchased from independent dealers in our exclusive nationwide network. Our alarm monitoring contracts generally have a non-cancelable initial term of three years, generally allow for periodic price increases and provide for automatic renewals during which the subscriber may cancel the contract upon 30 days’ proper written notice. Revenues are recognized as the related monitoring services are provided. Other revenues are derived primarily from the provision of third-party contract monitoring services and from field technical repair services.

 

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Cost of services primarily consists of direct labor associated with monitoring and servicing subscriber accounts and expenses related to field technical repair services. Sales, general and administrative expenses primarily include the cost of personnel conducting sales and administrative activities and other costs related to sales, administration and operations. All direct external costs associated with the creation of subscriber accounts are capitalized and amortized over ten years using a 135% declining balance method. Internal costs, including all personnel and related support costs incurred solely in connection with subscriber account acquisitions and transitions, are expensed as incurred.

 

Attrition

 

We purchase subscriber contracts from our exclusive network of independent dealers. These contracts with our subscribers are typically three-year non-cancelable contracts with automatic renewal provisions during which the subscriber may cancel the contract upon 30 days’ proper written notice. A portion of our subscriber base can be expected to cancel its service every year. Subscribers may choose not to renew or terminate their contract for a variety of reasons, including relocation, cost, switching to our competitors’ service and service issues. A majority of canceled accounts result from subscriber relocation or the inability to contact the subscriber.

 

Account cancellation, otherwise referred to as subscriber attrition, has a direct impact on the number of subscribers we serve and hence our financial results, including revenues, operating income and cash flow. We define our attrition rate as the number of canceled accounts in a given period divided by the average of the beginning and ending balance of subscribers for that period. We consider an account canceled when a subscriber terminates in accordance with the terms of the contract or if payment from the subscriber is deemed uncollectible. If a subscriber relocates but continues his service, this is not a cancellation. If the subscriber relocates and discontinues his service and a new subscriber takes over the service continuing the revenue stream, this is a cancellation and a new owner takeover. We adjust the number of canceled accounts by excluding those that are contractually guaranteed by our dealers. Our typical dealer contract provides that if a subscriber cancels in the first year of its contract, the dealer must replace the lost monthly revenue attributable to the canceled contract and either replace the canceled account with a new one or refund our purchase price. To help ensure the dealer’s obligation to us, we typically hold back a portion of the purchase price for every account we purchase. In some cases, the amount of the purchase holdback may be less than actual attrition experience. In recent years, a substantial portion of the accounts that canceled within this initial 12-month period were replaced by the dealers at no additional cost to us.

 

The table below presents subscriber data for the twelve months ended December 31, 2005 and 2004:

 

    

Twelve Months Ended

December 31,


 
     2005

    2004

 

Beginning balance of accounts

   450,412     419,778  

Accounts purchased

   95,130     87,649  

Accounts canceled (1)

   (57,428 )   (55,188 )

Accounts guaranteed to be refunded from holdback

   (2,181 )   (1,827 )

Ending balance of accounts

   485,933     450,412  

Attrition rate

   12.3 %   12.7 %

(1) Net of canceled accounts that are contractually guaranteed by the dealer and new owner takeovers.

 

Results of Operations

 

Three Months Ended December 31, 2005 Compared to Three Months Ended December 31, 2004

 

Revenues. Total revenues were $46.7 million in the three months ended December 31, 2005 compared to $41.4 million in the three months ended December 31, 2004, which was an increase of $5.3 million, or 13%. This increase was primarily attributable to an increase in the number of subscriber accounts to 485,933 as of December 31, 2005 from 450,412 as of December 31, 2004 and a net increase in average revenue per customer.

 

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Cost of services. Cost of services was $5.7 million in the three months ended December 31, 2005 compared to $4.7 million in three months ended December 31, 2004, which was an increase of $1.0 million, or 21%. As a percentage of revenues, cost of services was 12% for the three months ended December 31, 2005 and 11% for the three months ended December 31, 2004 principally due to higher field technical service expense as a result of proportionately higher service calls.

 

Sales, general and administrative (SG&A). SG&A was $9.2 million in the three months ended December 31, 2005 compared to $7.5 million in the three months ended December 31, 2004, which was an increase of $1.7 million, or 23%. As a percentage of revenues, SG&A was 19.6% for the three months ended December 31, 2005 and 18.1% for the three months ended December 31, 2004. The increase in SG&A expense as a percentage of revenues was principally due to expense related to adjusting the fair value of a written put option as described in Note 3 (Related Party Transactions), increased telecommunication costs related to the use of cellular to monitor a small portion of our customer base, salaries related to creating a lead generation program and the addition of a Chief Operating Officer.

 

Amortization. Amortization of intangibles was $22.1 million in the three months ended December 31, 2005 compared to $19.5 million in the three months ended December 31, 2004, which was an increase of $2.6 million, or 13%. The increase was attributable to growth in our purchased subscriber accounts through our authorized dealer program.

 

Interest expense. Interest expense was $12.2 million in the three months ended December 31, 2005 compared to $10.3 million in the three months ended December 31, 2004, which was an increase of $1.9 million, or 18%. The increase resulted from the $0.7 million of accrued interest related to the Dividend Election made by the redeemable preferred shareholders on November 4, 2005 (see Note 4 (Redeemable Preferred Stock)), an increase in borrowing under our revolving line of credit throughout the period incurred to fund our purchase of subscriber accounts, and increases in variable interest rates. Our average interest rate increased to 10.4% in the three months ended December 31, 2005 from 10.2% in the three months ended December 31, 2004 as a result of higher average interest rates on our credit facility.

 

Provision (benefit) from income taxes. Beginning in June 2005, due to experiencing a cumulative loss before income taxes for the three-year period ended June 30, 2005, we established a valuation allowance to fully reserve our net deferred tax assets (see Critical Accounting Policies – Income Taxes and Deferred Tax Assets). Therefore, there was no provision or benefit for income taxes for the three months ended December 31, 2005 compared to a $0.5 million benefit for the three months ended December 31, 2004.

 

Net loss. Net loss was $3.1 million in the three months ended December 31, 2005 compared to a net loss of $0.6 million in the three months ended December 31, 2004 primarily due to higher interest expense.

 

Six Months Ended December 31, 2005 Compared to Six Months Ended December 31, 2004

 

Revenues. Total revenues were $91.8 million in the six months ended December 31, 2005 compared to $82.0 million in the six months ended December 31, 2004, which was an increase of $9.8 million, or 12%. This increase was primarily attributable to an increase in the number of subscriber accounts to 485,933 as of December 31, 2005 from 450,412 as of December 31, 2004 and a net increase in average revenue per customer.

 

Cost of services. Cost of services were $11.2 million in the six months ended December 31, 2005 compared to $9.5 million in six months ended December 31, 2004, which was an increase of $1.7 million, or 18%. As a percentage of revenues, cost of services was 12% for both the six months ended December 31, 2005 and December 31, 2004.

 

Sales, general and administrative. SG&A was $17.9 million in the six months ended December 31, 2005 compared to $15.1 million in the six months ended December 31, 2004, which was an increase of $2.8 million, or 19%. As a percentage of revenues, SG&A was 19% for the six months ended December 31, 2005 and 18% for the six months ended December 31, 2004. The increase in SG&A expense as a percentage of revenues was principally due to increased telecommunication costs related to the use of cellular to monitor a small portion of our customer base, salaries related to creating a lead generation program and the addition of a Chief Operating Officer.

 

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Amortization. Amortization of intangibles was $43.6 million in the six months ended December 31, 2005 compared to $38.3 million in the six months ended December 31, 2004, which was an increase of $5.3 million, or 14%. The increase was attributable to growth in our purchased subscriber accounts through our authorized dealer program.

 

Interest expense. Interest expense was $23.2 million in the six months ended December 31, 2005 compared to $20.2 million in the six months ended December 31, 2004, which was an increase of $3.0 million, or 15%. The increase resulted from $0.7 million of accrued interest related to the Dividend Election made by the redeemable preferred shareholders on November 4, 2005 (see Note 4 - Redeemable Preferred Stock), an increase in our average long-term debt outstanding throughout the period incurred to fund our purchase of subscriber accounts, and increases in variable interest rates. Our average interest rate increased to 10.2% in the six months ended December 31, 2005 from 10.1% in the six months ended December 31, 2004 as a result of higher average interest rates on our credit facility.

 

Provision (benefit) from income taxes. Beginning in June 2005, due to experiencing a cumulative loss before income taxes for the three-year period ended June 30, 2005, we established a valuation allowance to fully reserve our net deferred tax assets (see Critical Accounting Policies – Income Taxes and Deferred Tax Assets). Therefore, there was no provision or benefit for income taxes for the six months ended December 31, 2005 compared to a $0.6 million benefit for the six months ended December 31, 2004.

 

Net loss. Net loss was $5.3 million in the six months ended December 31, 2005 compared to a loss of $1.4 million in the six months ended December 31, 2004 primarily due to higher interest expense.

 

Liquidity and Capital Resources

 

General. Our operating strategy requires the availability of significant funds to finance growth through subscriber account purchases. Additional cash requirements include debt service and capital expenditures. We have financed our growth from a combination of long-term borrowings, issuance of preferred stock and cash flows provided by operations.

 

Major components of our working capital include accounts receivable, deferred revenue, purchase holdbacks and accrued interest payable. We expect to experience negative working capital in the future primarily due to accrued interest payable and purchase holdbacks. Purchase holdbacks are dependent on the number of subscriber accounts we purchase, the timing and amount of our payment of the purchase holdbacks to dealers, and the percentage of the purchase price we withhold to ensure a dealer’s obligation during the guarantee period. Accrued interest payable is dependent on the level of our debt and the timing of interest payments.

 

As of December 31, 2005 and June 30, 2005, we had working capital deficits of $12.1 million and $11.8 million, respectively.

 

Net cash provided by operating activities for the six months ended December 31, 2005 was $40.6 million, as compared to $39.7 million for the six months ended December 31, 2004. The increase in cash provided by operating activities for the six months ended December 31, 2005 was primarily due to growth in our subscriber base and the resulting increases in revenues which was offset by somewhat higher interest payments.

 

Net cash used in investing activities for the six months ended December 31, 2005 was $52.3 million, compared to $56.2 million for the six months ended December 31, 2004. For the six months ended December 31, 2005, capital expenditures were $2.4 million versus $1.6 million for the six months ended December 31, 2004. Capital expenditures were primarily for our central monitoring station, telephone systems, computer systems and leasehold improvements for our offices. Capital expenditures are expected to vary based on the growth of our subscriber account base and improvements to our technology, operating and financial systems. Purchases of subscriber accounts consist of all direct external payments associated with the purchase of subscriber accounts. The portion of the purchase holdback paid to dealers at the end of the guarantee period is included in this amount when paid.

 

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Our net cash provided by financing activities for the six months ended December 31, 2005 was $13.3 million, as compared to $15.0 million for the six months ended December 31, 2004.

 

As of December 31, 2005, we had $260.0 million outstanding under our credit facility, bearing interest at a weighted average rate for the six months ended December 31, 2005 of approximately 7.5% per annum, and we had approximately $56.1 million in borrowing availability under our revolving credit line, of which $22.6 million was immediately available as calculated under the covenants in our credit facility. In addition, we had $181.7 million in principal amount outstanding of senior subordinated and subordinated notes as of December 31, 2005.

 

As of June 30, 2005, there were 8,247,075 shares of Series A preferred stock authorized of which 8,175,075 shares were issued and outstanding. On November 4, 2005, the holders of our Series A preferred stock notified us of their election for the Series A preferred stock to begin accruing dividends as permitted under our articles of incorporation (the “Dividend Election”). As a result of the Dividend Election, we must redeem the Series A preferred stock on June 30, 2008. If we have not redeemed the Series A preferred stock on June 30, 2008, the holders of a majority of the outstanding Series A preferred stock may elect to initiate the sale or liquidation of the Company.

 

As a result of the Dividend Election made on November 4, 2005, we recorded the Series A preferred stock as a debt instrument by reclassifying, from additional paid-in capital to a long-term liability, the amount necessary to adjust the Series A preferred stock to its fair value as of the dividend election date. We obtained an independent valuation of the Series A preferred stock to determine the fair value of the Series A preferred stock. On November 4, 2005, the fair value of the of the Series A preferred stock was $45.2 million. The fair value of the liability will be accreted to the redemption amount of $57.9 million to be paid at June 30, 2008 using the interest rate implicit at the dividend election date. As of December 31, 2005, we reported a liability for the Series A preferred stock of $45.9 million consisting of $45.2 million as of November 4, 2005, which was the fair value of the Series A Preferred stock, plus accrued interest of $0.7 million. The liquidation preference of the Series A preferred stock as of December 31, 2005 is $45.8 million as calculated per our articles of incorporation (see Liquidation Preference in Note 4 - Redeemable Preferred Stock to the financial statements, included in Part 1 - Item 1 of this Quarterly Report on Form 10-Q).

 

On March 28, 2005, we amended certain provisions of our credit facility that included elimination of mandatory reductions to the revolving credit facility, a 75 basis point reduction in the variable interest rate for our revolving credit line and term loan, and a 25 basis point reduction in commitment fees at our current borrowing level.

 

On July 14, 2004, we completed a recapitalization in which we redeemed approximately $5.6 million of the Series C and Series C-1 preferred stock held by the Windward entities and then issued shares of a new Series A preferred stock or Class A common stock to our preferred shareholders in exchange for all their shares of preferred stock, Class A common stock and warrants to purchase Class A common stock. The Windward entities subsequently sold the shares of Class A common stock they received in the exchange to two new investors at $6.00 per share. We financed the total $6.8 million cost of the recapitalization, including the $5.6 million redemption payment and approximately $1.2 million of fees and expenses, with borrowings under our senior credit facility.

 

Prior to the recapitalization, we were obligated to accrue cumulative dividends on each series of our previously outstanding preferred stock at varying rates, but we were prohibited from paying these dividends under the terms of our credit facility and the indenture governing the senior subordinated notes if an event of default existed or would result from such payment. The recapitalization allowed us to restructure our accrued dividends by converting the accrued dividends into common and preferred stock.

 

On August 25, 2003, we issued $160.0 million of senior subordinated notes at 11.75% with a maturity date of September 1, 2010. Interest payments are to be made semi-annually in cash in arrears on March 1 and September 1 of each year beginning on March 1, 2004. On December 16, 2004, we completed an exchange offer in which we exchanged new notes that were registered under the Securities Act of 1933 for the senior subordinated notes. In accordance with the registration rights agreement associated with these notes, we incurred special interest on the senior subordinated notes in the amount of $470,000 in connection with the exchange offer.

 

Further on August 25, 2003, we entered into a new credit facility agreement with Fleet National Bank (“Fleet”) as administrative agent, Bank of America, N.A. as syndication agent, and a syndicate of lenders, including Fleet and Bank of America, N.A., as amended on July 14, 2004. Our credit facility is comprised of a $175.0 million term loan that matures in fiscal 2010 and a $145.0 million revolving credit facility that matures in fiscal 2009. Indebtedness

 

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under the credit facility is secured by all of our assets. Payments under the term loan are payable in quarterly installments from December 31, 2003 through June 30, 2009. The quarterly payment is calculated based upon the amount of the original facility multiplied by 0.25% for the quarters ended December 31, 2003 through September 30, 2006, 1.25% for the quarters ended December 31, 2006 through September 30, 2007 and 3.00% for the quarters ended December 31, 2007 through June 30, 2009 with the remaining balance due at maturity. We used the borrowings under this credit facility together with the proceeds of the senior subordinated notes offering primarily to repay our prior credit facility, to repay all of our $12 million 12% senior subordinated notes due June 30, 2007, and to repurchase $20.5 million principal amount of our 14.5% subordinated notes due March 1, 2010 at a repurchase price of approximately $23.2 million. In connection with our August 2003 refinancing, we amended the terms of our subordinated notes to extend the maturity date of the then remaining $20.5 million principal amount from January 18, 2009 to March 1, 2010. Prior to the amendment, interest accrued on the subordinated notes at 13.5% per annum with interest payable semi-annually in cash at a rate of 12% per annum with the remaining 1.5% interest per annum added to the outstanding principal amount of the subordinated notes. The 1.5% per annum interest rate increased to 2.5% per annum on December 15, 2003 and the increased rate applied retroactively to August 25, 2003.

 

We will require substantial cash flow to fully implement our business strategy and meet our principal and interest obligations with respect to the senior subordinated notes and our other indebtedness. We anticipate that cash flow generated from operations and borrowings under our credit facility will provide sufficient liquidity to fund these requirements for the foreseeable future. Following the August 2003 refinancing, we continue to have significant borrowing capacity under our credit facility. This capacity coupled with anticipated cash flow from operations is expected to meet and satisfy our short-term obligations.

 

We further preserve our borrowing capacity by following a cash management practice of maintaining as low as possible ongoing cash balance. However, our ability to meet our debt service and other obligations depends on our future performance, which in turn is subject to general economic conditions and other factors, certain of which are beyond our control. If we are unable to generate sufficient cash flow from operations or otherwise to comply with the terms of the indenture governing the senior subordinated notes or our other debt instruments, we may be required to refinance all or a portion of our existing debt or obtain additional financing. Further, the agreements or indentures governing our credit facility, our senior subordinated notes and subordinated notes contain financial covenants relating to capital expenditure limits, maximum total debt to annualized quarterly EBITDA, maximum total senior debt to annualized quarterly EBITDA, interest coverage and fixed charge coverage that may impact our ability to refinance all or a portion of our existing debt or obtain additional financing. As of December 31, 2005, we were in compliance with all required financial tests.

 

Critical Accounting Policies

 

Our discussion and analysis of results of operations and financial condition are based upon our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of financial statements in accordance with GAAP requires management to use judgment in making estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and disclosure of contingent assets and liabilities. We base our estimates and assumptions on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. These estimates and assumptions are evaluated on an ongoing basis. Due to the nature of certain assets and liabilities, there are uncertainties associated with some of the judgments, assumptions and estimates which are required to be made. Reported results could have been materially different under a different set of assumptions and estimates for certain accounting principle applications.

 

Long Lived Assets—Subscriber Accounts. Subscriber accounts relate to the cost of acquiring portfolios of monitoring service contracts from independent dealers. The subscriber accounts are recorded at cost. All direct external costs associated with the creation of subscriber accounts are capitalized. Internal costs, including all personnel and related support costs, incurred solely in connection with subscriber account acquisitions and transitions are expensed as incurred. The cost of subscriber account pools are amortized using the 10-year 135% declining balance method. Subscriber accounts are amortized in pools because of the accounts’ homogeneous characteristics resulting primarily from the extremely disciplined due diligence program that we have implemented in which a contract must meet certain purchase criteria before we will purchase that account. All of our customers contract for essentially the same service and we are consistent in providing that service regardless of the customers’ locations.

 

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A 10-year 135% declining balance amortization method was selected to provide a matching of amortization expense to individual subscriber revenues based on historical performance of our subscriber base. The realizable value and remaining useful lives of these assets could be impacted by changes in subscriber attrition rates, which could have an adverse effect on our earnings.

 

We review the subscriber accounts for impairment or a change in amortization period whenever events or changes indicate that the carrying amount of the asset may not be recoverable or the life should be shortened. For purposes of recognition and measurement of an impairment loss, we view subscriber accounts as a single pool because of the assets’ homogeneous characteristics, which is the lowest level for which identifiable cash flows are largely independent of the cash flows of the other assets and liabilities. If we determine that an impairment has occurred, we write the subscriber accounts down to their fair value.

 

Income Taxes and Deferred Tax Assets. As part of preparing our financial statements, significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and the need for a valuation allowance related to our deferred tax assets. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, especially the amortization of subscriber accounts, which are amortized using a 10-year 135% declining balance method for financial reporting purposes and are generally amortized using a 10-year straight-line method for tax purposes. These differences result in deferred tax assets and liabilities, which are included within our balance sheet. We must then in accordance with Financial Accounting Standards Board Statement No. 109, Accounting for Income Taxes, assess the realizability of the deferred tax assets. Accordingly, we have fully reserved our deferred tax asset as a result of experiencing a cumulative loss before income taxes for the three-year period ended June 30, 2005. We also considered possible tax planning strategies. In assessing the realizability of the deferred tax assets, management considers whether it is more likely than not that some portion, or all of the deferred tax assets, will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income (including reversals of deferred tax liabilities) during the periods in which those temporary differences will become deductible.

 

Goodwill. As of December 31, 2005 we had goodwill of $14.8 million, which represents 2.8% of our total assets. We test goodwill annually for impairment and record an impairment charge if the carrying amount exceeds the fair value. We use a discounted cash flow approach as well as other methods to determine the fair value used in our test for impairment of goodwill. The results of this methodology depend upon a number of estimates and assumptions relating to cash flows, discount rates and other matters. Accordingly, such testing is subject to certain uncertainties, which could cause the fair value of goodwill to fluctuate from period to period.

 

Recent Accounting Pronouncements

 

On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), Share-Based Payment (“SFAS 123(R)”), which is a revision of SFAS 123. SFAS 123(R) supercedes APB 25, and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure will no longer be an alternative. SFAS 123(R) is effective no later than the beginning of the first fiscal year beginning after December 15, 2005. We expect to adopt SFAS 123(R) on July 1, 2006. The adoption of SFAS 123(R)’s fair value method may have a significant impact on our results of operations, although it will have no impact on our overall financial position. We will implement SFAS 123(R) using the “prospective” method.

 

Off-Balance Sheet Arrangements

 

We do not have any off-balance sheet arrangements, as defined in Regulation S-K Item 303(a)(4)(ii)(A)-(D), that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

We have interest rate risk, in that borrowings under our credit facility are based on variable market interest rates. As of December 31, 2005, we had $260.0 million of variable rate debt outstanding under our credit facility.

 

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Presently, the revolving credit line bears interest at a rate of prime plus 2.25% or LIBOR plus 3.25%, with the term loan at a rate of prime plus 2.75% or LIBOR plus 3.75%. To control our exposure to interest rates under our facility, we are required to utilize interest rate caps as required by our credit facility if our ratio of fixed interest debt to total debt should fall below 25%. As of December 31, 2005, we were in compliance with this ratio. A hypothetical 10% increase in our credit facility’s weighted average interest rate of 7.5% per annum for the six months ended December 31, 2005 would correspondingly decrease our earnings and operating cash flows by approximately $1.0 million.

 

Our privately issued $21.7 million subordinated notes due March 1, 2010 have a fixed interest rate of 14.5%, but have exposure to changes in the debt’s fair value. In connection with our August 2003 refinancing, we amended the terms of these subordinated notes to extend the maturity date from January 18, 2009 to March 1, 2010 and to increase the interest rate from 13.5% per annum to 14.5% per annum. In addition, we issued $160.0 million aggregate principal amount of our senior subordinated notes due September 1, 2010 with a fixed interest rate of 11.75%, which has exposure to changes in the debt’s fair value. We believe that the fair value of our total subordinated debt is approximately $178.1 million (book of $181.7 million). The fair value of our total subordinated debt is based on the quoted market price of our senior subordinated debt.

 

Item 4. Controls and Procedures

 

We maintain a system of controls and procedures designed to provide reasonable assurance as to the reliability of the financial statements and other disclosures included in this report, as well as to safeguard assets from unauthorized use or disposition. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15d-15(e) under supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. Based upon that evaluation, as of the end of the period covered by this Quarterly Report on Form 10-Q our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 are effective in timely alerting them to material information required to be included in our periodic Securities and Exchange Commission filings. No significant changes were made to our internal controls over financial reporting or in other factors that have materially affected or are reasonably likely to materially affect these controls during our most recent fiscal quarter. The design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events.

 

PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

 

In December 2004, a lawsuit was served on the Company in Gatan, et al., vs. Alarm One, Inc., et al., a case then pending in the Superior Court for Alameda County, California, and which was originally filed against Alarm One, Inc. and others in 2003. The Company was served with a complaint seeking certification of a class of persons whose Alarm One contracts were assigned to the Company between March 1, 2000 and December 13, 2004. The operative complaint in this matter alleges claims by two named plaintiffs against the Company, as the claims filed by the two original named plaintiffs against Alarm One, Inc. have now been settled out of this case by Alarm One, Inc., and neither of the original named plaintiffs had contracts which were assigned to the Company. The complaint alleges that the Company has violated various California consumer protection statutes, including the California Home Solicitation Act, the California Unruh Act, the California Consumers Legal Remedies Act, and the California Unfair Competition Law, as well as breached the contracts, by failing to comply with various statute requirements or improperly enforcing the contracts in light of the various statute requirements. The new named plaintiffs seek damages, or alternatively, rescission or reformation of the contracts assigned to the Company, as well as compensatory damages, attorneys’ fees, costs and expenses, punitive damages, and certain injunctive relief. Plaintiffs moved for class certification of their claims against the Company on December 1, 2005, and no class has been certified as yet. The Company believes it acted properly and lawfully in its dealings with its customers, and that most if not all of the claims asserted in the case have already been addressed by the prior settlement by Alarm One, Inc., or alternatively are the sole responsibility of Alarm One, Inc., and not the Company. As a result, the Company intends to vigorously defend and contest any and all issues or threatened claims in this matter. Management is currently unable to determine the outcome of the claims or to estimate the amount of potential loss. In accordance with SFAS No. 5, Accounting for Contingencies, the Company has not established a loss accrual associated with this claim.

 

The Company is party to various legal proceedings and claims that have arisen in the ordinary course of its business. In the opinion of management, the amount of ultimate liability with respect to these actions will not have a material impact on the financial position or results of operations of the Company.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

On September 15, 2005, we granted to employees options to purchase 85,800 shares of our Class A common stock under our 2005 Stock Option Plan at an exercise price of $6.00 per share and options to purchase 15,500 shares of our Class A common stock under our 2001 Stock Option Plan at an exercise price of $6.00 per share. These transactions were exempt from the registration requirements of the Securities Act by virtue of Rule 701 because they were issued in compensatory circumstances to employees in compliance with that Rule.

 

Item 3. Defaults Upon Senior Securities

 

None.

 

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Item 4. Submission of Matters to a Vote of Security Holders

 

None.

 

Item 5. Other Information

 

None.

 

Item 6. Exhibits

 

2.1    Recapitalization Agreement, dated July 14, 2004, among Monitronics International, Inc., Austin Ventures III-A, L.P., Austin Ventures III-B, L.P., Austin Ventures V, L.P., Austin Ventures V Affiliates Fund, Capital Resource Lenders II, L.P., ABRY Partners IV, L.P., ABRY Investment Partnership, L.P., Windward Capital Partners II, L.P., Windward Capital LP II, LLC, New York Life Capital Partners II, L.P., PPM America Private Equity Fund LP and The Northwestern Mutual Life Insurance Company. (1)
3.1    Restated Articles of Incorporation of Monitronics International, Inc. (2)
3.2    Bylaws of Monitronics International, Inc. (3)
31.1*    Certification of the Chief Executive Officer of Monitronics International, Inc. pursuant to Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2*    Certification of the Chief Financial Officer of Monitronics International, Inc. pursuant to Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1**    Certification of the Chief Executive Officer of Monitronics International, Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2**    Certification of the Chief Financial Officer of Monitronics International, Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(1) Previously filed as Exhibit 2.1 to Amendment No. 3 to the registrant’s Registration Statement on Form S-4 (File No. 333-110025) and incorporated herein by reference.
(2) Previously filed as Exhibit 3.1 to Amendment No. 3 to the registrant’s Registration Statement on Form S-4 (File No. 333-110025) and incorporated herein by reference.
(3) Previously filed as Exhibit 3.2 to the registrant’s Registration Statement on Form S-4 (File No. 333-110025) and incorporated herein by reference.
  * Filed herewith.
** Furnished herewith.

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

    MONITRONICS INTERNATIONAL, INC.
    By:  

/s/ James R. Hull


        James R. Hull
        Chief Executive Officer and President
        (Principal Executive Officer)
    By:  

/s/ Michael R. Meyers


        Michael R. Meyers
        Chief Financial Officer and Vice President
Date: February 10, 2006       (Principal Financial and Accounting Officer)

 

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