Protection One Inc. Q3 2008 (Qtr End 09/30/08) Earnings Call Transcript

Protection One Inc. (PONE)

Q3 2008 Earnings Call

November 7, 2008 10:00 am ET

Executives

Richard Ginsburg - President, Chief Executive Officer and Director

Darius G. Nevin - Executive Vice President, Chief Financial Officer

Analysts

Jeff Kessler – Imperial Capital

Presentation

Operator

Welcome to the Protection One’s conference call to review the company’s third quarter 2008 results. By now you should have received a copy of their earnings press release. If you’ve not received a copy, please call 785-856-9368 to request one. A copy is also available on the investor relation section of Protection One’s website at ProtectionOne.com.

Before we begin, please note that the following live broadcast by Richard Ginsburg, Protection One’s President and CEO and Darius Nevin, the company’s Executive Vice President and CFO is copyrighted to Protection One.

In addition, the company’s remarks today that are not historical facts may be forward looking statements that involve risks and uncertainties. Forward looking statements may include words or phrases such as we believe, we anticipate, we expect or words of similar meaning. Forward looking statements may also describe the company’s future plans, objectives, expectations or goals. Such statement may address future events and conditions concerning customer retention, debt levels and debt service capacity. Actual results may differ materially from events and conditions concerning customer retention, debt levels and debt service capacity. Actual results may differ materially from those projected, implied, or anticipated by the company’s forward looking statements as a result of numerous factors including the company’s significant debt obligations, net losses and competition.

For further discussions affecting the company’s performance see Protection One’s annual report on form 10-K for the year ended December 31, 2007 and its quarterly report on form 10-Q ended September 30, 2008 which the company expects will be filed with the SEC on Monday, November 10.

Protection One disclaims any obligation to update any forward-looking statements as a result of developments occurring after this call. During today’s call the company will provide alternative views of certain results that do not conform to generally accepted accounting principles.

The company believes the alternative views will enhance the understanding of its performance. The company has provided schedules that reconcile these non-GAAP views with its resulted reports on a GAAP basis as part of its earnings press release which again is available at ProtectionOne.com.

As a reminder today’s call is being recorded. A replay of the call and webcast will be available today at approximately 1pm EST through the investor relations section of the company’s website or by calling 888-203-1112. The replay pass code is 6479194.

Now let me turn things over to Richard.

Richard Ginsburg

Good morning everyone, this is Richard Ginsburg. After providing an overview I’m going to turn the call over to Darius Nevin, our CFO who will review his usual financial results. I want to do something a little bit differently here this morning. In light of the economy I would first like to take the opportunity of this call to address questions that some of you might have about our capital structure, our covenants, counter party risk and supply chain. So, let me start.

P One’s net debt maturity is three years from now in November of 2011 when our $115 million 12% senior notes are due. We have a revolver that’s $25 millions and that matures in March of 2010. Today, we use less than $5 million of that revolver for letters of credit that we can also replace using cash collateral. Lehmnan commercial paper is at $2.5 million participant in that revolver.

On the senior credit facility we’re required to repay $750,000 of it each quarter or $3 million a year and we’re going to start paying an excess cash flow sweep on that instrument in the first quarter of 2009 for the 2008 fiscal year.

Today we have roughly $40 million of cash invested in United States Treasury portfolios and we generate positive cash flow after our debt service. Our senior credit facility has typical leverage in interest coverage maintenance covenants and we’ve adequate cushion even after both requirements tighten slightly at the end of this year. Our 12% notes and the new unsecured term loan do not have maintenance covenants, only an incurrence test requiring a minimum interest coverage ratio of 2.25 times.

Turning to counter party rents, Bank of America is counterparty to our interest rate swaps and as such, we believe the risk of counterparty default is remote. These swaps convert interest on $250 million of our senior credit facility from LIBOR plus 225 basis points to a weighted average fixed rate of 5.42%.

Turning to insurance, AIG’s well-capitalized insurance subsidiaries and Liberty Mutual are our principal insurance carriers.

In terms of supply chain, Honeywell and GE provide most of our electronic securities system equipment.

And finally, it’s important to note, we can dial down our roughly $75 million investment in new systems if we need to build free cash flow and increase EBITDA in the near term. All in all, under the circumstances, we believe we are well positioned. Darius and I will be happy to take more questions on the subject during Q&A. We thought it would be helpful to bring this out early because I know many of you may have had questions about what I just said. So, let’s turn back to business.

As it stated in the earnings release this morning, the company remains very focused on several key initiatives. We want to continue delivering commercial RMR net growth while returning our residential portfolio to a growth trend as well. We are emphasizing sales of our e-secure product line that gives us a competitive edge and increases average recurring revenue or ARPU per unit.

The complement to an effective additions program is vigilance unattritioned. We continue to offer great service to our customers and remind them of the value that we provide everyday and especially during these times of economic uncertainty and what is becoming rising crime.

On the operations side, we’re implementing retail process improvements that we expect will improve margins for monitoring service as we head into 2009.

Turning to our wholesale segment, this unit delivered increased revenue this quarter and more than twice the RMR additions that it did one year ago.

In network multi-family, I have asked the leadership team to concentrate their efforts on existing customer base until economic conditions improve. So, let me touch on some of these points in a bit more depth here.

We increased commercial RMR additions by 6% in the quarter compared to one year ago. It’s important to note that as of September 30 the company had $6 million of commercial RMR also up 6% from a year ago. This represents 29.1% of our total retail portfolio up from 27.4% last year. We’re committed to strengthening our position in the commercial space and we expect to end the year with approximately 200 commercial sales reps, which will be up from the roughly 170 from the first half of this year.

Despite the economic head wind, we’re optimistic the demand will persist for the value proposition we offer in commercial security services. We have a national footprint, we have a dedicated commercial only monitoring center, and we have the ability to deliver multiple innovative, yet cost effective services tailored to the needs of key vertical markets.

In residential, we are experiencing increasing success with our e-secure product family including bundles designed to highlight the power of web-based control and monitoring. Residential ARPU or new editions during the third quarter was up 13% from one year ago.

As most of you know, we ended the BellSouth alliance at the end of June of this year. In fact, leads and sales from that relationship had been declining since the third quarter of 2007. Although internal residential additions in the third quarter decrease by 6% compared to last year, I think it’s important to know that outside the southeast region where BellSouth was, we increased residential additions by almost 3% with the help of our improving online presence and market initiatives.

The new website we launched at the beginning of October is already having an impact on our web matrix. Though residential RMR at the end of the quarter was 2.6% less than one year ago we only began marketing using the P One brand in the southeast this past quarter. I’m optimistic we can return to quarterly residential RMR additions to develop our alliance levels in the not too distant future.

Let’s turn to attrition because I know that’s on everyone’s mind. We did see an increase in retail cancellations due to financial reasons cited by our customers. As I’ve noted in past calls, we do expect to be in a challenging attrition environment for at least the next couple of quarters. Our retail attrition rate was helped actually by the improvements that we’ve made in the ISG attrition rate compared to one year earlier.

Let me close by mentioning that we’re paying very close attention to providing great customer care in a cost effective manner. To that end, we have initiated several process improvements that have resulted in a head count reduction to date of approximately 150 positions or 5% on our consolidated basis since April. We have also decided to focus our network multi-family business unit even more on taking great care of its existing customers and less on developing new relationships which require significant upfront investment. As a result, creation costs in that group are expected to decline.

In summary before I turn the call over to Darius, we just completed a quarter that was one of the most challenging we have seen in a long time. Nevertheless we remain very focused and still make progress on the key elements of our business climb.

I’m going to turn the call over to Darius, who will release additional financial results and then if you have any questions we’ll be be more than happy to take them.

Darius G. Nevin

Thank you Richard and good morning everyone. I plan to run through the key captions on the income statement and then the balance sheet. All the comparisons will be to the third quarter of 2007 which I would note happened after the merger with IASG. Consolidated monitoring and service revenue was essentially unchanged though the mix shifted. Retail monitoring revenue declined by less than 1% to $64 million because attrition outpaced additions growth and price increases.

Wholesale monitoring revenue increased by almost 8% to $12.6 million principally from growth provided by our largest customer. Multi-family monitoring revenue declined by about 5% to $7.6 million due to a decrease in RMR in force. I would like to highlight that retail monitoring service revenue increased sequentially from the second quarter. The increase of nearly $300,000 came from growth in commercial, price increases, and more [TNM] service.

Our consolidated monitoring and gross margin percentage decreased to 66.8% from 68.4% for several reasons. Lower margin wholesale revenue now represents 14.9% of total monitoring and service revenue compared to 13.9% one year ago. Conversely high margin multi-family revenue now represents only 9% of total monitoring and service revenue compared to 9.5% one year ago. Our retail groups percent a total monitoring and service revenue also declined by about half a percent.

We had higher fuel costs and duplicate payroll costs related to centralizing staffing in the monitoring centers. Gross margin on our retail monitoring and service revenue was consistent with the prior quarter but ticked down half a percent to 70.7% from last year. This is due to the slight revenue decline combined with temporarily incurring higher staffing costs during our centralization undertaking.

The company expects to improve retail contribution through reduced head count and more use of automation tools to manage accounts remotely. Netting the revenue and direct costs impacts consolidated gross margin for monitoring and service revenue decreased about $1.4 million or 2.3% to $56.2 million dollars.

Looking back one quarter though, this metric increased by $600,000 or about 1.1%. As of last quarter we recorded a reduction in the total of G&A and merger related severance compared to the one year ago period. However, higher medical and workers comp benefits offset the absence of the merger related severance that we experienced in 2007.

We used $2 million cash on maintenance CapEx in the quarter and $4.5 million over the last 9 months including investing $300,000 and $1.7 million in vehicles to capital leases in those same periods.

If we look at RMR creation activities now, our retail segment created approximately $600,000 of RMR essentially unchanged from 2007. Separately, we purchased $23,000 of RMR this quarter compared to $11,000 last year.

In the third quarter, our activities creating RMR resulted in our incurring a consolidated total of $20.4 million of net costs compared to $17.2 million in 2007. Net creation activity expenses that flowed through the income statement and thus affected EBITDA increased to $9.6 million from $7.9 million.

Our retail activity accounted for $18.2 million in net costs this quarter compared to $15.3 million last year. Our net spending on creation and acquisition activity increased because of lead generation costs through our new marketing strategies which got underway early in the second quarter. Creation multiple was also impacted by shift from commercial outright sales to lease sales which have a higher creation cost but contribute more RMR per unit. We also incurred more fuel costs along with additional sales management and technical support expenses in order to position ourselves for future commercial growth.

Continuing our way down the income statement, consolidated operating income for the quarter decreased to $900,000 from $4.2 million in 2007. This decrease is largely because the cost to care for our retail customers and selling expenses increased. We also incurred $1.9 million more amortization of deferred customer acquisition costs in excess of amortization of deferred revenue which were only partially offset by the decline in merger related severance.

Adjusted EBITDA for the quarter came in at $27.1 million compared to $30.2 million one year earlier which is consistent with the guidance we gave last year that EBITDA would trend lower.

Interest expense for the third quarter 2008 was $12.2 million compared to $13.3 million one year earlier. These amounts include net non-cash amortization of debt costs, discounts and premiums of approximately $100,000 in the third quarter of 2008 compared to $1.7 million one year earlier. Excluding those items, interest expense was $12.1 million this year and $11.6 million last year. Significantly higher interest on our senior unsecured $110 million instrument was partially offset by lower interest on the senior term loan.

At current LIBOR and prime rates, the company’s annualized cash interest expense is approximately $47 million which is about $1 million lower than last quarter because of the recent reductions in the prime rate.

Finally, at the end of September we had approximately $523.7 million face amount of debt and capital debt outstanding compared to $526 million calculated the same way at the end of December. Our cash position at the end of September was $40.5 million compared to $41 million at the end of December. Net debt decreased slightly because free cash flow was largely absorbed by fees and expenses incurred in refinancing our subordinated debt in the first quarter.

With that, we’d like to open the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jeff Kessler – Imperial Capital.

Jeff Kessler – Imperial Capital

With regard to your RMR, I should say more importantly, your creation costs, you have two initiatives that you are undergoing and maybe you are fairly well through. One obviously is the shift away from the old BellSouth marketing scheme toward your multiple new marketing schemes in internal and number two is the secure initiative. At what point are the start up costs and the types of cost of just getting the stuff up and running going to be subsumed by the actual revenue production of mostly RMR that you get from that, so that we can get to a point at which they’ll some type of steady state, year over year comparison that will be a more apples to apples comparison of these start up costs?

Darius G. Nevin

Let me at least try to tackle part of that question, with any amounts of new type of channel, which we use the web and our pay-per-click undertaking there as really the develop of a new channel there are going to be startup inefficiencies. I will note that we have paid a lot of attention to our efforts where we, as Richard noted, we introduced a new website in October and from that website we are seeing significantly greater, higher conversions of people who go to the website, who then are asking for a security consultation.

We have made a significant progress within our sales force in taking those types of leads, which are extremely high quality leads and converting those into actual appointments and then converting those into sales. We’re tracking all of those metrics and there was inefficiency at the start as with any type of program at every single level in terms of getting people to the website, getting them through the website, getting them to a sit and to a close. All of those metrics are improving. We expect to continue to improve. That’s for the one element of how we improve creation costs.

There’s another element which is to drive our sales force to sell a different type of product that generates a higher RMR per unit, higher ARPU, a telecom term and we are seeing as I think Richard mentioned, we’re seeing significantly higher percentage of our sales coming from e-secure which is our interactive service. To give you an idea, that’s typically a $45 RMR type service offering which is significantly higher than our typical $30 residential offering.

There’s greater efficiency in turning those dollars spent on the web into actual appointments and closed sales plus there’s the other aspect which is that a typical sale now is going to generate more RMR. When you have all of those things working and we’ve modeled it out, our expectation is that we will see improved productivity on a go forward basis in other than a sort of doomsday economic scenario.

Jeff Kessler – Imperial Capital

You are, the question I guess is to try to put a date on it, like January 13. Given the fact that 2009 is not going to be the world’s greatest year, do you have some reasonable expectation of at what point during the year are you going to see this thing cross over into more positive territory relative to the start up costs? By mid year 2009 or --

Darius G. Nevin

Are you asking when are we going to start to see positive RMR growth? I’m not sure of the question.

Jeff Kessler – Imperial Capital

I think the question is positive RMR growth from these new alternatives you’re putting in.

Darius G. Nevin

Yes, I think that’s a fair assumption that somewhere in the middle of next year and I don’t want to say second or third quarter but somewhere in that area we should see improving productivity from the web that translates into additional residential and commercial sales. In addition as Richard noted, we’ve increased our commercial head count and we are undertaking many initiatives in that area as well in order to make that part of our distribution channel more effective. We have a number of things working that lead us to believe and expect that we should see positive growth, let’s say, middle of next year.

Richard Ginsburg

Again, Jeff, this is Richard, it’s also important to know that we are spending money on brand building which is something that we never did before. When we did initial research and our brand was not as strong as our other two large competitors, we also think it’s important now and going into 2009 to continue that marketing spend which helps the brand. You know more than anyone, one of our competitors can be changing their brand, so we think it’s an opportunity to strengthen our brand during that time. There’s a number of things that we’re working on.

As it relates to web spending, quadrangle of partners, they have significant experience with the internet. They’re helping us out. We’re monitoring these costs very, very closely and as Darius mentioned, I am pleased that we are seeing ARPU increasing. Clearly the efforts are working, but as you know, there’s a lot of uncertainty going into 2009 but I think the web is interesting because it gives us the ability, for instance, to turn that off at a moment’s notice if we find we have to. I’m optimistic.

Jeff Kessler – Imperial Capital

Okay, can you talk about your attrition, both trends you’re seeing the way you reported in growth attrition and talk about net attrition? What I’m trying to get is the nature of the attrition change that you may be seeing right now.

Richard Ginsburg

We’re seeing an increase in non-pays and financial reasons on residential sides like all other competitors are. We’re seeing some, a little bit of commercial attrition especially, we’re seeing some commercial customers maybe closing down some locations so we’re being hurt by that. As I mentioned in prior calls, that we expected attrition to go up slightly. It has, but I think the good news is, these are uncontrollable reasons that are not based on the performance of the company. Darius, I don’t know if you want to kind of get into some of the net discussions, you have some numbers in front of you.

Darius G. Nevin

Jeff, just to give you an idea; if we look at the retail numbers on a gross basis, we reported 14.6% for the quarter versus 14.4% for a year ago. Those same numbers adjusted for new owners or move-in accounts depending upon your terminology was 13.2% for the quarter just ended and 12.5% one year earlier.

Jeff Kessler – Imperial Capital

You have numbers, do you still keep numbers for the old base business or have you completely amalgamated both the old business and AISG?

Richard Ginsburg

Yes, we have those numbers and on a standalone basis, the way we think about it is, the non-IASG accounts because the way we are tracking that ISG acquired portfolio is as a, if you will, is wasting assets but since there aren’t any additions going into that portfolio if you exclude those what we acquired it was 13.6 percent in the quarter that just ended versus 12.9% that’s on a gross basis. On a net basis 12% for Q3 08 and 10.7% for Q3 07.

Jeff Kessler – Imperial Capital

All right, and that 12% versus 10.7% is mainly attributable to the factors that you just spoke about; a lot of them uncontrollable?

Richard Ginsburg

Yes. Exactly, but in our account base we, like everybody else, have people that probably bought houses that they can’t afford, there’s some level of foreclosure occurring, some level of people who lost their jobs and have decided that this is something they can’t continue to pay for. One thing I would note is we include in cancellations; let’s say somebody calls us and says, look, my wife just lost her job or my husband just lost his job, I don’t want to cancel the service, I just want to suspend it; give us a chance to get back on our feet. We do offer our customers that option and we do count that as a cancellation. If they’re still in our system, we expect them to resume at some point, but for the purposes of public reporting that’s out of our base. Many of those folks will come back, in fact.

Darius G. Nevin

Also, Jeff, some commercial customers that are slow to pay, especially some of our local governments that are a little bit slower to pay, the way we factor an attrition, we do have some of that in that attrition number that probably will come back. Jeff, I think the interesting this is, as Richard mentioned is, the one thing we having working for us; we are seeing, and it varies by month, we do see IASG attrition trending down. Even if our base goes up a little bit, the non-IASG portfolio goes up a little bit; we do have working in our favor that IASG attrition coming down from what were very high levels. That can help mitigate the overall portfolio increase.

Jeff Kessler – Imperial Capital

Can you go a little bit into your creation multiple cost increases?

Darius G. Nevin

I think I covered the most of the highlights. It’s mostly, largely a pay-per-click more marketing activities to, and again, those are start up and we are very convinced that that’s something that we need to be doing. There is an impact of higher sales overhead. We are increasing our sales management level within the company because we are convinced that we get greater productivity by having more of our sales reps working directly for a sales specialist as opposed to a general manager.

The other critical factor that we have is that compared to last year, we sold more systems on an operating lease basis than we did on an outright sales basis. We put the title pass to the customer and we got a maintenance agreement. We did more of that last year than we did this year. I would just note to you that we are, in fact, looking at our mix of outright and lease and I would expect that we’ll see more; we may head back in the other direction and try to lower our investment by selling more systems like that. Not an abrupt change, but we are perhaps looking at shifting a little bit.

Jeff Kessler – Imperial Capital

I promise, one final question that is wholesale monitoring. It was up. I guess that’s good looking news. The question is that’s just you getting one big account or are you beginning to see yourself take share in that business?

Darius G. Nevin

Now that the majority of the consolidation is done at the wholesale business and we’ve gotten our act together in a technology perspective, we are starting to use our power and we are starting to see ourselves take some customers from other wholesale competitors. We also have a small lending business which we think is a competitive advantage. It’s probably too early to tell. I think next quarter we will have a better idea, but we have been pleased. As you know, the wholesale business is lumpy. You can wake up one morning and you’re going to lose a big customer and have an attrition spike. I would say I’m cautiously optimistic that our sales people are starting to get more efficient in that business.

Operator

Gentlemen, we have no further questions. At this time I’d like to thank everybody for joining us on today’s call. Have a great afternoon and a great weekend.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!