Protection One, Inc. Q2 2008 Earnings Call Transcript

Protection One, Inc. (PONE)

Q2 2008 Earnings Call

August 8, 2008 10:00 am ET

Executives

Richard Ginsburg – President & CEO

Darius G. Nevin – Executive VP & CFO

Analysts

Jeff Kessler – Imperial Capital

Presentation

Operator

Welcome to Protection One’s conference call to review the company’s second quarter 2008 results. By now you should have received a copy of the earnings press release. If you did not receive a copy, please call 785-856-9368 to request one. A copy is also available on the Investor Relations 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 also may describe the company’s future plans, objectives, expectations, or goals. Such statements may address future events and conditions concerning customer retention, debt levels, and debt service capacity. Actual results may differ materially from those debt obligations, net losses and competition. For a further discussion of factors affecting the company’s performance, see Protection One’s Annual Report on Form 10-K for the year ended December 31, 2007, and it’s quarterly report on Form 10-Q for the quarter ended June 30, 2008, which the company expects will be filed with the SEC on Monday, August 11.

Protection One disclaims any obligation to update any forward-looking statements as a result of developments occurring after the date of this call. During today's call the company will provide alternative views of its earning results that do not conform to generally accepted accounting principals. The company believes that these alternative views will enhance the understanding of its performance.

The company has provided schedules that reconcile these non-GAAP views with its reported results on a GAAP basis as part of its earnings press release which again is available at protectionone.com. (Operator Instructions)

Now let me turn things over to Richard Ginsburg.

Richard Ginsburg

We really appreciate the opportunity to discuss our results with you. After providing an overview I’m going to turn the call over to Darius Nevin as I always do. Darius, as you know, is our Chief Financial Officer and he will review our financial results, and then after that, we’ll both be more than happy to take your questions.

So we delivered improvement or maintained consistency in some very important areas this quarter, which gives me optimism for the balance of the year. I’m most pleased by our having reduced retail attrition, which fell to an annualized gross rate of 12.9% in the second quarter, compared to 13.6% one year earlier. We believe consistent growth is built on low attrition and the key objective of the merger with IASG. Excluding legal expenses, which increased because of an ongoing legacy IASG matter that we inherited, we reduced consolidated G&A by $2.3 million compared to the same period one year earlier. That’s an annualized rate of more than $9 million. Third, our marketing department continued to ramp up planned spending on lead generation activities that helped deliver consistent RMR additions in a transition quarter for us and as everyone knows, with a tough economy.

The retail additions were flat with the prior year. Our Bell South alliance was winding down and lead flow from traditional sources such as home sales and new owners was down across the country. We were especially pleased that our new marketing initiatives enabled us to achieve growth in residential additions outside of the Bell South region for the first time in many, many years. Fourth, given the economy, we had been proceeding cautiously in building our commercial sales headcount. As a result, commercial additions remained about 44% of total RMR added in the quarter. We are pushing forward with expanding this commercial group including the national accounts team and increasing marketing support to commercial. We expect growth of RMR additions will fall.

As of June 30^th, we had $5.9 million of commercial RMR off almost 6% from a year ago. This represents 28.5% of our total retail portfolio up from 26.9%. The last point I want to make about retail is that we have launched new initiatives to lower costs further which I think will please everyone. That will enable us to invest more in marketing to drive growth for the company. With optimism that IASG attrition will continue to head in the right direction, and with the integration of IASG largely complete, we have initiated some process changes that should lower our cost to provide monitoring and service to our existing base. For example, since April 1^st we have reduced monitoring center and field headcount by more than 100 or a little more than 5% of our workforce. Expect to hear xxx more from me on this subject. We are already seeing some benefit as EBITDA goes down on a year-over-year basis has increased from the first quarter to the second.

In our other segments, wholesale achieved a very important technology milestone and some monitoring system conversion in early July and we now expect this unit will more efficiently balance its monitoring demands across its four station footprint. We have already eliminated headcount that was dedicated to supporting the old monitoring system that we operated.

Wholesale also had a tremendous RMR additions quarter working with its largest clients. These efforts resulted in RMR additions growth of 25% over the prior year levels. Lastly, multifamily is aggressively managing its cost to keep them in line with revenue decreases.

In summary, we used the quarter to continue building on the key elements of our plan to resume retail growth based on strategic marketing, more disciplined selling, and improved cash flow from our existing account base. Equally as important, though, wholesale did reach a significant integration milestone and demonstrated its unique value add to our wholesale customers.

That’s all I have for now. I’m going to turn the call over to Darius. He’ll review some additional financial results and then again we’ll both take some questions.

Darius G. Nevin

I will try to provide some more financial context for the key areas Richard highlighted. All the comparisons will be to the second quarter of 2007 which I would note occurred after the merger with IASG.

Consolidated monitoring and service revenues decreased by less than 1%. Our wholesale segment rode healthy RMR additions growth to a 5.2% monitoring revenue increase that partially offset some of the impact of a 1.4% decrease in retail monitoring revenue and a 4.8% decline in multifamilies monitoring revenue. Our retail segments revenue decrease was caused by high attrition on the acquired IASG account base. Annualized gross attrition for the quarter was 18.6% on the IASG base and 11.8% on the balance of the portfolio. The attrition rate on the IASG accounts, however, has declined 200 basis points from the annualized rate in the fourth quarter last year. Multifamilies $400,000 revenue loss stems from lower RMR and force and less time and material service billings.

It’s worthwhile mentioning that despite the small decrease in retail monitoring revenue compared to last year, monitoring revenue is up slightly from the first quarter of this year and we were able to show improvement in RMR during the second quarter as a result of lower attrition and price increases.

Turning to direct costs now, consolidated monitoring of service costs increased to 33% of related revenues from 31.3% for reasons that included lower margin wholesale revenue now represents 14.1% of total monitoring and service revenue compared to 13.3% one year ago. Number two, IASG was understaffed when we closed the merger and we increased headcount to lift service levels to acceptable ranges. Third, wholesale growth has come from lower margin customers and last, higher fuel costs added approximately $300,000 to expense.

Even with the fuel increase, gross margin on our retail monitoring and service revenue improved slightly from last year as we began implementing some of our cost reduction strategies. Gross margin percentage improved by almost 200 basis points compared to results in the first quarter that were distorted somewhat by the amps conversion effort. The process improvements to which Richard alluded will also lift retail gross margin when fully implemented, and to capitalize on the investments we’ve made updating their monitoring platform, our wholesale management team is developing staffing models to improve contribution but without affecting customer service levels.

Netting the revenue and direct cost impacts, consolidated gross margin for monitoring and service revenues decreased $1.9 million or 3.2% to $55.6 million. We offset most of that gross margin decrease by lowering G&A expenses by approximately $1.6 million through reductions in labor and facility expenses in our retail and wholesale segments as a result of the merger. As Richard noted, has it not been for additional legal costs relating to claims against IASG existing at the time of the merger, G&A would have improved in the quarter by $2.3 million. Even with the impact of higher legal expenses, G&A costs improved to 21.5% of revenue from 23% one year ago.

We used $1.4 million cash on maintenance CapEx in the quarter and $2.4 million over the least six months and also invested $1 million and $1.4 million in vehicles through capital leases in those same periods. Turning our attention to RMR creation activities, our retail segment crated approximately $606,000 RMR, essentially unchanged from 2007. Separately we purchased only $2,000 of RMR this quarter compared to $19,000 in last year’s second quarter. In creating and acquiring that RMR, we incurred either through net expenses or by deferring a consolidated total of $19.6 million of net costs compared to $16.2 million in 2007. Please note that net creation activity expenses that flowed through the income statement increased to $9.3 million from $7 million.

Our retail activity accounted for $17.7 million of net costs in the second quarter compared to $14.7 million last year. Net spending on creation and acquisition activities increased for a number of reasons, some of which will improve over time, and some of which will persist. The single largest impact was spending on lead generation through our new marketing strategies which just got underway, but we are seeing some positive results such as residential ads growth outside the southeast. Our spending has not reached optimum efficiency. We are, however, seeing increasing levels of salesperson productivity and expect more. Creation multiple was also impacted by a shift from commercial outright sales to lease sales which have a higher creation cost but contribute more RMR per unit. We believe that if we hadn’t shifted more emphasis to RMR, additions would have decreased instead of staying level with last year given economic challenges. We also incurred more fuel costs, sales management, and technical support expenses to position ourselves to drive future commercial growth. Even with these increases, we were still able to add subscribers at 29 times RMR during the quarter, a significant discount to purchasing RMR in the open market.

Continuing our way down the income statement, consolidated opening income for the quarter decreased to $2.8 million from $4.4 million in 2007, largely because selling expenses increased and we incurred $1.6 million more amortization and depreciation costs which were only partially offset by the decline and merger related severance.

Adjusted EBITDA for the quarter came in at $27.2 million compared to $29.5 million one year earlier. At the time we reported last year, we did indicate that we didn’t think we would be able to sustain EBITDA at that level over the near term. In summary, lower monitoring and service revenues and higher monitoring and service costs were largely offset by lower G&A costs but creation costs expense, especially selling expenses, increased which caused EBITDA to decline.

Interest expense for the second quarter of 2008 was $12.1 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 second quarter of this year compared to $1.6 million one year earlier. Excluding those items, interest expense was $12 million this year and $11.7 million 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 $48 million.

Finally, at the end of March, we had approximately $524.8 million face amount of debt and capital leases outstanding compared to $526 million calculated the same way at the end of December. Our cash position at the end of June was essentially unchanged from that at the end of December. Net debt decreased slightly because free cash flow was largely absorbed by fees and expenses of our subordinated debt financing in the first quarter.

Back to you, Richard.

Richard Ginsburg

So Dana, we’ll see if we have any questions and we’ll be more than happy to accommodate those.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jeffrey Kessler - Imperial Capital.

Jeff Kessler – Imperial Capital

I realize that you’re now combining all the numbers and you’re probably adverse to separating out IASG from original P1 accounts, but is there any color that you could give on what the performance of some of the pre-IASG business was like, particularly on the retail side, because I know that wholesale is completely distorted by IASG.

Richard Ginsburg

Clearly the attrition was higher than we thought it would be and as Darius mentioned, that 18% base, that’s a static pool of accounts that’s just sitting there and kind of looking at it as a wasted asset because when the new customers are put on, when you take an IASG customer and upgrade them or move them, it goes into the P1 base, so that base is just going to look bad, but clearly the attrition was higher than we thought it would be when we took the company over and the attrition was in the mid to high 20% range after we took it over. It’s gone down. It’s pretty consistent with how it’s gone down. We took over Protection One many years ago but I would say in summary it was higher than we thought it would be and we’re just working it down.

Darius G. Nevin

I would agree. The trend lines are in the right direction. I wouldn’t be surprised if we took a slight breather in terms of the attrition coming down during this coming quarter just because that’s the, for all alarm companies, the third quarter is the period typically of highest attrition.

Jeff Kessler – Imperial Capital

Assuming people move, hopefully aren’t moving too much this summer.

Darius G. Nevin

I think we said that maybe in one of our prior calls that we were possibly expecting more of a flat attrition come this year if the housing paralysis were to continue, so as opposed to that seasonality of third quarter going up, we thought we might see a flat attrition trend.

Jeff Kessler – Imperial Capital

Do you have a changed target on the IASG base for where you think you can take it down to?

Richard Ginsburg

No. The goal is to get it down to P1 levels and/or lower, and it’s not going to happen overnight, but it hopefully will happen over the next year, year and a half. We’ve done it before. We’ll do it again sans any unusual circumstances but the goal is to get it performing where P1 is which we think is attainable.

Jeff Kessler – Imperial Capital

Second question is on creation costs and what’s gone on with and without the Bell South business in terms of creating new customers. Your creation costs has gone up and yet you have been able to create a fair amount of new customers outside of the Bell South area. Are you going to take the model, whatever that model is, you maybe want to describe it, what you’re doing to get those new customers and are you going to plug that into the old Bell South area to revitalize the growth there, but will that incur the same type of creation cost increases that you just saw in the second quarter?

Richard Ginsburg

One of the things that’s a little tricky when you look at the Bell South region is we intentionally did not put a lot of marketing dollars into the region in the past four or five months because we would have been had a double pay, meaning we would have paid for marketing initiatives to generate leads in the southeast and then we would have had to pay Bell South up until June 30 of this year, so that was very tricky. So now that’s behind us, now we’re actually starting to put money into the southeast region.

Darius G. Nevin

That’s exactly right, and I wouldn’t draw too many conclusions from the increase in creation multiple that you’re seeing in the second quarter. Whenever you undertake to start a new activity and to launch it, you end up with higher costs at the outset typically then you will on a run rate basis. We are expecting to see, as I noted in my comments, we are expecting to see productivity improvements in our residential sales force that will help bring down that creation costs; in other words, we wouldn’t spend the money on lead generation activity if we didn’t think we could get a return by increasing the amount of RMR added per residential salesperson.

Jeff Kessler – Imperial Capital

Don’t get me wrong, I’m almost shocked to see the growth outside of the south. I do realize that it did incur costs to jump start that.

Richard Ginsburg

That was a key test for us. We’re frankly pleasantly surprised by that as well, but when you think about it, there is no reason why we shouldn’t be able to... Once we apply a professional marketing program and put the kind of dollars behind it that we have and we have a good presence in many markets and we have a good product and a good sales force on the residential side, we are able to, when the corporate marketing department produces leads, quality leads, our sales force can close them and our installation people can install them and do so on a cost-effective basis. Now on the commercial side, that effort is a quarter or so behind in terms of applying some of our new marketing approach and you’ll start to see the benefits of lifting commercial RMR additions we think in the third and in the fourth quarter.

Jeff Kessler – Imperial Capital

So quarters three and four, we should see some upturn in that 27% or 28% of the retail business that is commercial?

Richard Ginsburg

Right, exactly, when you think about what’s being added every quarter, commercial is 27%, 28% of the base, but the additions are in the 40% to 50% range and we would like to get it up to 50% and cross over. So as long as we’re adding a higher percentage each quarter than is in the base, that ratio is going to continue to flight up.

Jeff Kessler – Imperial Capital

So the commercial remains and is 40% to 50% of the new adds that you’re bringing on.

Richard Ginsburg

Exactly, but our strategy hasn’t changed in terms of continuing to emphasize commercial additions growth. It will get a disproportionate amount of our investment.

Jeff Kessler – Imperial Capital

How long do you expect the IASG level of IASG legal expenditures to go on?

Darius G. Nevin

It’s just very hard to tell. We feel strongly about some of the issues in the case and the company and the board believes in our position so unfortunately its costly but we inherited it and again all I can say is that we feel very strongly about our position so I can’t answer that.

Richard Ginsburg

And we’ve had some very good decisions by the court recently that have strengthened our position, we believe.

Jeff Kessler – Imperial Capital

But you can’t give any kind of timing estimate yet?

Richard Ginsburg

Jeff, that’s a tough one because the other side may be on this call. So we’d rather not go into that.

Darius G. Nevin

We were recently awarded some feedback in one of the wins we had so we’re optimistic there but again still a little bit touchy subject, but again, we feel pretty strongly about our case.

Jeff Kessler – Imperial Capital

You refinanced your debt unfortunately at like the worst day of the worst period of the absolutely worst day you could possibly refinance debt in the history of the world and I’m just wondering if there is a chance that you guys might consider looking at that debt even if there is prepayment cost s and taking that coupon down at some point.

Richard Ginsburg

We structured the debt so we would not be locked into it for more than a year.

Darius G. Nevin

That’s exactly right, Jeff. We will as Richard noted, there are no prepayment penalties after the first year. We are very grateful for the investment that our current investors and new parties made in the company. As you note, the single worst day in all of 2008 and probably 2007 to have raised capital so we do appreciate what they did for us but we will without doubt be taking a look at that instrument to be doing something by I think it’s March 14 of next year, hopefully we’ll be able to refinance it at a lower coupon.

Jeff Kessler – Imperial Capital

Multifamily, so we’ve gone through this now for like three years of listening to why multifamily is down and how it could be turned around and yet it hasn’t been turned around yet, and just wondering what your views are on multifamily since you’ve worked really hard on trying to turn it around.

Darius G. Nevin

We like multifamily because it generates a lot of cash for us and whether it’s shrinking or whether it stabilizes, ultimately that business is an important element of the company because of its EBITDA contribution and its cash flow contribution. So I would suggest that... And maybe I need to do a better job in future calls in highlighting the company’s cash contribution to overall results and how it helps us finance what we’re trying to do in our retail business. We have a good management team there, we have a good set of customers, but it’s sort of the classic cash cow that we use to fund what we’re trying to accomplish in our retail segment. And wholesale to a certain extent is also a significant cash contributor.

Richard Ginsburg

Even though it has been shrinking and we have been struggling to get it stabilized and growing, to Darius’ point, it’s still generating more than $1 million in month for us and it’s a very high margin business. There is a core group of customers there that are going to continue renewing and stay with us and our renewal rates on customers that are coming up for term have been good. They could be better, but we’re not ones to give up, especially on something that generates so much cash for the company. If this was a cash drain, I would totally understand the frustration with it, but I think we have to balance the fact that I think EBITDA wise it’s over $1.3 million a month and when you get right down to cash, it’s over $1 million a month.

Darius G. Nevin

So Jeff, what we’re kind of saying to you and to other folks who are evaluating the company is we’d like to be evaluated based on what we do with that retail business. Are we growing it at an acceptable rate, are we managing our costs there? And then the other assets, particularly multifamily, we want to manage that for cash and then we want to see reasonable growth out of our wholesale business to exploit its dominant position, but again, what moves the needle at P1 is going to be that retail business, and whether we execute there is going to determine the overall success of the company.

Operator

We have no further questions in the queue. I’d like to thank everybody for joining us on today’s conference call and that does conclude today’s conference. Have a great weekend and thank you for joining us.

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