(EDGAR Online via COMTEX) -- ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis provides information concerning our results of operations and financial condition. This discussion should be read in conjunction with our accompanying consolidated financial statements and the notes thereto included elsewhere herein.
Monitronics International, Inc. and its subsidiaries (collectively, "Monitronics" or the "Company", doing business as Brinks Home SecurityTM) provide residential customers and commercial client accounts with monitored home and business security systems, as well as interactive and home automation services, in the United States, Canada and Puerto Rico. Monitronics customers are obtained through our direct-to-consumer sales channel (the "Direct to Consumer Channel"), which offers both DIY and professional installation security solutions and our exclusive authorized dealer network (the "Dealer Channel"), which provides product and installation services, as well as support to customers.
As previously disclosed, on June 30, 2019 (the "Petition Date"), Monitronics and certain of its domestic subsidiaries (collectively, the "Debtors"), filed voluntary petitions for relief (collectively, the "Petitions" and, the cases commenced thereby, the "Chapter 11 Cases") under chapter 11 of title 11 of the United States Code (the "Bankruptcy Code") in the United States Bankruptcy Court for the Southern District of Texas (the "Bankruptcy Court"). The Debtors' Chapter 11 Cases were jointly administered under the caption In re Monitronics International, Inc., et al., Case No. 19-33650. On August 7, 2019, the Bankruptcy Court entered an order, Docket No. 199 (the "Confirmation Order"), confirming and approving the Debtors' Joint Partial Prepackaged Plan of Reorganization (including all exhibits thereto, and as modified by the Confirmation Order, the
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"Plan") that was previously filed with the Bankruptcy Court on June 30, 2019. On August 30, 2019 (the "Effective Date"), the conditions to the effectiveness of the Plan were satisfied and the Company emerged from Chapter 11 after completing a series of transactions through which the Company and its former parent, Ascent Capital Group, Inc. ("Ascent Capital") merged (the "Merger") in accordance with the terms of the Agreement and Plan of Merger, dated as of May 24, 2019 (the "Merger Agreement"). Monitronics was the surviving corporation and, immediately following the Merger, was redomiciled in Delaware in accordance with the terms of the Merger Agreement.
Upon emergence from Chapter 11 on the Effective Date, the Company applied Accounting Standards Codification ("ASC") 852, Reorganizations ("ASC 852"), in preparing its consolidated financial statements (see Note 3, Emergence from Bankruptcy and Note 4, Fresh Start Accounting). The Company selected a convenience date of August 31, 2019 for purposes of applying fresh start accounting as the activity between the convenience date and the Effective Date did not result in a material difference in the financial results. As a result of the application of fresh start accounting and the effects of the implementation of the Plan, a new entity for financial reporting purposes was created. References to "Successor" or "Successor Company" relate to the balance sheet and results of operations of Monitronics on and subsequent to September 1, 2019. References to "Predecessor" or "Predecessor Company" refer to the balance sheet and results of operations of Monitronics prior to September 1, 2019. With the exception of interest and amortization expense, the Company's operating results and key operating performance measures on a consolidated basis were not materially impacted by the reorganization. As such, references to the "Company" could refer to either the Predecessor or Successor periods, as defined.
In recent years, we have implemented several initiatives related to account growth, creation costs, attrition and margin improvements to combat decreases in the generation of new subscriber accounts and negative trends in subscriber attrition.
We believe that generating account growth at a reasonable cost is essential to scaling our business and generating stakeholder value. We currently generate new accounts through both our Dealer Channel and Direct to Consumer Channel. Our ability to grow new accounts in the future will be impacted by our ability to adjust to changes in consumer buying behavior and increased competition from technology, telecommunications and cable companies. We currently have several initiatives in place to drive profitable account growth, which include:
enhancing our brand recognition with consumers, which we believe is bolstered by the rebranding to Brinks Home Security,
differentiating and profitably growing our Direct to Consumer Channel under the Brinks Home Security brand,
recruiting and retaining high quality dealers into our Authorized Dealer Program,
assisting new and existing dealers with training and marketing initiatives to increase productivity, and
offering third-party equipment financing to consumers, which is expected to assist in driving account growth at lower creation costs.
Creation Cost Efficiency
We also consider the management of creation costs to be a key driver in improving our financial results. Generating accounts at lower creation costs per account would improve our profitability and cash flows. The initiatives related to managing creation costs include:
improving performance in our Direct to Consumer Channel including generating higher quality leads at favorable cost, increasing sales close rates and enhancing our customer activation process,
negotiating lower subscriber account purchase price multiples in our Dealer Channel, and
expanding the use and availability of third-party financing, which will drive down net creation costs.
While we have also experienced higher subscriber attrition rates in the past few years, we have continued to develop our efforts to manage subscriber attrition, which we believe will help drive increases in our subscriber base and stakeholder value. We currently have several initiatives in place to reduce subscriber attrition, which include:
maintaining high customer service levels,
effectively managing the credit quality of new customers,
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expanding our efforts to both retain customers who have indicated a desire to cancel service and win-back previous customers,
using predictive modeling to identify subscribers with a higher risk of cancellation and engaging with these subscribers to obtain contract extensions on terms favorable to the Company, and
implementing effective pricing strategies.
We have also adopted initiatives to reduce expenses and improve our financial results, which include:
reducing our operating costs by right sizing the cost structure to the business and leveraging our scale,
increasing use of automation, and
implementing more sophisticated purchasing techniques.
While there are uncertainties related to the successful implementation of the foregoing initiatives impacting our ability to achieve net profitability and positive cash flows in the near term, we believe they will position us to improve our operating performance, increase cash flows and create stakeholder value over the long-term.
During the years ended December 31, 2019 and 2018, we acquired 81,386 and 112,920 subscriber accounts, respectively, through our Dealer Channel and Direct to Consumer Channel. The decrease in accounts acquired for the year ended December 31, 2019 is due to year over year decline in accounts generated in our Direct to Consumer Channel and fewer accounts acquired from negotiated account acquisitions. The decline in accounts acquired in our Direct to Consumer Channel was largely due to the reduction of product subsidies in an effort to improve the credit quality of customers acquired. There were no bulk buys during the year ended December 31, 2019, as compared to approximately 17,800 accounts acquired from negotiated account acquisitions during the year ended December 31, 2018.
RMR acquired during the years ended December 31, 2019 and 2018 was approximately $3,929,000 and $5,326,000, respectively.
Account cancellations, otherwise referred to as subscriber attrition, has a direct impact on the number of subscribers that the Company services and on its financial results, including revenues, operating income and cash flow. A portion of the subscriber base can be expected to cancel their service every year. Subscribers may choose not to renew or to terminate their contract for a variety of reasons, including relocation, cost, switching to a competitor's service, limited use by the subscriber or low perceived value. The largest categories of cancelled accounts relate to subscriber relocation or those cancelled due to non-payment. The Company defines its attrition rate as the number of cancelled accounts in a given period divided by the weighted average number of subscribers for that period. The Company considers an account cancelled if payment from the subscriber is deemed uncollectible or if the subscriber cancels for various reasons. If a subscriber relocates but continues its service, it is not a cancellation. If the subscriber relocates, discontinues its service and a new subscriber assumes the original subscriber's service and continues the revenue stream, it is also not a cancellation. The Company adjusts the number of cancelled accounts by excluding those that are contractually guaranteed by its dealers. The typical dealer contract provides that if a subscriber cancels in the first year of its contract, the dealer must either replace the cancelled account with a new one or refund to the Company the cost paid to acquire the contract. To help ensure the dealer's obligation to the Company, the Company typically maintains a dealer funded holdback reserve ranging from 5-8% of subscriber accounts in the guarantee period. In some cases, the amount of the holdback liability is less than actual attrition experience.
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The table below presents subscriber data for the years ended December 31, 2019 and 2018:
Years Ended December 31, 2019 2018 Beginning balance of accounts 921,750 975,996 Accounts acquired 81,386 112,920 Accounts cancelled (150,494 ) (162,579 ) Cancelled accounts guaranteed by dealer and other adjustments (a) (4,884 ) (4,587 ) Ending balance of accounts 847,758 921,750 Monthly weighted average accounts 884,337 950,705 Attrition rate - Unit 17.0 % 17.1 % Attrition rate - RMR (b) 17.9 % 14.9 %
(a) Includes cancelled accounts that are contractually guaranteed to be refunded from holdback.
(b) The RMR of cancelled accounts follows the same definition as subscriber unit attrition as noted above. RMR attrition is defined as the RMR of cancelled accounts in a given period, adjusted for the impact of price increases or decreases in that period, divided by the weighted average of RMR for that period.
The unit attrition rate for the years ended December 31, 2019 and 2018 was 17.0% and 17.1%, respectively. The RMR attrition rate for the years ended December 31, 2019 and 2018 was 17.9% and 14.9%, respectively. The increase in the RMR attrition rate for the year ended December 31, 2019 was primarily attributable to a more aggressive price increase strategy in the prior year.
We analyze our attrition by classifying accounts into annual pools based on the year of acquisition. We then track the number of cancelled accounts as a percentage of the initial number of accounts acquired for each pool for each year subsequent to its acquisition. Based on the average cancellation rate across the pools, the Company's attrition rate is generally very low within the initial 12 month period after considering the accounts which were replaced or refunded by the dealers at no additional cost to the Company. Over the next few years of the subscriber account life, the number of subscribers that cancel as a percentage of the initial number of subscribers in that pool gradually increases and historically has peaked following the end of the initial contract term, which is typically three to five years. Subsequent to the peak following the end of the initial contract term, the number of subscribers that cancel as a percentage of the initial number of subscribers in that pool normalizes. Accounts generated through the Direct to Consumer Channel have homogeneous characteristics as accounts generated through the Dealer Channel and follow the same attrition curves. However, accounts generated through the Direct to Consumer Channel have attrition of approximately 10% in the initial 12 month period following account acquisition which is higher than accounts generated in the Dealer Channel due to the dealer guarantee period.
We evaluate the performance of our operations based on financial measures such as revenue and "Adjusted EBITDA." Adjusted EBITDA is a non-GAAP financial measure and is defined as net income (loss) before interest expense, interest income, income taxes, depreciation, amortization (including the amortization of subscriber accounts, dealer network and other intangible assets), restructuring charges, stock-based compensation, and other non-cash or non-recurring charges. We believe that Adjusted EBITDA is an important indicator of the operational strength and performance of our business. In addition, this measure is used by management to evaluate operating results and perform analytical comparisons and identify strategies to improve performance. Adjusted EBITDA is also a measure that is customarily used by financial analysts to evaluate the financial performance of companies in the security alarm monitoring industry and is one of the financial measures, subject to certain adjustments, by which our covenants are calculated under the agreements governing our debt obligations. Adjusted EBITDA does not represent cash flow from operations as defined by generally accepted accounting principles in the United States ("GAAP"), should not be construed as an alternative to net income or loss and is indicative neither of our results of operations nor of cash flows available to fund all of our cash needs. It is, however, a measurement that we believe is useful to investors in analyzing our operating performance. Accordingly, Adjusted EBITDA should be considered in addition to, but not as a substitute for, net income, cash flow provided by operating activities and other measures of financial performance prepared in accordance with GAAP. As companies often define non-GAAP financial measures differently, Adjusted EBITDA as calculated by Monitronics should not be compared to any similarly titled measures reported by other companies.
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Results of Operations
For a discussion of our results of operations for the year ended December 31, 2017, including a year-to-year comparison between 2018 and 2017, refer to "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our final prospectus filed pursuant to Item 424(b)(3) on January 9, 2020.
Year Ended December 31, 2019 Compared to Year Ended December 31, 2018
Fresh Start Accounting Adjustments. With the exception of interest expense, the Company's operating results and key operating performance measures on a consolidated basis were not materially impacted by the reorganization. We believe that certain of our consolidated operating results for the period from January 1, 2019 through August 31, 2019, when combined with our consolidated operating results for the period from September 1, 2019 through December 31, 2019, is comparable to certain operating results from the comparable prior year period. Accordingly, we believe that discussing the non-GAAP combined results of operations and cash flows of the Predecessor Company and the Successor Company for the year ended December 31, 2019 is useful when analyzing certain performance measures.
The following table sets forth selected data from the accompanying consolidated statements of operations and comprehensive income (loss) for the periods indicated (dollar amounts in thousands).
Successor Company Predecessor Company Period from September 1, Non-GAAP Combined Year 2019 through Period from January 1, Ended December 31, December 31, 2019 through August Year Ended 2019 2019 31, 2019 December 31, 2018 Net revenue $ 504,505 $ 162,219 $ 342,286 $ 540,358 Cost of services 112,274 36,988 75,286 128,939 Selling, general and administrative, including stock-based and long-term incentive compensation 132,509 52,144 80,365 118,940 Amortization of subscriber accounts, deferred contract acquisition costs and other intangible assets 200,484 69,693 130,791 211,639 Interest expense 134,060 28,979 105,081 180,770 Income (loss) before income taxes 567,561 (32,627 ) 600,188 (690,302 ) Income tax expense (benefit) 2,479 704 1,775 (11,552 ) Net income (loss) 565,082 (33,331 ) 598,413 (678,750 ) Adjusted EBITDA (a) $ 266,460 $ 79,087 $ 187,373 $ 289,448 Adjusted EBITDA as a percentage of Net revenue 52.8 % 48.8 % 54.7 % 53.6 % Expensed Subscriber acquisition costs, net Gross subscriber acquisition costs $ 38,325 $ 13,381 $ 24,944 $ 47,874 Revenue associated with subscriber acquisition costs (7,769 ) (2,282 ) (5,487 ) (4,678 ) Expensed Subscriber acquisition costs, net $ 30,556 $ 11,099 $ 19,457 $ 43,196
(a) See reconciliation of Net income (loss) to Adjusted EBITDA below.
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Net revenue. Net revenue decreased $35,853,000, or 6.6%, for the year ended December 31, 2019, as compared to the prior year. The decrease in net revenue is primarily attributable to a decrease in alarm monitoring revenue of $31,418,000 due to the lower average number of subscribers in 2019. Additionally, average RMR per subscriber decreased from $45.27 as of December 31, 2018 to $45.12 as of December 31, 2019 due to changing mix of customers generated through the Direct to Consumer Channel that typically have lower RMR as a result of the elimination of equipment subsidy. Monitoring revenue also reflects the negative impact of a $5,331,000 fair value adjustment that reduced deferred revenue upon the Company's emergence from bankruptcy in accordance with ASC 852. Product, installation and service revenue decreased $6,673,000 largely due to the decline in accounts acquired in the Direct to Consumer Channel in 2019 and a decrease in pre-emergence field service jobs associated with contract extensions. These decreases were partially offset by an increase in other revenue of $2,238,000 as a result of the full year impact of paper statement fees implemented in the fourth quarter of 2018.
Cost of services. Cost of services decreased $16,665,000, or 12.9%, for the year ended December 31, 2019, as compared to the prior year. The decrease for the year ended December 31, 2019 is primarily attributable to lower labor costs due to year over year decline in customers as well as other pre-emergence cost saving measures. Subscriber acquisition costs, which include expensed equipment and labor costs associated with the creation of new subscribers, decreased to $8,977,000 for the year ended December 31, 2019, as compared to $14,722,000 for the year ended December 31, 2018, due to lower product sales volume in the Company's Direct to Consumer Channel as discussed above. Cost of services as a percentage of net revenue, excluding the effect of the fair value adjustment, decreased from 23.9% for the year ended December 31, 2018 to 22.0% for the year ended December 31, 2019.
Selling, general and administrative. Selling, general and administrative costs ("SG&A") increased $13,569,000, or 11.4%, for the year ended December 31, 2019, as compared to the prior year. The increase is primarily attributable to increased consulting fees on integration and implementation of various company initiatives and increased duplicative labor costs due to the outsourcing of a customer care call center for a portion of 2019. Additionally, the Company received a $4,800,000 insurance settlement in 2019 as compared to an aggregate settlement of $12,500,000 received in 2018 from multiple carriers. These insurance receivable settlements related to coverage provided by our insurance carriers in the 2017 class action litigation of alleged violation of telemarketing laws. These increases are partially offset by decreases in rebranding expense and severance expense. Rebranding expense and severance expense recognized in the year ended December 31, 2018 was $7,410,000 and $1,059,000, respectively, with no corresponding expenses in the year ended December 31, 2019. Subscriber acquisition costs included in SG&A decreased to $29,348,000 for the year ended December 31, 2019, as compared to $33,152,000 for the year ended December 31, 2018, due to reduced subscriber acquisition selling and marketing costs associated with the creation of new subscribers. SG&A as a percentage of net revenue, excluding the effect of the fair value adjustment, increased from 22.0% for the year ended December 31, 2018 to 26.0% for the year ended December 31, 2019.
Amortization of subscriber accounts, deferred contract acquisition costs and other intangible assets. Amortization of subscriber accounts, deferred contract acquisition costs and other intangible assets decreased $11,155,000, or 5.3%, for the year ended December 31, 2019, as compared to the prior year. The decrease is related to a lower number of subscriber accounts purchased in the last year ended December 31, 2019, compared to the prior year. This decrease is partially offset by the impact of the fresh start adjustments, in which the existing subscriber accounts as of August 31, 2019 were stated at fair value and set up on the 14-year 235% double-declining curve. This curve is shorter than the methodology utilized on newly generated subscriber accounts, due to the various aged vintages of the Company's subscriber base at August 31, 2019. The shorter amortization curve results in higher amortization expense per period. Additionally contributing to the offset is amortization on the newly established Dealer Network asset recognized upon the Company's emergence from bankruptcy.
Interest expense. Interest expense decreased $46,710,000, or 25.8%, for the year ended December 31, 2019, as compared to the prior year. The decrease in interest expense is attributable to the Company's decreased outstanding debt balances upon the reorganization, primarily related to the retirement of the Company's 9.125% Senior Notes, and the impact of accelerated amortization of deferred financing costs and debt discount related to the Company's predecessor debt agreements of $26,085,000 recognized in interest expense in the fourth quarter of 2018. Offsetting the decreases seen in the successor period of 2019 were increases in interest expense prior to and in the bankruptcy, due to higher debt outstanding and higher interest rates.
Income tax expense (benefit). The Company had pre-tax income of $567,561,000 and income tax expense of $2,479,000 for the year ended December 31, 2019. The driver behind the pre-tax income for the year ended December 31, 2019 is the gain on restructuring and reorganization of $669,722,000 recognized during the year ended December 31, 2019, primarily due to gains recognized on the conversion from debt to equity and discounted cash settlement of the Predecessor Company's high yield senior notes in accordance with the Company's bankruptcy Plan. There are no income tax impacts from this gain due to net operating loss carryforwards available for the 2019 tax year. Income tax expense for the year ended December 31, 2019 is attributable to the Company's state tax expense incurred from Texas margin tax. The Company had pre-
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tax loss of $690,302,000 and income tax benefit of $11,552,000 for the year ended December 31, 2018. The income tax benefit for the year ended December 31, 2018 is attributable to the deferred tax impact of the goodwill impairment of $563,549,000, partially offset by the Company's state tax expense incurred from Texas margin tax.
Net income (loss). The Company had net income of $565,082,000 for the year ended December 31, 2019, as compared to a net loss of $678,750,000 for the year ended December 31, 2018. Net income for the year ended December 31, 2019 is attributable to the gain on restructuring and reorganization of $669,722,000. The gain on restructuring and reorganization is primarily due to gains recognized on the conversion from debt to equity and discounted cash settlement of the Predecessor Company's high yield senior notes in accordance with the Company's bankruptcy plan. This gain was offset by net loss generated from normal operations as discussed above. The net loss for the year ended December 31, 2018 was primarily attributable to the goodwill impairment of $563,549,000 and net losses generated from normal operations. Adjusted EBITDA
Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 The following table provides a reconciliation of Net income (loss) to total . . .
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