Protection One (PONE)

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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 June 30, 2008

or

o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d)

OF THE SECURITIES EXCHANGE ACT OF 1934

Indicate by check mark whether each of the registrants (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 such registrants were required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes x  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.                (Check one):

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

As of August 5, 2008, Protection One, Inc. had outstanding 25,306,913 shares of Common Stock, par value $0.01 per share. As of such date, Protection One Alarm Monitoring, Inc. had outstanding 110 shares of Common Stock, par value $0.10 per share, all of which were owned by Protection One, Inc.

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This Quarterly Report on Form 10-Q and the materials incorporated by reference herein include “forward-looking statements” intended to qualify for the safe harbor from liability established by the Private Securities Litigation Reform Act of 1995.  Statements that are not historical fact are forward-looking.  These forward-looking statements generally can be identified by, among other things, the use of forward-looking language such as the words “estimate,” “project,” “intend,” “believe,” “expect,” “anticipate,” “may,” “will,” “would,” “should,” “could,” “seeks,” “plans,” “intends,” or other words of similar import or their negatives.  Similarly, statements herein that describe our objectives, plans or goals also are forward-looking statements.  Such statements include those made on matters such as our earnings and financial condition, litigation, accounting matters, our business, our efforts to consolidate and reduce costs, our customer account acquisition strategy and attrition, our liquidity and sources of funding and our capital expenditures.  All forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements.  The forward-looking statements included herein are made only as of the date of this report and we undertake no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances, except as required by federal securities laws.  Certain factors that could cause actual results to differ include: our history of losses, which are likely to continue; principal and interest payment requirements of and restrictive covenants governing our indebtedness; difficulty in integrating the businesses of Protection One and Integrated Alarm Services Group, Inc. (“IASG”); disruption from our merger with IASG, including lost business opportunities and difficulty maintaining relationships with employees, customers and suppliers; competition, including competition from companies that are larger than we are and have greater resources than we do; losses of our customers over time and difficulty acquiring new customers; termination of the marketing alliance with BellSouth; changes in technology that may make our services less attractive or obsolete or require significant expenditures to upgrade; the development of new services or service innovations by our competitors; potential liability for failure to respond adequately to alarm activations; changes in management; the potential for environmental or man-made catastrophes in areas of high customer account concentration; changes in conditions affecting the economy or security alarm monitoring service providers generally; and changes in federal, state or local government or other regulations or standards affecting our operations and insurance coverage.  New factors emerge from time to time, and it is not possible for us to predict all of such factors or the impact of each such factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.  For a discussion of these and other risks and uncertainties that could cause actual results to differ materially from those contained in our forward-looking statements, please refer to “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2007.

Unless the context otherwise indicates, all references in this report to the “Company,” “Protection One,” “we,” “us” or “our” or similar words are to Protection One, Inc., its direct wholly owned subsidiary, Protection One Alarm Monitoring, Inc. (“POAMI”), and POAMI’s wholly owned subsidiaries.  Protection One’s sole asset is POAMI and POAMI’s wholly owned subsidiaries, and accordingly, there are no separate financial statements for POAMI.  Each of Protection One and POAMI is a Delaware corporation organized in September 1991.

Stockholders and other security holders or buyers of our securities or our other creditors should not assume that material events subsequent to the date of this report have not occurred.

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PROTECTION ONE, INC. AND SUBSIDIARIES

INDEX

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PART I – FINANCIAL INFORMATION

ITEM 1.     FINANCIAL STATEMENTS

PROTECTION ONE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except for share and per share amounts)

(Unaudited)

The accompanying notes are an integral part of these

condensed consolidated financial statements.

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PROTECTION ONE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED
STATEMENTS OF OPERATIONS AND

COMPREHENSIVE LOSS

(Dollars in thousands, except for per share amounts)

(Unaudited)

The accompanying notes are an integral part of these

condensed consolidated financial statements.

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PROTECTION ONE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF

OPERATIONS AND COMPREHENSIVE LOSS

(Dollars in thousands, except for per share amounts)

(Unaudited)

The accompanying notes are an integral part of these

condensed consolidated financial statements.

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PROTECTION ONE, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

The accompanying notes are an integral part of these

condensed consolidated financial statements.

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PROTECTION ONE, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Protection One, Inc. (the “Company”), which is publicly-traded, is principally engaged in the business of providing security alarm monitoring services, including sales, installation and related servicing of security alarm systems for residential and business customers.  The Company also provides monitoring and support services to independent security alarm dealers on a wholesale basis.  Affiliates of Quadrangle Group LLC and Monarch Alternative Capital LP (collectively, the “Principal Stockholders”) own approximately 70% of the Company’s common stock.

The Company acquired all of the outstanding common stock of Integrated Alarm Services Group, Inc. (“IASG”) on April 2, 2007 (the “Merger”).  Holders of IASG common stock received 0.29 shares of Protection One, Inc. common stock for each share of IASG common stock held.  Cash was paid in lieu of fractional shares.  IASG financial results subsequent to April 2, 2007 are consolidated with Protection One, Inc. financial results.  See Note 7, “IASG Acquisition,” for additional discussion of the Merger and a pro forma presentation of financial results of the combined entity.

On March 14, 2008, Protection One Alarm Monitoring, Inc. (“POAMI”) borrowed $110.3 million under a new unsecured term loan facility (the “Unsecured Term Loan”) to allow it to redeem all of the 8.125% Senior Subordinated Notes due 2009 (the “Senior Subordinated Notes”).  Using the proceeds from the Unsecured Term Loan and available cash on hand, POAMI deposited with the trustee an amount sufficient to redeem all of the Senior Subordinated Notes.  Accordingly, POAMI’s and the guarantors’ obligations under the Senior Subordinated Notes Indenture were satisfied and discharged effective March 14, 2008.  The Unsecured Term Loan lenders include, among others, entities affiliated with the Principal Stockholders and Arlon Group.  Affiliates of the Principal Stockholders collectively owned over 70% of the Company’s common stock as of June 30, 2008, and one of the Company’s former directors is affiliated with Arlon Group.

The Company’s unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles, or GAAP, for interim financial information and in accordance with the instructions to Form 10-Q.  Accordingly, certain information and footnote disclosures normally included in financial statements presented in accordance with GAAP have been condensed or omitted. These financial statements should be read in conjunction with the audited financial statements and notes thereto for the year ended December 31, 2007 included in the Company’s Annual Report on Form 10-K, filed with the Securities and Exchange Commission, or the SEC, on March 17, 2008.

In the opinion of management of the Company, all adjustments considered necessary for a fair presentation of the financial statements have been included. The results of operations presented for the six and three months ended June 30, 2008 and 2007 are not necessarily indicative of the results to be expected for the full year.

For the six months ended June 30, 2008 and 2007, the Company had stock options that represented 0.5 million and 0.9 million  dilutive potential common shares, respectively.  For the three months ended June 30, 2008 and 2007, the Company had stock options that represented 0.4 million and 0.9 million dilutive potential common shares, respectively.  These securities were not included in the computation of diluted earnings per share because to do so would have been anti-dilutive for each of the periods presented.

The following reflects the Company’s carrying value in property and equipment as of the following periods (dollars in thousands):

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Depreciation expense was $6.3 million and $4.9 million for the six months ended June 30, 2008 and 2007, respectively.  Depreciation expense was $3.0 million and $2.7 million for the three months ended June 30, 2008 and 2007, respectively.  The amount of fixed asset additions included in accounts payable was $0.1 million and $0.2 million at June 30, 2008 and 2007, respectively.

Rental equipment is comprised of commercial security equipment that does not require monitoring services by the Company and is leased to customers, typically over a 5-year initial lease term.  Accumulated depreciation of $1.7 million and $1.1 million was recorded on these assets as of June 30, 2008 and December 31, 2007, respectively.  The following is a schedule, by year, of minimum future rental revenue on non-cancelable operating leases as of June 30, 2008 and does not include payments received at the inception of the lease which are deferred and amortized to income over the lease term (dollars in thousands):

3.    Intangible Assets:

A roll-forward of the Company’s amortizable intangible assets for the six months ended June 30, 2008 is presented by segment and in total in the following table (dollars in thousands):

Amortization expense was $27.3 million and $21.7 million for the six months ended June 30, 2008 and 2007, respectively.  Amortization expense was $13.6 million and $14.3 million for the three months ended June 30, 2008 and 2007, respectively.  The table below reflects the estimated aggregate amortization expense for the remainder of 2008 and each of the four succeeding fiscal years on the existing base of amortizable intangible assets as of June 30, 2008 (dollars in thousands):

There was no change in the carrying value of goodwill or trade names for the six months ended June 30, 2008.  In the six months ended June 30, 2007, goodwill additions of $23.1 million and trade name additions of $5.0 million were recorded in connection with the Merger.

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The following reflects the components of accrued liabilities as of the periods indicated (dollars in thousands):

Long-term debt and capital leases are as follows (dollars in thousands):

On April 26, 2006, the Company entered into an amended and restated senior credit agreement (“Senior Credit Agreement”) increasing the outstanding term loan borrowings by $66.8 million to $300.0 million.  The applicable margins with respect to the amended term loan were reduced by 0.50% to 1.50% for base rate borrowing and 2.50% for Eurodollar borrowing.  In the first quarter of 2007, the Company entered into the first amendment to the Senior Credit Agreement that further reduced the applicable margins by 0.25% to 1.25% for base rate borrowing and 2.25% for Eurodollar borrowing.  Depending on the Company’s leverage ratio at the time of borrowing, the applicable margin with respect to a revolving loan may range from 1.25% to 2.25% for base rate borrowing and 2.25% to 3.25% for Eurodollar borrowing.  The senior credit facility is secured by substantially all assets of the Company, requires quarterly principal payments of $0.75 million and requires potential annual prepayments based on a calculation of “Excess Cash Flow” as defined in the Senior Credit Agreement, commencing with the year ending December 31, 2008 and due in the first quarter of the subsequent year.  The incremental proceeds from the term loan, together with approximately $10 million of excess cash, were used to make an aggregate special cash distribution in May 2006 of approximately $75 million, including a dividend to holders of the Company’s common stock and to make related payments to members of management of the Company who held options for the Company’s common stock.  The senior credit facility includes a $25.0 million revolving credit facility, of which $22.2 million remains available as of August 5, 2008 after reducing total availability by $2.8 million for an outstanding letter of credit.  The revolving credit facility matures April 18, 2010 and the term loan matures March 31, 2012.  The weighted average annual interest rate before fees on the senior credit facility was 4.74% and 7.21% at June 30, 2008 and December 31, 2007, respectively.

On April 2, 2007, POAMI completed the exchange offer (the “Exchange Offer”) for up to $125 million aggregate principal amount of the IASG 12% Senior Secured Notes due 2011 (the “IASG Notes”).  Pursuant to the terms of the Exchange Offer, validly tendered IASG Notes were exchanged for newly issued 12% Senior Secured Notes of POAMI due 2011 (the “Senior Secured Notes”).  Of the $125 million aggregate principal amount of IASG Notes outstanding, $115.3 million were tendered for exchange.   The estimated fair value of the Senior Secured Notes was determined based on an effective interest rate of 9.5%, which was deemed to be

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reasonable based on the Company’s review of materials regarding potential debt offering alternatives, which resulted in a premium of $10.3 million on the date of exchange.

The Senior Secured Notes, which rank equally with POAMI’s existing and future senior secured indebtedness, including any indebtedness incurred under the senior credit facility, are jointly and severally guaranteed by Protection One, Inc. and its subsidiaries and secured by second priority liens granted to the trustee for the benefit of the holders of the Senior Secured Notes on substantially all of the Company’s tangible and intangible property.

The Senior Secured Notes initially bore interest at the rate of 13% per annum, payable semiannually on May 15 and November 15 of each year, commencing on May 15, 2007.  Pursuant to the terms of a Registration Rights Agreement entered into at the time the Senior Secured Notes were issued, following the consummation of a registered exchange offer pursuant to which the Senior Secured Notes were exchanged for notes that were registered with the SEC, the Senior Secured Notes bear interest at the rate of 12% per annum.  POAMI completed the registered exchange offer pursuant to the Registration Rights Agreement on June 12, 2007.

POAMI may redeem the Senior Secured Notes at any time prior to November 15, 2008 at its option, in whole or in part, at a redemption price equal to the greater of: 100% of the principal amount of the Senior Secured Notes being redeemed or the sum of the present values of the remaining scheduled payments to November 15, 2008 of principal and interest on the Senior Secured Notes being redeemed on the redemption date (not including any portion of any payments of interest accrued to the redemption date) discounted to the redemption date on a semi-annual basis (assuming a 360-day year consisting of twelve 30-day months) at a discount rate equal to the Treasury rate plus 50 basis points.  POAMI may also redeem the Senior Secured Notes at any time on and after November 15, 2008, in whole or in part, at certain specified redemption prices, plus accrued and unpaid interest and additional interest, if any, to the date of the redemption.

Upon the occurrence of certain change of control events, each holder of Senior Secured Notes will have the right to require POAMI to repurchase all or any part of that holder’s Senior Secured Notes for a cash payment equal to 101% of the aggregate principal amount of the Senior Secured Notes repurchased plus accrued and unpaid interest and additional interest, if any, to the date of purchase, subject to certain restrictions in the Senior Credit Agreement.

The indenture governing the Senior Secured Notes contains covenants that restrict POAMI’s ability and the ability of the guarantors (subject to certain exceptions) to, among other things:  borrow additional money; pay dividends on or redeem capital stock, or make other restricted payments or investments; sell assets; merge or consolidate with any other person; effect a consolidation or merger; or enter into affiliated transactions.

On March 14, 2008, POAMI borrowed $110.3 million under a new unsecured term loan facility to allow it to redeem all of the Senior Subordinated Notes.  The Unsecured Term Loan bears interest at the prime rate plus 11.5% per annum and matures in 2013.  Interest is payable semi-annually in arrears on March 14 and September 14 of each year, with the first interest payment due on September 14, 2008.  The annual interest rate before fees was 16.5% at June 30, 2008.  The Unsecured Term Loan lenders include, among others, entities affiliated with the Principal Stockholders and Arlon Group.  Affiliates of the Principal Stockholders collectively owned over 70% of the Company’s common stock as of June 30, 2008, and one of the Company’s former directors is affiliated with Arlon Group.  The Company recorded $2.3 million and $1.9 million of related party interest expense for the six and three months ended June 30, 2008, respectively.

Using the proceeds from the Unsecured Term Loan and available cash on hand, the Company deposited with the trustee an amount sufficient to redeem all of the Senior Subordinated Notes.  Accordingly, the Company’s obligations under the Senior Subordinated Notes Indenture were satisfied and discharged effective March 14, 2008.  A loss of $12.8 million was recorded in connection with the retirement of the Senior Subordinated Notes during the first quarter of 2008.  The loss is primarily comprised of the write-off of $7.0 million in unamortized discount and $5.8 million in make-whole payments and termination fees.

The Company acquires vehicles under a 4-year capital lease agreement.  Accumulated depreciation on these assets as of June 30, 2008 and December 31, 2007 was $2.9 million and $1.8 million, respectively.  The following is a schedule of future

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minimum lease payments under capital leases together with the present value of net minimum lease payments as of June 30, 2008 (dollars in thousands):

(a)  Reflected in the condensed consolidated balance sheet as current and non-current obligations under debt and capital leases of $2,442 and $3,380, respectively.

The Unsecured Term Loan Agreement, the indenture governing the Senior Secured Notes (the “Senior Secured Notes Indenture”) and the Senior Credit Agreement contain certain covenants and restrictions, including with respect to the Company’s ability to incur debt and pay dividends, based on earnings before interest, taxes, depreciation, and amortization, or EBITDA.  The definition of EBITDA varies between the Unsecured Term Loan Agreement, the Senior Secured Notes Indenture and the Senior Credit Agreement.  EBITDA is generally derived by adding to income (loss) before income taxes, the sum of interest expense, depreciation and amortization expense, including amortization of deferred customer acquisition costs less amortization of deferred customer acquisition revenue.  However, under the varying definitions, additional adjustments are sometimes required.

The Company’s Senior Credit Agreement, the Senior Secured Notes Indenture and the Unsecured Term Loan Agreement contain the financial covenants and current tests, respectively, summarized below:

At June 30, 2008, the Company was in compliance with the financial covenants and other maintenance tests of each of these debt instruments.  The interest coverage ratio incurrence test under each of the Senior Secured Notes Indenture and the Unsecured Term Loan is an incurrence based test (not a maintenance test), and the Company cannot be deemed to be in default solely due to failure to meet the interest coverage ratio test.  Failure to meet the interest coverage ratio tests could result in restrictions on the Company’s ability to incur additional ratio indebtedness; however, the Company may borrow additional funds under other permitted indebtedness provisions of the debt instruments, including all amounts currently available under the revolving credit facility.  These debt instruments also restrict the Company’s ability to pay dividends to stockholders, but do not otherwise restrict the Company’s ability to fund cash obligations.

In May 2005, as required by the Company’s then existing credit agreement, the Company entered into two separate interest rate cap agreements for a one-time aggregate cost of $0.9 million.  The Company’s objective was to protect against increases in interest expense caused by fluctuation in the LIBOR interest rate.  One of the interest rate caps expired in May 2008.  The other interest rate cap provides protection on $75 million of the Company’s long term debt over a five-year period ending May 24, 2010 if LIBOR exceeds 6%.

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In the second quarter of 2008, in connection with the interest rate swaps entered into and described below, the interest rate caps were de-designated as hedges.  The fair market value of the unexpired cap agreement was $0.05 million at June 30, 2008 and the fair market value of both cap agreements was $0.04 million at December 31, 2007.  These values are reflected in other assets.  Prior to de-designation, changes resulting from fair market value adjustments were reflected in accumulated other comprehensive gain (loss) in the condensed consolidated balance sheet and as a component of unrealized other comprehensive income in the condensed consolidated statement of operations and comprehensive loss.  Subsequent to de-designation, the interest rate cap is considered an economic derivative and changes in fair value will be recorded in earnings.

In April 2008, the Company entered into two interest rate swap agreements to fix the interest rate at a one month LIBOR rate of 3.19% on $6 million and $144 million of its floating rate debt under the senior credit facility through September 2010 and October 2010, respectively.  With the current applicable margin on the Company’s Eurodollar borrowings under its senior credit facility at 2.25%, the effective interest rate on the covered debt is expected to be at a fixed rate of 5.44%.  The interest rate swaps are accounted for as cash flow hedges.

In May 2008, the Company entered into another interest rate swap agreement to fix the interest rate on an additional $100 million of its floating rate debt under the senior credit facility at a one month LIBOR rate of 3.15% through November 2010.  With the current applicable margin on the Company’s Eurodollar borrowings under its senior credit facility at 2.25%, the effective interest rate on the covered debt is expected to be at a fixed rate of 5.40%.  The interest rate swap is accounted for as a cash flow hedge.

The fair value of the interest rate swaps and the interest rate cap are reflected in other assets.  The table below is a summary of the Company’s derivative positions as of June 30, 2008 (dollars in thousands):

All derivatives are recognized on the balance sheet at their fair value. Changes in the fair value of a derivative that is highly effective and that is designated and qualifies as a cash flow hedge, to the extent that the hedge is effective, are recorded in other comprehensive income, until earnings are affected by the variability of cash flows of the hedged transaction (e.g., until periodic settlements of a variable-rate asset or liability are recorded in earnings). Any hedge ineffectiveness (the amount by which the changes in fair value of the derivative exceeds the variability in cash flows of the forecasted transaction) is recorded in current-period earnings as other income or expense. Changes in the fair value of economic derivatives are reported in current-period earnings as interest expense.  There was no ineffectiveness recorded in other income or expense for any of the periods presented.  Below is a summary of the amounts charged to earnings and other comprehensive income (“OCI”) for the periods indicated (dollars in thousands):

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The Company estimates $0.2 million of the net unrealized gain existing at June 30, 2008 will be reclassified to earnings within the next twelve months.

The Company documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as cash flow hedges to specific forecasted transactions (e.g., interest payments). The Company also regularly assesses whether the derivatives that are used in hedging transactions have been highly effective in offsetting changes in the cash flows of hedged items and whether those derivatives may be expected to remain highly effective in future periods.  The Company uses the dollar offset method to perform the analysis.  The Company discontinues hedge accounting prospectively when (1) it determines that the derivative is no longer effective in offsetting changes in the cash flows of the hedged item; (2) the derivative expires or is sold, terminated or exercised; (3) it is no longer probable that the forecasted transaction will occur; or (4) management determines that designating the derivative as a hedging instrument is no longer appropriate or desired.

When the Company discontinues hedge accounting because it is no longer probable that the forecasted transaction will occur in the originally expected period, the gain or loss on the derivative remains in accumulated other comprehensive income and is reclassified into earnings when the forecasted transaction affects earnings. However, if it is probable that a forecasted transaction will not occur by the end of the originally specified time period or within an additional two-month period of time thereafter, the gains and losses that were accumulated in other comprehensive income will be recognized immediately in earnings. In all situations in which hedge accounting is discontinued and the derivative remains outstanding, the Company will carry the derivative at its fair value on the balance sheet, recognizing changes in the fair value in current-period earnings.

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS 157”).  SFAS 157 applies whenever other accounting pronouncements require or permit assets or liabilities to be measured at fair value.  Accordingly, SFAS 157 does not expand the use of fair value in any new circumstances. SFAS 157 establishes a fair value hierarchy that prioritizes the information used to develop assumptions used to determine the exit price. SFAS 157 also establishes valuation techniques that are used to measure fair value. To increase consistency and comparability in fair value measurements and related disclosures, the fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels:

Level 1 – quoted prices in active markets for identical assets or liabilities;

Level 2 – directly or indirectly observable inputs other than quoted prices; and

Level 3 – unobservable inputs.

The following table presents, for each SFAS 157 hierarchy level, the Company’s assets and liabilities that are measured at fair value on a recurring basis on the condensed consolidating balance sheet at June 30, 2008 (in thousands):

These instruments are valued using observable benchmark rates at commonly quoted intervals for the life of the instruments.

On April 2, 2007, the Company completed its acquisition of IASG.  The Company issued 7,066,960 shares of its common stock and 713,104 stock options in exchange for the outstanding shares of IASG common stock and IASG stock options, respectively.  The consideration associated with the common stock and stock options was based on $12.125 per share, the average closing price of the Company’s common stock for the two trading days immediately prior and subsequent to December 20, 2006, the announcement date of the Merger.  In connection with the Merger, the Company’s common stock was approved for listing on the Nasdaq Global Market LLC and now trades under the symbol “PONE.”  See Note 5, “Debt and Capital Leases—Senior Secured Notes,” for information on the Exchange Offer completed in connection with the Merger.

The Merger was accounted for using the purchase method of accounting under Financial Accounting Standards Board Statement No. 141 (“FAS 141”), “Business Combinations.”  Under the purchase method of accounting, Protection One is considered the

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acquirer of IASG for accounting purposes and the total purchase price is allocated to the assets acquired and liabilities assumed from IASG based on their fair values as of April 2, 2007.  Under the purchase method of accounting, the net consideration was $96.7 million, comprised of Protection One common stock of $85.7 million, the assumption of IASG stock options that were converted into the Company’s stock options with a value of $2.9 million, and $8.1 million in transaction costs, including investment banker fees, consulting fees and other professional fees.

As of June 30, 2008 and December 31, 2007, the Company had $0.5 million and $0.7 million, respectively, recorded related to duplicate facilities acquired and closed in connection with the Merger.  During the six months ended June 30, 2008, the Company made payments of $0.2 million related to these facilities and incurred no additional expenses.  The Company also recorded a liability of $1.0 million related to one-time termination benefits in connection with the Merger as a part of the purchase price allocation.  These one-time termination benefits were paid during the year ended December 31, 2007.  Total cash payments related to severance and retention with future service requirements during the six months ended June 30, 2008 were $0.5 million.  No additional payments for severance and retention are expected to be made in the remainder of 2008.

The results of operations of IASG have been included in the Company’s condensed consolidated statement of operations for the three and six months ended June 30, 2008 and the three months ended June 30, 2007.  The 2007 pro forma financial information in the table below summarizes the combined results of operations of the Company and IASG, as though the companies had been combined as of the beginning of the period presented.  These results have been prepared by adjusting the historical results of the Company to include the historical results of IASG and the impact of the purchase price allocation discussed above.

The following pro forma combined results of operations have been provided for illustrative purposes only and do not purport to be indicative of the actual results that would have been achieved by the combined companies for the periods presented or that will be achieved by the combined company in the future (dollar amounts in thousands, except per share amounts).

The Company accounts for stock options as prescribed by the provisions of Statement of Financial Accounting Standards No. 123R (“SFAS 123R”), “Share-Based Payment,” which requires the measurement and recognition of compensation expense for all share-based payment awards to employees and directors based on estimated fair values.  Share-based compensation related to stock options granted to employees of $0.7 million and $0.3 million was recorded in general and administrative expense for the six and three months ended June 30, 2008, respectively.   Share-based compensation related to stock options granted to employees of $0.7 million and $0.4 million was recorded in general and administrative expense for the six and three months ended June 30, 2007, respectively.  No tax benefit was recorded because the Company does not have taxable income and is currently fully reserving its federal deferred tax assets.  There were no amounts capitalized relating to share-based employee compensation in the six or three months ended June 30, 2008 or 2007.  The Company granted a total of 31,900 restricted share units to independent directors on June 4, 2008.  Twenty-five percent of the restricted share units vest on the first, second, third and fourth anniversaries of the date of grant.  There were no stock options granted in the first six months of 2008 and no stock options or restricted share units granted in the first six months of 2007.

9.  Related Party Transactions:

The Unsecured Term Loan lenders include, among others, entities affiliated with the Principal Stockholders and Arlon Group.  See Note 5, “Debt and Capital Leases—Unsecured Term Loan,” for additional information regarding related party transactions under the Unsecured Term Loan Agreement.

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On April 18, 2005, the Company entered into management agreements with each of Quadrangle Advisors LLC (“QA”) and Quadrangle Debt Recovery Advisors LLC (“QDRA,” and together with QA, the “Advisors”), pursuant to which the Advisors, affiliates of the Principal Stockholders, provided business and financial advisory and consulting services to the Company in exchange for annual fees of $1.0 million (in the case of QA) and $0.5 million (in the case of QDRA), payable in advance in quarterly installments.  The Principal Stockholders management agreements also provided that when and if the Advisors advised or consulted with the Company’s board of directors or senior executive officers with respect to an acquisition by the Company, divesture (if the Company did not engage a financial advisor with respect to such divesture) or financing transaction, they could require the Company to pay additional fees in connection with any such transaction in an amount not to exceed 0.667% (in the case of QA) and 0.333% (in the case of QDRA) of the aggregate value of such transaction.  The Principal Stockholders management agreements were terminated as of April 2, 2007 in connection with the completion of the Merger.  The Company’s board of directors concluded that it was in the best interests of the Company to terminate these arrangements with the Advisors upon completion of the Merger due, in part, to the Principal Stockholders’ ownership interest in the Company decreasing to 70.0% from 97.1% and eliminating the Advisors’ role providing business and financial advisory and consulting services to the Company.

The Company paid the Advisors aggregate management fees of $2.7 million and $2.3 million in the six and three months ended June 30, 2007, respectively, pursuant to the terms of the management agreements.  For the three months ended June 30, 2007, the amounts included $0.4 million for the second quarterly installment of the 2007 annual fees and $1.9 million for services rendered in connection with the Merger, or 1% of the aggregate value of the Merger.  The $1.9 million fee was capitalized as a direct cost of the Merger.

The Company is a defendant in a number of pending legal proceedings incidental to the normal course of its business and operations.  The Company does not expect the outcome of these proceedings, either individually or in the aggregate, to have a material adverse effect on the Company’s financial condition, results of operations or liquidity.

On April 17, 2006, the Company was named a defendant in a litigation proceeding brought by Frank and Anne Scardino arising out of a June 2005 fire at their home in Villanova, Pennsylvania (Frank and Anne Scardino v. Eagle Systems, Inc., Eagle Monitoring, Inc. and Protection One Alarm Monitoring, Inc. d/b/a Dynawatch, Delaware County, Pennsylvania Court of Common Pleas, Cause No. 06-4485). The complaint alleges that the defendants failed to provide contracted fire detection and monitoring services, breaching their contractual and warranty obligations in violation of Pennsylvania Unfair Trade Practices and Consumer Protection Law, resulting in alleged damages to plaintiffs in excess of $3.0 million.  Under the Unfair Trade Practices and Consumer Protection Law, claimants may be entitled to seek treble damages, attorneys’ fees and costs.  The complaint also asserted claims based on alleged negligence and gross negligence; however, the Company’s preliminary objections to these counts were granted by the court, and these claims were accordingly dismissed.

The Company has notified its liability insurance carriers of the claim and has answered the remaining counts.  Discovery has commenced in the matter.  The depositions of all appearing parties and various third-parties have occurred.  Expert discovery began in July 2008.  Plaintiffs have sought to extend the trial date to March 2009.

The Company does not believe that it breached its contractual obligations or otherwise violated its duties in connection with this matter.

On June 26, 2006, Thomas J. Few, Sr., the former president of IASG, initiated litigation against IASG, seeking a monetary award for amounts allegedly due to him under an employment agreement.  The claim was filed in the Superior Court of New Jersey, in the Bergen County Law Division.  (Thomas J. Few, Sr. v. Integrated Alarm Service Group, Inc., Superior Court of the State of New Jersey, Bergen County Division, Docket No. BER-L-4573-06.)  Mr. Few alleged that he was owed up to 36 months of pay as well as an amount representing accrued but unused vacation as a result of his resignation following the alleged breach of the employment agreement.  IASG denies various allegations in the complaint and has asserted various affirmative defenses and counterclaims against Mr. Few, including breach of the terms of his employment agreement, violation of various restrictive covenants and breach of fiduciary duty.

Discovery proceedings commenced as ordered by the Bergen County Law Division.  Mr. Few died on July 18, 2007, and on October 3, 2007, his estate was formally substituted as the Plaintiff in the proceeding.

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IASG filed a Motion for Sanctions Against Plaintiff for Spoliation of Evidence (the “Motion”) on February 21, 2008.  At a hearing on IASG’s Motion on April 9, 2008, the Court found, among other things, that Thomas Few, Sr. had intentionally spoliated evidence and sanctioned Plaintiff by issuing an adverse inference jury instruction concerning the destruction of evidence and ordered Plaintiff to pay IASG’s counsel fees incurred in connection with the Motion.  Discovery will continue as directed by the Court.

The Company does not believe that IASG breached its contractual obligations or otherwise violated its duties in connection with this matter and intends to vigorously defend the matter.

On April 30, 2007, IASG and its subsidiaries Criticom International Corporation and Monital Signal Corporation were served in a lawsuit brought by By the Carat, Inc. and John P. Humbert, Jr. and his wife, Valery Humbert, its owners, in connection with a December 2004 armed robbery of their jewelry business.  (By the Carat, Inc., John P. Humbert, Jr. and Valery Humbert v. Knightwatch Security Systems, Criticom International Corporation, Monital Signal Corporation, Integrated Alarm Services Group, Inc., et al, Superior Court of New Jersey, Monmouth County Law Division, Docket No.: MON-L-5830-06). The complaint seeks unspecified damages for alleged bodily injury and property losses based on various causes of action including breach of contract, breach of the covenant of good faith and fair dealing, consumer fraud, intentional and negligent infliction of emotional distress, breach of warranty and gross negligence.

The Company has notified its insurance carriers of the matter and has engaged counsel to defend the Company.  The Company filed a motion which resulted in the dismissal of the plaintiff’s claims for breach of the covenant of good faith and fair dealing, consumer fraud, and breach of warranty.  The material claims which remain are breach of contract (as to By the Carat, Inc. only) and gross negligence and negligent/intentional infliction of emotional distress (as to John and Valery Humbert, as individuals).

As to the remaining claims, the Company has filed an answer including various affirmative defenses.  In addition, the Company has asserted a contractual counterclaim against By the Carat, Inc. (for indemnification as to the claims made by John P. Humbert, Jr. and his wife), contractual cross claims against co-defendant Knightwatch Security Systems, Inc. (for indemnification as to the claims made by all plaintiffs), and a third-party complaint against the perpetrators (which will allow for apportionment of fault under New Jersey statutory law).  The parties are presently engaged in written and expert discovery.  Subject to further extension, the end date for written, expert and deposition discovery is December 15, 2008.

The Company occasionally receives notices of consumer complaints filed with various state agencies.  The Company has developed a dispute resolution process for addressing these administrative complaints.  The ultimate outcome of such matters cannot presently be determined; however, in the opinion of management, the resolution of such matters will not have a material adverse effect on the Company’s consolidated financial position, results of operations or liquidity.

As part of the Merger, the Company assumed obligations to provide open lines of credit to dealers, subject to the terms of the agreements with the dealers.  At June 30, 2008 and December 31, 2007, the amount available to dealers under these lines of credit was $0.8 million and $0.5 million, respectively.

The Company is potentially entitled to certain contingent payments, depending on whether Westar claims and receives certain additional tax benefits in the future with respect to the February 17, 2004 sale transaction.  While these potential contingent payments, if any, could be significant, the Company is unable to determine at this time whether Westar will claim any such benefits or, if Westar were to claim any such benefits, the amount of the benefits that Westar would claim or when or whether Westar would actually receive any such benefits.  Due to this uncertainty, the Company has not recorded any tax benefit with respect to any such potential contingent payments.

Until June 30, 2008, the Company was a partner in a marketing alliance with AT&T (through AT&T’s acquisition of BellSouth) through which the Company offered, through its Retail segment, monitored security services to the residential, single-family market and to businesses in 17 of the larger metropolitan markets in a nine-state region of the southeastern United States.  Upon termination of the agreement on June 30, 2008, the Company agreed to make a one-time payment of $2.3 million in satisfaction of the

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Company’s recurring royalty obligations under the AT&T agreement.  In addition, AT&T agreed to reimburse the Company $1.0 million for rebranding costs.  In July 2008, the Company made the $2.3 million payment to AT&T, net of the $1.0 million rebranding reimbursement.  The $2.3 million prepayment of  royalty fees is an alternative payment arrangement to the original AT&T agreement, which called for paying a recurring royalty fee for thirty-six months after the termination of the agreement.  As such, the prepayment will be amortized as a cost of monitoring and related services revenue over a three year period.  The $1.0 million rebranding reimbursement will be recorded in the current year as an offset to the Company’s total rebranding costs, which are expected to approximate $1.8 million. The Company incurred $0.2 million and $0.1 million of rebranding costs in the six and three months ended June 30, 2008, respectively.

The Company organizes its operations into three business segments:  Retail, Wholesale and Multifamily.  The Company’s operating segments are defined as components for which separate financial information is available that is evaluated regularly by the chief operating decision maker.  The operating segments are managed separately because each operating segment represents a strategic business unit that serves different markets.  All of Protection One’s reportable segments operate in the United States of America.

The Company’s Retail segment provides security alarm monitoring services, which include sales, installation and related servicing of security alarm systems for residential and business customers.  The Company’s Wholesale segment provides monitoring, financing and business support services to independent security alarm dealers.  The Company’s Multifamily segment provides security alarm services to apartments, condominiums and other multi-family dwellings.

The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.  The Company manages its business segments based on earnings before interest, income taxes, depreciation, amortization (including amortization of deferred customer acquisition costs and revenue) and other items, referred to as Adjusted EBITDA.

Reportable segments (dollars in thousands):