Summary

We are recommending purchase of IASG as we believe the stock is significantly undervalued and a positive catalyst is imminent.  The company has been in the process of exploring strategic alternatives over the past year.  While there have been many blunders and bumps in the road, we believe the process is finally about to come to a head. 

We believe several potential acquirers will bid for the company in whole or in part, at a valuation within a range of $3.60 to $4.50 per share.  This represents a 38-73% premium to today’s current price of $2.60 per share.  While this is not exactly a homerun, we think it represents a very attractive return given our expectations of an announcement within a month or two. 

Business

The company provides alarm monitoring services to three customer segments: 1) wholesale, 2) retail, and 3) commercial.  In addition, the company extends working capital loans to independent alarm-monitoring dealers.  The wholesale segment serves independent alarm-monitoring dealers on an outsourced basis.  The retail segment serves the company’s residential end customers.  The commercial segment serves institutions and businesses. 

In addition, the company extends loans to independent dealers at an average of 12-13% per annum and in return, the dealer outsources the monitoring of its accounts to IASG.  This business is basically a wash for IASG as its cost of capital is very high -- senior notes currently bear 13% interest per annum.  Any acquirer with a lower cost of capital could substantially improve the return characteristics of this business.  

The company was founded by an ex-investment banker named Tim McGinn.  Along with industry veteran Thomas Few, they embarked on building the business through acquisitions.  Alarm service monitoring typically has very good cash flow characteristics for operators with cost discipline and scale.  For IASG, a combination of poor management and a lack of sufficient scale have prevented the company from operating efficiently and profitably.  Much of this stems from ill-advised acquisitions that were not complimentary to the existing infrastructure and thus the return on invested capital was poor and in some cases, negative. 

History

FBR brought the company public in July 2004 at a price of $9.25 and it’s been in a steady decline ever since.  Without going into a drawn-out discussion of all that went wrong, suffice it to say that prior management blazed the trail all the way down to the current price.  Quarter after quarter, shareholders suffered from management’s over-promising and subsequent under-delivering.  The company simply never achieved the economies of scale that previous management pitched on the IPO roadshow. The sole analyst on the equity and bonds, FBR (naturally), threw in the towel earlier this year and dropped coverage. 

The board eventually woke up in July of this year and replaced the founding management team (Tim McGinn and Tom Few) with Charles (“Chick”) May, a well-respected industry veteran with an excellent track record.  May has been in the alarm security business for over 40 years and is 61.  He has already made his money and we don’t believe he agreed to run this company for the long-term.  Simply put, we think May took the reins for the sole purpose of dressing it up for sale, as his friend, John Mabry, has been a board member since March 2003 and is now non-executive Chairman.  May has been an advisor to the industry since 2002 and has experience monetizing companies in this space.  He purchased Smith Alarm Systems in 1995, built it up to over 75,000 accounts and sold it to Ameritech/SBC in June 2001.  Prior to that, May founded National Guardian in 1980 and ran Guardian Security from 1984-1994, both of which were exited successfully.

Current State of Operations

In a nutshell, the residential segment which represents about 47% of recurring monthly revenues (RMR) has been a thorn in the Company’s side.  The wholesale and commercial segments have been operating quite steadily.   

Attrition problems continued in the residential segment during the Q3 after the company raised prices and 90+ day accounts increased.  Attrition had been decent in the two previous quarters.  90+ day accounts are added to attrition upon occurrence and can have a dramatic effect on the number in both directions.  Lower 90+ day accounts helped in the first half of 2006 and the opposite happened in Q3. 

Management did note, however, that Q4 is showing signs of improvement with better DSOs, better collection of long-dated receivables and stabilizing attrition.  Management is targeting attrition in the low teens which is more inline with industry peers.  They have been there before, but only occasionally under previous poor management.  May is confident the company can achieve this goal and is taking the appropriate steps.  We liked their decision to divest of some high cost accounts in June and purchase the Minnesota accounts in September that were already being serviced on an outsourced basis.  May is focusing on lower cost, lower attrition accounts that are more geographically concentrated near service centers, and said it best in the June divestiture release:

“The transaction is positive for IASG shareholders, our customers and employees. The accounts are in service areas which do not fit in our desired profile. The sale of these accounts will provide a positive gain to IASG in 2006 not including the gain on sale which will be deferred until certain criteria are met. As a part of restructuring our retail division we are analyzing all of the accounts we have on a region by region basis to determine our costs to service, cancellation rates and whether they fit with our profile for profitable low attrition customers. We anticipate more sales of accounts which do not meet our profile as well as additional purchases of accounts that are representative of our desired profile."

He also addressed the divestiture positively stating…  “In many, many years of experience in the alarm industry, geographic disbursement of the sort is inefficient, expensive and ultimately results in high attrition.”  It appears evident to us that May is actively addressing the operational issues and repositioning residential assets to enhance value and attain a higher acquisition multiple. 

On a brighter note, the commercial segment (about 13% of RMR) achieved record bookings in Q3, continuing a streak of 3 positive quarters in a row.  Margins in the wholesale business (about 40% RMR) are also trending higher and reached the mid 60%s in Q3, up 5% from last year.  These two businesses appear to be doing quite well and management feels they are very well positioned for continued growth.      

In summary, the residential segment continues to have problems while the wholesale and commercial segments continue to improve.  We don’t believe that residential is terminal and better positioning it will only enhance its value to an acquirer.

Strategic Alternative Process

The company initially hired Allen & Company in late December 2005 to explore strategic alternatives including the outright sale of the business.  We believe this was an expensive stunt by prior management to placate angry shareholders. 

Nonetheless, during the Allen & Co. engagement, a private company called Alarm Security Group (ASG) submitted a written preliminary offer to buy IASG for $3.60/share in cash plus up to 20% of the combined surviving entity.  If we value the 20% remainder interest at zero, the cash part of the offer is still about 38% higher than the current price.  As expected, management sidetracked the offer despite a bid that our sources tell us was sincere.  We think the bid at the very least illustrates the underlying value of the business to a private buyer. 

Six months and $1mm later, the board fired Allen & Co. as well as McGinn and Few.  The board then engaged Houlihan Lokey shortly thereafter.  In addition, a member of Contrarian Capital Management, the company’s largest shareholder, joined the board after threatening a proxy fight.  Contrarian is very motivated to monetize their position to the highest bidder and their average cost appears to be much higher than the current market price.  Given the support Contrarian appears to have among other large shareholders, we believe there will be little dissention among the board. 

The company has $125 million in 12% senior secured notes outstanding.  Ownership is concentrated among several firms that bought in the original private placement.  Our understanding is that most of the noteholders are also shareholders and that they will support a reasonable transaction. 

So at this point, we have a board that has:

1)       Fired an ineffective banker;

2)       Fired the value destroying management team that hired the banker;

3)       Invited onto the board the largest shareholder who was ready to go hostile;

4)       Engaged a new banker, and

5)       Hired an adviser out of retirement to run and improve the business during the process.

All of the above activity gives us a rather high degree of confidence that the board is very serious about selling the company.  This is supported by our checks on the process which have indicated multiple interested parties.  In addition, last week the company issued parachutes to 3 top executives for protection in a change of control transaction.  

If you believe like we do that the company is clearly on the block, then the next question becomes: What’s it worth to private buyer?

Valuation

The alarm-monitoring industry has enjoyed a very active M&A market recently with both strategic and financial buyers participating.  Clearly the strategic buyer has a significant advantage simply because achieving synergies through integration is relatively straightforward.  The servicing of alarm monitoring contracts is essentially “layered” onto the acquirers existing infrastructure.  In IASG’s case, we believe a strategic buyer with a national presence can eliminate $6-8 million in redundant costs and corporate overhead within a short period of time.  This provides an attractive proposition for a strategic buyer such as Brink’s, Honeywell, Protection One and ASG among others.   

Valuation (balance sheet data as of 9/30/06)

Shares outstanding = 24.681mm

Current stock price = $2.60

Market cap = $64.2mm

Debt = $125.7mm (have $30mm untapped credit facility as well)

Cash + loans receivable = $32.4mm (pro forma for recent MN contracts acquisition)

Enterprise Value = $157.5mm

Retail monthly RMR (Recurring Monthly Revenue) = $3.43mm (pro forma for MN acquisition)

Commercial monthly RMR = $.97mm

Wholesale RMR = $2.9mm

Retail accounts have been selling for 30-35x RMR and commercial accounts typically get a little higher due to lower attrition, roughly 36-40x RMR.  Wholesale can sell for 6x EBITDA or 22-24x RMR.  Applying the low end of these ranges provides the following:

Retail = $3.43mm x 30 = $102.9mm (low end of multiple range due to current issues and quality of portfolio)

Commercial - $.97mm x 36 = $34.9mm

Wholesale - $2.9mm x 22 = $63.8mm

Total value = $201.6mm - $93.3mm net debt = $108.3mm or $4.39/share.  That’s 69% upside from here in a reasonable scenario.  Discount the multiples by another 10% and we still have 37% upside to $3.57/share.  As a point of reference, the company divested an underperforming residential portfolio at 35x RMR.  We believe 30x seems like a conservative assumption.  The profitability and current trajectory of the wholesale and commercial segments should support the above assumed multiples. 

And for good measure, we won’t give any value to the company’s $115 million of NOLs outstanding.  We don’t expect any taxes on divestitures.

Risks

We are invested for the event and the key risk is that the company doesn’t get bought.  If that proves to be the case, we can take comfort at the current valuation levels with Chick May at the helm.  He is repositioning the company to be more efficient and profitable.  In short, we don’t see a lot of downside risk at $2.60, which equates to about 6x run-rate EBITDA.