Summary of ADT CORP - Yahoo! Finance

Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
Introduction
The following discussion should be read in conjunction with our Condensed, Consolidated and Combined Financial Statements and the notes thereto, which are included in Item 1 of this Quarterly Report on Form 10-Q, as well as our Annual Report on Form 10-K for the fiscal year ended September 28, 2012, which was filed with the U.S. Securities and Exchange Commission ("SEC") on November 27, 2012 (the "2012 Form 10-K"). This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including but not limited to those provided in Item 1A. Risk Factors and under the heading "Cautionary Statement Regarding Forward-Looking Statements" below. The Condensed, Consolidated and Combined Financial Statements include our combined operations, assets and liabilities and have been prepared in accordance with generally accepted accounting principles in the United States of America ("GAAP"). As part of a plan to separate into three independent companies, on or prior to September 28, 2012, Tyco transferred the equity interests of the entities that held all of the assets and liabilities of its residential and small business security business in the United States and Canada to ADT (the "Separation"). Our Condensed and Consolidated Balance Sheets as of December 28, 2012 and September 28, 2012 reflect the consolidated financial position of The ADT Corporation and its subsidiaries as an independent publicly-traded company. Additionally, our Condensed, Consolidated and Combined Statements of Operations, Comprehensive Income and Cash Flows for the quarter ended December 28, 2012 reflect our operations and cash flows as a standalone company. Prior to the Separation on September 28, 2012, our financial position, results of operations and cash flows consisted of Tyco's residential and small business security business in the United States, Canada and certain U.S. territories and have been derived from Tyco's historical accounting records and presented on a carve-out basis. As such, our Condensed, Consolidated and Combined Statements of Operations, Comprehensive Income and Cash Flows for the quarter ended December 30, 2011 consist of the combined results of operations of the ADT North American Residential Security Business of Tyco.
We conduct business through our operating entities and report financial and operating information in one reportable segment. We have a 52- or 53-week fiscal year that ends on the last Friday in September. Both fiscal year 2013 and fiscal year 2012 are 52-week years.
Business Overview
ADT is a leading provider of electronic security, interactive home and business automation and related monitoring services. We currently serve more than six million customers, making us the largest company of our kind in both the United States and Canada.
Our subscriber-based business requires significant upfront costs to generate new customers, which in turn provide predictable recurring revenue generated from monthly monitoring fees. In any period, our business results will be impacted by a number of factors including: customer additions, costs associated with adding new customers, average revenue per customer, costs related to providing services to customers and customer tenure. We manage our business to optimize these key factors. We focus on investing wisely in each of our customer acquisition channels to grow our account base in a cost effective manner and generate positive future cash flows and attractive margins. We also focus on "Creating Customers for Life" by maintaining consistently high levels of customer satisfaction, which increases customer tenure and improves profitability. Key Performance Measures
We operate our business with the goal of retaining customers for long periods of time in order to recoup our initial investment in new customers, achieving cash flow break-even in slightly less than three years. We generate substantial recurring net operating cash flow from our customer base. In evaluating our results, we review the following key performance indicators:
Customer Growth. Growth of our customer base is crucial to drive our recurring customer revenue as well as to leverage costs of operations. To grow our customer base, we market our electronic security and home/business automation systems and services through national television advertisements, Internet advertising and also through a direct sales force and an authorized dealer network. The key customer metrics that we use to track customer growth are gross customer additions and ending customers. Gross customer additions are new monitored customers installed or acquired during the period.
Customer Attrition Rate. Our economic model is highly dependent on customer retention. Success in retaining customers is driven in part by our discipline in accepting new customers with favorable characteristics and by providing high quality equipment, installation, monitoring and customer service. We evaluate our customer retention based upon the recurring revenue lost resulting from customer attrition, net of dealer charge-backs and re-sales. Dealer charge-backs represent customer cancellations charged back to the dealers because the customer cancelled service during the initial period of the contract,

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generally 12 to 15 months. Re-sales are inactive customer sites that are returned to active service during the period. The attrition rate is a 52 week trailing ratio, the numerator of which is the annualized recurring revenue lost during the period due to attrition and the denominator of which is total annualized recurring revenue based on an average of recurring revenue under contract at the beginning of each month during the period. Recurring Customer Revenue. Recurring customer revenue is generated by contractual monthly recurring fees for monitoring and other recurring services provided to our customers. Our other revenue consists of revenue associated with sale of equipment, deferred revenue related to upfront installations fees, non-routine repair and maintenance services and customer termination charges. Average Revenue per Customer. Average revenue per customer measures the average amount of recurring revenue per customer per month, and is calculated based on the recurring revenue under contract at the end of the period, divided by the total number of customers under contract at the end of the period. Cost to Serve Expenses. Cost to serve expenses represent the cost of providing services to our customers reflected in our Condensed, Consolidated and Combined Statements of Operations and include costs associated with service calls for customers who have maintenance contracts, costs of monitoring, call center customer service and guard response, partnership commissions and continuing equity programs, bad debt expense and general and administrative expenses. Recurring customer revenue less cost to serve expenses represents our recurring revenue margin.
Gross Subscriber Acquisition Cost Expenses. Gross subscriber acquisition cost expenses represent the cost of acquiring new customers reflected in our Condensed, Consolidated and Combined Statements of Operations and include advertising, marketing, and both direct and indirect selling costs for all new accounts as well as sales commissions and installation costs.
Earnings before interest, taxes, depreciation and amortization ("EBITDA"). EBITDA is a non-GAAP measure reflecting net income adjusted for interest, taxes and certain non-cash items which include depreciation of subscriber system assets and other fixed assets, amortization of deferred costs and deferred revenue associated with customer acquisitions, and amortization of dealer and other intangible assets. We believe EBITDA is useful to provide investors with information about operating profits, adjusted for significant non-cash items, generated from the existing customer base. A reconciliation of EBITDA to net income (the most comparable GAAP measure) is provided under "-Results of Operations-Non-GAAP Measures."
Free Cash Flow ("FCF"). FCF is a non-GAAP measure that our management employs to measure cash that is free from any significant existing obligation and is available to service debt and make investments. The difference between net cash provided by operating activities (the most comparable GAAP measure) and FCF is cash outlays for capital expenditures, subscriber system assets, dealer generated customer accounts and bulk account purchases. A reconciliation of FCF to net cash provided by operating activities is provided under "-Results of Operations-Non-GAAP Measures."

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Results of Operations
(in millions, except as otherwise indicated)
                                                                   For the Quarters Ended
                                                          December 28, 2012      December 30, 2011
Recurring customer revenue                               $            744       $             708
Other revenue                                                          65                      87
     Total revenue                                                    809                     795
Operating income                                                      186                     176
Interest expense, net                                                 (24 )                   (22 )
Other income                                                            6                       -
Income tax expense                                                    (63 )                   (61 )
     Net income                                          $            105       $              93

Summary Cash Flow Data:
     Net cash provided by operating activities           $            409       $             337
     Net cash used in investing activities                           (276 )                  (250 )
     Net cash provided by (used in) financing activities               15                     (91 )

Key Performance Indicators:
    Ending number of customers (thousands)                          6,428                   6,394
    Gross customer additions (thousands)                              257                     295
    Customer attrition rate (percent)                                13.8 %                  13.0 %
    Average revenue per customer (dollars)               $          39.27       $           37.51
    Cost to serve expenses                               $            241       $             239
    Gross subscriber acquisition cost expenses           $            111       $             134
    EBITDA                                               $            417       $             386
    FCF                                                  $            149       $              87

As mentioned above, we manage our business to optimize a number of factors including: customer additions, costs associated with adding new customers, average revenue per customer, costs related to providing services to customers and customer tenure. In order to understand how these key factors impact our Condensed, Consolidated and Combined Statements of Operations, we consider the following components of our expenses: cost to serve expenses, gross subscriber acquisition cost expenses and depreciation and amortization. The following tables reflect the location of these costs in our Condensed, Consolidated and Combined Statements of Operations for the quarters ended December 28, 2012 and December 30, 2011:

                                               For the Quarter Ended December 28, 2012
                                                         Selling, general and
(in millions)                    Cost of revenue        administrative expenses            Total
Cost to serve expenses         $               98     $                     143     $             241
Gross subscriber acquisition
cost expenses                                  13                            98                   111
Depreciation and amortization                 217                            40                   257
Other                                           8                             -                     8
    Total                      $              336     $                     281     $             617


                                               For the Quarter Ended December 30, 2011
                                                         Selling, general and
(in millions)                    Cost of revenue        administrative expenses            Total
Cost to serve expenses         $               90     $                     149     $             239
Gross subscriber acquisition
cost expenses                                  45                            89                   134
Depreciation and amortization                 203                            36                   239
Other                                           7                             -                     7
    Total                      $              345     $                     274     $             619

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Quarter Ended December 28, 2012 Compared with Quarter Ended December 30, 2011 Revenue
Revenue of $809 million increased by $14 million, or 1.8%, for the quarter ended December 28, 2012 as compared with the quarter ended December 30, 2011, as a result of growth in recurring customer revenue, which increased by $36 million, or 5.1%. The majority of this increase was related to higher average revenue per customer, with less than 1% due to growth in customer accounts, net of attrition. The increase in recurring customer revenue was partially offset by a reduction of $22 million, or 25.3%, in other revenue due to the mix shift toward more ADT-owned systems rather than outright system sales, increasing deferred revenue and reducing current period installation revenue.
Average revenue per customer increased by $1.76, or 4.7%, as of December 28, 2012 compared with December 30, 2011. Approximately 65% of the growth in average revenue per customer resulted from price escalations, with the remaining 35% resulting from a richer mix from new customer additions, including increased take rates on ADT Pulse.
Gross customer additions fell by 38,000, or 12.9%, for the quarter ended December 28, 2012, as compared with the quarter ended December 30, 2011, as a result of lower dealer channel production as well as the impact of Hurricane Sandy. Net of attrition, our ending number of customers grew by 34,000, or 0.5%, from December 30, 2011 to December 28, 2012. Our annualized customer attrition as of December 28, 2012 was 13.8% compared with 13.0% as of December 30, 2011. Despite some pressure on disconnects from Hurricane Sandy, attrition remained flat from September 28, 2012. We continue to focus on high quality service and our disciplined customer selection process in order to limit customer attrition. Operating Income
Operating income of $186 million increased by $10 million, or 5.7%, for the quarter ended December 28, 2012 as compared with the quarter ended December 30, 2011. Operating margin was 23.0% for the quarter ended December 28, 2012 compared with 22.1% for the quarter ended December 30, 2011. Operating expenses for the quarter ended December 28, 2012, which included $6 million of non-recurring costs related to the Separation, totaled $623 million, up 0.6% or $4 million as compared with the quarter ended December 30, 2011. The increase in operating expenses includes $18 million in higher depreciation and amortization expense related to our subscriber system assets and dealer generated accounts. Cost to serve expenses totaled $241 million for the quarter ended December 28, 2012 as compared to $239 million for the quarter ended December 30, 2011. Cost to serve expenses for the quarter ended December 30, 2011 include integration costs related to the acquisition of Broadview Security of $5 million and restructuring related expenses of approximately $2 million. After considering these items, cost to serve expenses increased by approximately $9 million for the quarter ended December 28, 2012 as compared with the quarter ended December 30, 2011. This increase was a result of higher customer service and maintenance expenses, which was driven by account growth, $4 million in dis-synergies associated with the separation of our business from the commercial security business of Tyco and expenses of approximately $2 million from Hurricane Sandy. The overall increase in operating expenses was partially offset by a $23 million reduction in gross subscriber acquisition cost expenses. This decrease resulted from the deferral of a higher proportion of upfront installation costs associated with the mix shift toward more ADT-owned systems. Interest Expense, net
Net interest expense was $24 million for the quarter ended December 28, 2012 compared with $22 million for the quarter ended December 30, 2011. Interest expense for the quarter ended December 30, 2011 includes allocated interest expense related to Tyco's external debt of $21 million. Income Tax Expense
Income tax expense of $63 million increased $2 million for the quarter ended December 28, 2012 as compared with the quarter ended December 30, 2011, while the effective tax rate fell to 37.5%. The effective tax rate reflects the impact of a discrete charge of $5.6 million due to a California legislative change enacted on November 6, 2012, offset by a favorable impact resulting from $6.4 million in non-taxable other income. See Note 8 to the Condensed, Consolidated and Combined Financial Statements for more information on other income. The effective tax rate can vary from period to period due to permanent tax adjustments, discrete items such as the settlement of income tax audits and changes in tax laws, as well as recurring factors such as changes in the overall effective state tax rate.
Non-GAAP Measures
In an effort to provide investors with additional information regarding our results as determined by GAAP, we also disclose non-GAAP measures which management believes provide useful information to investors. These measures consist of EBITDA and FCF. These measures are not financial measures under GAAP and should not be considered as substitutes for net income, operating profit, cash from operating activities or any other operating performance measure calculated in accordance with GAAP, and they may not be comparable to similarly titled measures reported by other companies. We use EBITDA to

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measure the operational strength and performance of our business. We use FCF as an additional performance measure of our ability to service debt and make investments. These measures, or measures that are based on them, may be used as components in our incentive compensation plans.
We believe EBITDA is useful because it measures our success in acquiring, retaining and servicing our customer base and our ability to generate and grow our recurring revenue while providing a high level of customer service in a cost-effective manner. EBITDA excludes interest expense and the provision for income taxes. Excluding these items eliminates the expenses associated with our capitalization and tax structure. Because EBITDA excludes interest expense, it does not give effect to cash used for debt service requirements and thus does not reflect available funds for distributions, reinvestment or other discretionary uses. EBITDA also excludes depreciation and amortization, which eliminates the impact of non-cash charges related to capital investments. Depreciation and amortization includes depreciation of subscriber system assets and other fixed assets, amortization of deferred costs and deferred revenue associated with subscriber acquisitions and amortization of dealer and other intangible assets.
There are material limitations to using EBITDA. EBITDA may not be comparable to similarly titled measures reported by other companies. Furthermore, EBITDA does not take into account certain significant items, including depreciation and amortization, interest expense and tax expense, which directly affect our net income. These limitations are best addressed by considering the economic effects of the excluded items independently, and by considering EBITDA in conjunction with net income as calculated in accordance with GAAP.
FCF is defined as cash from operations less cash outlays related to capital expenditures, subscriber system assets, dealer generated customer accounts and bulk account purchases. Dealer generated accounts are accounts that are generated through our network of authorized dealers. Bulk account purchases represent accounts that we acquire from third parties outside of our authorized dealer network, such as other security service providers, on a selective basis. These items are subtracted from cash from operating activities because they represent long-term investments that are required for normal business activities. As a result, FCF is a useful measure of our cash that is free from significant existing obligations and available for other uses.
Furthermore, FCF adjusts for cash items that are ultimately within management's and the board of directors' discretion to direct and therefore may imply that there is less or more cash that is available for our programs than the most comparable GAAP measure. This limitation is best addressed by using FCF in combination with the GAAP cash flow numbers.
The tables below reconcile EBITDA to net income and FCF to cash flows from operating activities.

EBITDA
                                                        For the Quarters Ended
(in millions)                                 December 28, 2012       December 30, 2011
Net income                                   $             105       $              93
Interest expense, net                                       24                      22
Income tax expense                                          63                      61
Depreciation and intangible asset
amortization                                               227                     212
Amortization of deferred subscriber
acquisition costs                                           30                      27
Amortization of deferred subscriber
acquisition revenue                                        (32 )                   (29 )
EBITDA                                       $             417       $             386

EBITDA of $417 million increased $31 million, or 8.0%, for the quarter ended December 28, 2012, as compared with the same period of the prior year. The increase was primarily due to the impact of higher recurring customer revenue.

FCF
                                                        For the Quarters Ended
(in millions)                                 December 28, 2012       December 30, 2011
Net cash provided by operating activities    $             409       $             337
Dealer generated customer accounts and bulk
account purchases                                         (125 )                  (164 )
Subscriber system assets                                  (122 )                   (81 )
Capital expenditures                                       (13 )                    (5 )
FCF                                          $             149       $              87

For the quarter ended December 28, 2012, FCF increased $62 million compared with the quarter ended December 30, 2011. This increase was primarily due to an increase of $72 million in net cash provided by operating activities, which primarily resulted from higher EBITDA and improvements in working capital, and a decrease of $39 million in cash paid for

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dealer generated customer accounts and bulk account purchases. These factors were partially offset by an increase of $41 million in internally generated subscriber systems and an increase of $8 million in capital expenditures. Liquidity and Capital Resources
Liquidity and Cash Flow Analysis
Significant factors driving our liquidity position include cash flows generated from operating activities and investments in internally generated subscriber systems and dealer generated customer accounts. Our cash flows from operations includes cash received from monthly recurring revenue and upfront installation fees received from customers, less cash costs to provide services to our customers, including general and administrative costs, and certain costs, associated with acquiring new customers. Historically, we have generated and expect to continue to generate positive cash flow from operations. Prior to the Separation, our cash was regularly "swept" by Tyco at its discretion in conjunction with its centralized approach to cash management and financing of operations. Transfers of cash both to and from Tyco's cash management system are reflected as changes in parent company investment in the Condensed, Consolidated and Combined Statement of Cash Flows for the quarter ended December 30, 2011. Liquidity
At December 28, 2012, we had $382 million in cash and equivalents and another $750 million available under our revolving credit facility. As of December 28, 2012, we had not borrowed under our revolving credit facility. Our primary future cash needs are centered on operating activities, working capital, capital expenditures and strategic investments. In addition, we intend to use cash to repurchase shares of our common stock. We believe our cash position, amounts available under our revolving credit facility and cash provided by operating activities will be adequate to cover our operational and business needs in the foreseeable future.
On January 14, 2013, we issued $700 million aggregate principal amount of 4.125% senior notes due 2023 to certain institutional investors pursuant to certain exemptions from registration under the Securities Act of 1933, as amended. Net cash proceeds from the issuance of this term indebtedness totaled approximately $694 million and will be primarily used for the repurchase of outstanding shares of ADT's common stock. Any net proceeds not used for share repurchases are intended to be used for general corporate purposes. Interest is payable on June 15 and December 15 of each year, commencing on June 15, 2013. We may redeem the notes, in whole or in part, at any time prior to the maturity date at a redemption price equal to the greater of the principal amount of the notes to be redeemed, or a make-whole premium, plus in each case, accrued and unpaid interest to, but excluding, the redemption date. Share Repurchases
On November 26, 2012, our board of directors approved $2 billion of share repurchases over a three year period. Pursuant to this approval, we initiated a $100 million share repurchase plan in accordance with Rule 10b5-1 of the Securities Exchange Act of 1934, as amended (the "10b5-1 Plan"). During December 2012, we repurchased 0.6 million shares of our common stock under this plan for a total cost of approximately $26 million. Additionally, during January 2013, we repurchased 1.6 million shares of our common stock under this plan for a total cost of approximately $74 million. The 10b5-1 Plan was completed on January 23, 2013, and on January 29, 2013, we entered into an accelerated share repurchase agreement under which we will repurchase approximately $600 million of our common stock. This accelerated share repurchase program, which will be funded with proceeds from our recently completed debt offering, is expected to result in an immediate reduction in our common stock outstanding of approximately ten . . .