ADT Inc.: Form 10-Q for the period ended Jun 30, 2020

INTRODUCTION

The following discussion and analysis should be read in conjunction with our condensed consolidated financial statements, and the related notes thereto, included elsewhere in this Quarterly Report on Form 10-Q, as well as our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2019 (the “2019 Annual Report”), which was filed with the United States Securities and Exchange Commission (the “SEC”) on March 10, 2020, to enhance the understanding of our financial condition, changes in financial condition, and results of operations. The following discussion and analysis contains forward-looking statements about our business, operations, and financial performance based on current plans and estimates that involve risks, uncertainties, and assumptions. Actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause such differences are discussed in the sections of this Quarterly Report on Form 10-Q titled “Cautionary Statements Regarding Forward-Looking Statements” and “Item 1A. Risk Factors.”

OVERVIEW

ADT Inc., together with its wholly-owned subsidiaries (collectively, the “Company”, “we”, “our”, “us”, and “ADT”), is a leading provider of security, automation, and smart home solutions serving consumer and business customers in the United States (“U.S.”). We offer many ways to help protect customers by providing 24/7 professional monitoring services as well as delivering lifestyle-driven solutions via professionally installed, do-it-yourself (“DIY”), mobile, and digital-based offerings for consumer, small business, and larger commercial customers.

Our security and automation offerings involve the installation and monitoring of security and premises automation systems designed to detect intrusion; control access; sense movement, smoke, fire, carbon monoxide, flooding, temperature, and other environmental conditions and hazards; and address personal emergencies, such as injuries, medical emergencies, or incapacitation. Our products and services include interactive and smart home solutions which allow our customers to remotely monitor and manage their residential and commercial environments. Depending on the service plan and type of product installation, customers are able to remotely access information regarding the security of their residential or commercial environment, arm and disarm their security systems, adjust lighting or thermostat levels, monitor and react to defined events, or view real-time video from cameras covering different areas of their premises from web-enabled devices (such as smart phones, laptops, and tablet computers) and a customized web portal. Additionally, our interactive and smart home solutions enable customers to create customized and automated schedules for managing lights, thermostats, appliances, garage doors, cameras, and other connected devices. These systems can also be programmed to perform additional functions such as recording and viewing live video and sending text messages or other alerts based on triggering events or conditions.

As part of our innovative and dynamic growth markets, we are extending the concept of security from the physical home or business to personal on-the-go security and safety and cybersecurity. Customers’ increasingly mobile and active lifestyles have created new opportunities for us in the fast-growing market for self-monitored DIY products and mobile technology. Our technology also allows us to integrate with various third-party connected and wearable devices so that we can service our customers whether they are at home or on-the-go.

As of June 30, 2020, we served approximately 6.5 million recurring customers, excluding contracts monitored but not owned. We are one of the largest full-service companies with a national footprint and we deliver an integrated customer experience by maintaining the industry’s largest sales, installation, and service field force, as well as a 24/7 professional monitoring network.

BASIS OF PRESENTATION

All financial information presented in this section has been prepared in U.S. dollars in accordance with generally accepted accounting principles in the United States of America (“GAAP”) and includes the accounts of ADT Inc. and its subsidiaries. All intercompany transactions have been eliminated. We report financial and operating information in one segment.

FACTORS AFFECTING OPERATING RESULTS

Our subscriber-based business requires significant upfront investment to generate new customers, which in turn provides predictable recurring revenue generated from our monitoring and other services. In order to optimize returns on customer acquisitions and cash flow generation, we focus on the following key drivers of our business: best-in-class customer service; customer retention; disciplined, high-quality customer additions; efficient customer acquisition; and costs incurred to provide ongoing services to customers.

Our ability to add new subscribers depends on the overall demand for our products and services, which is driven by a number of external factors. The overall economic condition in the geographies in which we operate can impact our ability to attract new customers and grow our business in all customer channels. Growth in our residential customer base can be influenced by the overall state of the housing market. Growth in our commercial customer base can be influenced by the rate at which new businesses begin operations or existing businesses grow. The demand for our products and services is also impacted by the perceived threat of crime, as well as the quality of the service of our competitors.

The monthly fees that we generate from any individual customer vary based on the level of service provided and customer tenure. We offer a wide range of services at various price points from basic burglar alarm monitoring to our full suite of interactive services. Our ability to increase monthly fees at the individual customer level depends on a number of factors, including our ability to effectively introduce and market additional features and services that increase the value of our offerings to customers, which we believe drives customers to purchase higher levels of service and supports our ability to make periodic adjustments to pricing.

A portion of our customer base can be expected to cancel its service every year. Customers may choose not to renew or may terminate their contracts for a variety of reasons, including, but not limited to, relocation, cost, loss to competition, or service issues. Attrition has a direct impact on our financial results, including revenue, operating income, and cash flows.

COVID-19 Pandemic

During March 2020, the World Health Organization declared the outbreak of a novel coronavirus as a pandemic (the “COVID-19 Pandemic”), which has become increasingly widespread in the U.S. Containment efforts and responses to the COVID-19 Pandemic have varied by individuals, businesses, and state and local municipalities, and in certain areas of the U.S, initial and precautionary measures helped mitigate the spread of the coronavirus. However, subsequent easing of such measures resulted in the re-emergence of the coronavirus. The COVID-19 Pandemic has had a notable adverse impact on general economic conditions, including but not limited to the temporary closures of many businesses, “shelter in place” and other governmental regulations, and reduced consumer spending due to significant unemployment and other effects attributable to the COVID-19 Pandemic. In order to continue to service our customers, we have adjusted and are continuously evolving certain aspects of our operations to protect employees and customers, which includes (i) the temporary suspension of door-to-door sales as well as a small portion of dealer and direct sales channel activities, (ii) the implementation of health checklists for employees interacting with customers in-person, and (iii) the implementation of work from home actions, including the majority of our call center professionals.

While the COVID-19 Pandemic has impacted our commercial channel to a greater extent than our residential channel, we believe our overall recurring revenue and highly variable subscriber acquisition cost model provides a solid financial foundation for strong cash flow generation. Accordingly, we anticipate having sufficient liquidity and capital resources to continue (1) providing essential services, (2) satisfying our debt requirements, and (3) having the ability to return capital to our stockholders in the form of a regular quarterly dividend during the current challenging macroeconomic environment and the slowdown brought on by the COVID-19 Pandemic. We have not sought or requested government assistance as a result of the COVID-19 Pandemic, but we do expect to recognize favorable cash flows and other benefits associated with certain income tax and payroll tax provisions of the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”). While we have incurred additional costs associated with personal protective equipment for our employees and work from home actions, we also instituted various temporary cost control measures such as certain hiring freezes and voluntary furloughs for employees. Furthermore, we believe the economic downturn, the recent civil unrest, shelter in place requirements, and continued economic and COVID-19 Pandemic uncertainties increase awareness of the need for security, which together with an anticipated lower volume of customer relocations and the utilization of temporary pricing and retention initiatives for existing customers, may help counterbalance any increase in gross customer revenue attrition that we may experience as a result of reduced consumer or business spending caused by the COVID-19 Pandemic. Finally, we may see opportunities for additional acquisitions, continued investment in potential new revenue streams or capabilities, and low cost bulk account purchases.

We considered the emergence and pervasive economic impact of the COVID-19 Pandemic in our assessment of our financial position, results of operations, cash flows, and certain accounting estimates as of and for the three and six months ended June 30, 2020. Due to the evolving and uncertain nature of the COVID-19 Pandemic, it is possible that the effects of the COVID-19 Pandemic could materially impact our estimates and condensed consolidated financial statements in future reporting periods.

Radio Conversion Costs

The providers of 3G and Code-Division Multiple Access (“CDMA”) cellular networks have notified us that they will be retiring their 3G and CDMA networks during 2022. Accordingly, during 2019 we commenced a program to replace the 3G and CDMA cellular equipment used in many of our security systems. We continue to estimate the range of net costs for this replacement program at $200 million to $325 million through 2022, of which we have incurred $37 million through June 30, 2020. We expect to incur $50 million to $100 million of net costs during 2020, of which we have incurred $12 million for the six months ended June 30, 2020. These amounts and ranges are net of any revenue we collect from customers associated with these radio replacements and cellular network conversions. We seek to minimize these costs by converting customers during routine service visits whenever possible. The replacement program and pace of replacement are subject to change and may be influenced by our ability to access customer sites due to the COVID-19 Pandemic, cost-sharing opportunities with suppliers, carriers, and customers, as well as new and innovative technologies.

SIGNIFICANT EVENTS

The comparability of our results of operations has been impacted by the following:

Disposition of Canadian Operations

During November 2019, we sold ADT Security Services Canada, Inc. (“ADT Canada”) to TELUS Corporation (“TELUS”) for a selling price of $514 million (CAD $676 million). In connection with the sale of ADT Canada, we entered into a transition services agreement with TELUS whereby we will provide certain post-closing services to TELUS related to the business of ADT Canada. Additionally, we entered into a non-competition and non-solicitation agreement with TELUS pursuant to which we will not have any operations in Canada, subject to limited exceptions for cross-border commercial customers and mobile safety applications, for a period of seven years. Finally, we entered into a patent and trademark license agreement with TELUS granting the usage of our trademarks and patents in Canada to TELUS for a period of seven years.

The sale of ADT Canada did not represent a strategic shift that will have a major effect on our operations and financial results, and therefore, did not meet the criteria to be reported as discontinued operations.

Defenders Acquisition

During January 2020, we acquired Defender Holdings, Inc. (“Defenders”) (the “Defenders Acquisition”), which represented the acquisition of our largest independent dealer, for total consideration of approximately $290 million, which consisted of cash paid of $172 million, net of cash acquired, and the issuance of approximately 16 million shares of our common stock with a fair value of $114 million. In connection with the Defenders Acquisition, we settled a pre-existing relationship with Defenders in the amount of $81 million.

Equipment Ownership Model Change

During February 2020, we launched a new revenue model initiative for certain residential customers which revised the amount and nature of fees due at installation, introduced a 60 month monitoring contract option, and introduced a new retail installment contract which allows qualifying residential customers to repay the fees due at installation over the course of a 24, 36, or 60 month interest-free period. Due to the requirements of our initial third-party consumer financing program, we also transitioned our security system ownership model from a predominately Company-owned model to a predominately customer-owned model (the “Equipment Ownership Model Change”).

During March 2020, we entered into an uncommitted receivables securitization financing agreement (the “Receivables Facility”). Under the terms of the Receivables Facility, we may receive up to $200 million of financing secured by retail installment contract receivables from transactions involving security systems that were sold under a customer-owned model. During April 2020, we amended the Receivables Facility to also permit financing secured by retail installment contract receivables from transactions occurring under our Company-owned model. During May 2020, we started to transition our security system ownership model back to a predominately Company-owned model as a result of this amendment.

In connection with the above, and with respect to transactions arising through Defenders, which has historically used a customer-owned ownership model, subsequent to the Defenders Acquisition, our residential transactions during the three and six months ended June 30, 2020 were predominately based on a customer-owned model. In connection with our transition back to a Company-owned model, we do not expect to experience the same level of revenue growth subsequent to June 30, 2020 as reported in our results of operations for the three and six months ended June 30, 2020. We are in the early stages of our new revenue model initiative and we cannot be certain that this initiative or our transition back to a predominately Company-owned model, which is anticipated to include transactions arising through Defenders, will achieve the desired outcomes. Accordingly, the results of the new revenue model initiative and impact of our transition back to a predominately Company-owned model could have a material adverse effect on our business, financial condition, results of operations, cash flows, and key performance indicators.

KEY PERFORMANCE INDICATORS

In evaluating our results, we utilize key performance indicators, which include non-GAAP measures as well as certain other operating metrics such as recurring monthly revenue and gross customer revenue attrition. Our computations of key performance indicators may not be comparable to other similarly titled measures reported by other companies. Additionally, our operating metric key performance indicators are approximated as there may be variations to reported results in each period due to certain adjustments we might make in connection with the integration over several periods of acquired companies that calculated these metrics differently, or otherwise, including periodic reassessments and refinements in the ordinary course of business. These refinements, for example, may include changes due to systems conversion or historical methodology differences in legacy systems.

Recurring Monthly Revenue (“RMR”)

RMR is generated by contractual recurring fees for monitoring and other recurring services provided to our customers, including contracts monitored but not owned. We believe the presentation of RMR is useful because it measures the volume of revenue under contract at a given point in time.

Gross Customer Revenue Attrition

A portion of our customer base can be expected to cancel its service every year. Customers may choose not to renew or may terminate their contracts for a variety of reasons, including, but not limited to, relocation, cost, loss to competition, or service issues. Gross customer revenue attrition has a direct impact on our financial results, including revenue, operating income, and cash flows.

Gross customer revenue attrition is defined as RMR lost as a result of customer attrition, net of dealer charge-backs and reinstated customers, excluding contracts monitored but not owned and DIY customers. Customer sites are considered canceled when all services are terminated. Dealer charge-backs represent customer cancellations charged back to the dealers because the customer canceled service during the charge-back period, which is generally twelve to fifteen months.

Gross customer revenue attrition is calculated on a trailing twelve-month basis, the numerator of which is the RMR lost during the period due to attrition, net of dealer charge-backs and reinstated customers, excluding contracts monitored but not owned and DIY customers, and the denominator of which is total annualized RMR based on an average of RMR under contract at the beginning of each month during the period.

Adjusted EBITDA

Adjusted EBITDA is a non-GAAP measure that we believe is useful to investors to measure the operational strength and performance of our business. Our definition of Adjusted EBITDA, a reconciliation of Adjusted EBITDA to net income (loss) (the most comparable GAAP measure), and additional information, including a description of the limitations relating to the use of Adjusted EBITDA, are provided under “—Non-GAAP Measures.”

Free Cash Flow

Free Cash Flow is a non-GAAP measure that our management employs to measure cash that is available to repay debt, make other investments, and pay dividends. Our definition of Free Cash Flow, a reconciliation of Free Cash Flow to cash flows from operating activities (the most comparable GAAP measure), and additional information, including a description of the limitations relating to the use of Free Cash Flow, are provided under “—Non-GAAP Measures.”

Three Months Ended June 30, 2020 Compared to Three Months Ended June 30, 2019

The following table sets forth our condensed consolidated results of operations, and key performance indicators for the periods presented.

(in thousands, except as otherwise indicated)

(1) Refer to the “—Key Performance Indicators” section for the definitions of these key performance indicator

(2) Adjusted EBITDA is a non-GAAP measure. Refer to the “—Non-GAAP Measures” section for the definition of this term and reconciliation to the most comparable GAAP measure.

Monitoring and Related Services Revenue

The decrease in monitoring and related services revenue was driven by a decrease in recurring revenue. Recurring revenue decreased primarily from a reduction of revenue due to the sale of ADT Canada and customer attrition. These decreases were partially offset by improvements in average pricing, which was driven by the addition of new customers at higher rates as new customers generally selected higher priced services as compared to our existing customer base.

The decrease in RMR to $339 million as of June 30, 2020 from $351 million as of June 30, 2019 was primarily due to the sale of ADT Canada, which decreased RMR by approximately $16 million, and customer attrition. The decrease in RMR was partially offset by improvements in average pricing. As of June 30, 2020 and June 30, 2019, gross customer revenue attrition was 13.1% and 13.3%, respectively. The decrease in attrition was due to an improvement in disconnects primarily from relocations.

Installation and Other Revenue

The increase in installation and other revenue was primarily due to higher volume of revenue from equipment sold outright to residential customers as a result of the Defenders Acquisition and the Equipment Ownership Model Change. These increases were partially offset by a decrease in the volume of revenue from equipment sold outright to commercial customers as a result of the COVID-19 Pandemic and due to the sale of ADT Canada.

In connection with our transition back to a predominately Company-owned model for our residential transactions, we do not expect to experience the same level of revenue growth subsequent to June 30, 2020 as reported in our results of operations for the three months ended June 30, 2020.

Cost of Revenue

The increase in cost of revenue was primarily due to an increase in installation costs associated with a higher volume of transactions in which equipment was sold outright to residential customers as a result of the Defenders Acquisition and the Equipment Ownership Model Change. These increases were partially offset by a decrease in installation costs associated with a lower volume of transactions in which equipment was sold outright to commercial customers as a result of the COVID-19 Pandemic and due to the sale of ADT Canada, as well as a decrease in service costs primarily as a result of the sale of ADT Canada.

In connection with our transition back to a predominately Company-owned model for our residential transactions, we do not expect to experience the same level of increase in cost of revenue subsequent to June 30, 2020 as reported in our results of operations for the three months ended June 30, 2020.

Selling, General and Administrative Expenses

The increase in selling, general and administrative expenses was primarily due to $75 million of incremental expenses associated with the Defenders Acquisition, an increase in radio conversion costs of $12 million, an increase of $9 million in bad debt expense (exclusive of incremental bad debt expense from recent acquisitions) due to an increase in the volume of longer duration receivables and the estimated impact of the COVID-19 Pandemic, as well as increases in selling costs, which includes amortization of deferred subscriber acquisition costs. These increases were partially offset by a reduction in expenses of $18 million due to the sale of ADT Canada as well as a decrease in advertising expenses (exclusive of incremental advertising expenses from recent acquisitions).

Depreciation and Intangible Asset Amortization

The decrease in depreciation and intangible asset amortization expense was primarily due to a decrease of $23 million associated with the sale of ADT Canada.

Interest Expense, net

The increase in interest expense, net, was primarily due to (i) $23 million related to the changes in fair value of interest rate swap contracts as a result of cash flow hedges no longer being highly effective in connection with changes in the interest rate environment in response to the ongoing COVID-19 Pandemic, (ii) $13 million related to our variable-rate first lien term loans, net of the impact of our interest rate swaps, and (iii) $10 million primarily related to the timing of the issuance of $600 million of first lien notes during September 2019. These increases were partially offset by a decrease in interest expense of $10 million related to our second lien notes primarily as a result of a reduction in interest rate due to our refinancing during January 2020.

Loss on Extinguishment of Debt

There was no loss on extinguishment of debt during the three months ended June 30, 2020.

During the three months ended June 30, 2019, loss on extinguishment of debt totaled $67 million and included (i) $61 million associated with the call premium and partial write-off of unamortized deferred financing costs in connection with the $1 billion partial redemption of second lien notes in April 2019 and (ii) $6 million associated with the partial write-off of unamortized deferred financing costs and discount in connection with the $500 million repayment of a first lien term loan in April 2019.

Income Tax Benefit

Income tax benefit for the three months ended June 30, 2020 was $28 million, resulting in an effective tax rate for the period of 20.7%. The effective tax rate primarily represents the federal statutory rate of 21.0%, a state statutory tax rate, net of federal benefits, of 2.9%, a 9.7% unfavorable impact from non-deductible charges primarily due to the Defenders Acquisition, partially offset by a 6.7% favorable impact related to a decrease in unrecognized tax benefits.

Income tax benefit for the three months ended June 30, 2019 was $23 million, resulting in an effective tax rate for the period of 18.0%. The effective tax rate primarily represents the federal income tax rate of 21.0% and a 3.4% unfavorable impact associated with legislative changes.

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 state tax rate.

Six Months Ended June 30, 2020 Compared to Six Months Ended June 30, 2019

The following table sets forth our condensed consolidated results of operations, summary cash flow data, and key performance indicators for the periods presented.

(in thousands, except as otherwise indicated)

(1) Refer to the “—Key Performance Indicators” section for the definitions of these key performance indicators.

(2) Adjusted EBITDA and Free Cash Flow are non-GAAP measures. Refer to the “—Non-GAAP Measures” section for the definitions of these terms and reconciliations to the most comparable GAAP measures.

Monitoring and Related Services Revenue

The decrease in monitoring and related services revenue was driven by a decrease in recurring revenue. Recurring revenue decreased primarily from a reduction of revenue due to the sale of ADT Canada and customer attrition. These decreases were partially offset by improvements in average pricing, which was driven by the addition of new customers at higher rates as new customers generally selected higher priced services as compared to our existing customer base, and incremental revenue from recent acquisitions.

The decrease in RMR to $339 million as of June 30, 2020 from $351 million as of June 30, 2019 was primarily due to the sale of ADT Canada, which decreased RMR by approximately $16 million, and customer attrition. The decrease in RMR was partially offset by improvements in average pricing. As of June 30, 2020 and June 30, 2019, gross customer revenue attrition was 13.1% and 13.3%, respectively. The decrease in attrition was due to an improvement in disconnects primarily from relocations.

Installation and Other Revenue

The increase in installation and other revenue was primarily due to higher volume of revenue from equipment sold outright to residential customers as a result of the Defenders Acquisition and the Equipment Ownership Model Change. These increases were partially offset by a decrease in the volume of revenue from equipment sold outright to commercial customers as a result of the COVID-19 Pandemic and due to the sale of ADT Canada.

In connection with our transition back to a predominately Company-owned model for our residential transactions, we do not expect to experience the same level of revenue growth subsequent to June 30, 2020 as reported in our results of operations for the six months ended June 30, 2020.

Cost of Revenue

The increase in cost of revenue was primarily due to an increase in installation costs associated with a higher volume of transactions in which equipment was sold outright to residential customers as a result of the Defenders Acquisition and the Equipment Ownership Model Change. These increases were partially offset by a decrease in installation costs associated with a lower volume of transactions in which equipment was sold outright to commercial customers as a result of the COVID-19 Pandemic and due to the sale of ADT Canada, as well as a decrease in service costs primarily as a result of the sale of ADT Canada.

In connection with our transition back to a predominately Company-owned model for our residential transactions, we do not expect to experience the same level of increase in cost of revenue subsequent to June 30, 2020 as reported in our results of operations for the six months ended June 30, 2020.

Selling, General and Administrative Expenses

The increase in selling, general and administrative expenses was primarily due to $148 million of incremental expenses associated with the Defenders Acquisition, an increase of $38 million in bad debt expense (exclusive of incremental bad debt expense from recent acquisitions) due to the estimated impact of the COVID-19 Pandemic and an increase in the volume of longer duration receivables, an increase in radio conversion costs of $28 million, as well as increases in selling costs, which includes amortization of deferred subscriber acquisition costs. These increases were partially offset by a reduction in expenses of $32 million due to the sale of ADT Canada as well as a decrease in advertising expenses (exclusive of incremental advertising expenses from recent acquisitions).

Depreciation and Intangible Asset Amortization

The decrease in depreciation and intangible asset amortization expense was primarily due to a decrease of $46 million associated with the sale of ADT Canada, partially offset by an increase of $25 million associated with the amortization of customer contracts acquired under the ADT Authorized Dealer Program.

Merger, Restructuring, Integration, and Other

The increase in merger, restructuring, integration, and other was primarily due to a charge of $81 million associated with the settlement of a pre-existing relationship and $7 million due to fair value remeasurements on a strategic investment.

Interest Expense, net

The increase in interest expense, net, was primarily due to (i) $89 million related to the changes in fair value of interest rate swap contracts as a result of cash flow hedges no longer being highly effective in connection with changes in the interest rate environment in response to the ongoing COVID-19 Pandemic, (ii) $39 million related to the timing of the issuance of approximately $2 billion of first lien notes during 2019, and (iii) $11 million related to our variable-rate first lien term loans, net of the impact of our interest rate swaps. These increases were partially offset by a decrease in interest expense of $36 million related to our second lien notes due to the timing of partial redemptions during 2019 as well as a reduction in interest rate due to our refinancing during January 2020.

Loss on Extinguishment of Debt

During the six months ended June 30, 2020, loss on extinguishment of debt totaled $66 million and related to the call premium and write-off of unamortized deferred financing costs in connection with the redemption of second lien notes during February 2020.

During the six months ended June 30, 2019, loss on extinguishment of debt totaled $88 million and included (i) $22 million associated with the call premium and partial write-off of unamortized deferred financing costs in connection with the $300 million partial redemption of second lien notes in February 2019, (ii) $61 million associated with the call premium and partial write-off of unamortized deferred financing costs in connection with the $1 billion partial redemption of second lien notes in April 2019, and (iii) $6 million associated with the partial write-off of unamortized deferred financing costs and discount in connection with the $500 million repayment of a first lien term loan in April 2019.

Income Tax Benefit

Income tax benefit for the six months ended June 30, 2020 was $106 million, resulting in an effective tax rate for the period of 20.6%. The effective tax rate primarily represents the federal statutory rate of 21.0%, a state statutory tax rate, net of federal benefits, of 3.0%, a 2.8% unfavorable impact from non-deductible charges primarily due to the Defenders Acquisition, and a 1.3% unfavorable impact from an increase in valuation allowances primarily due to tax credits not expected to be utilized prior to expiration.

Income tax benefit for the six months ended June 30, 2019 was $45 million, resulting in an effective tax rate for the period of 21.0%. The effective tax rate primarily represents the federal income tax rate of 21.0%, a 1.8% unfavorable impact associated with legislative changes, and offset by a 1.2% favorable impact associated with the resolution of open tax years.

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 state tax rate.

NON-GAAP MEASURES

To provide investors with additional information in connection with our results as determined in accordance with GAAP, we disclose Adjusted EBITDA and Free Cash Flow as non-GAAP measures. These measures are not financial measures calculated in accordance with GAAP and should not be considered as a substitute for net income, operating income, cash flows, or any other measure calculated in accordance with GAAP, and may not be comparable to similarly titled measures reported by other companies.

Adjusted EBITDA

We believe that the presentation of Adjusted EBITDA is appropriate to provide additional information to investors about our operating profitability adjusted for certain non-cash items, non-routine items that we do not expect to continue at the same level in the future, as well as other items that are not core to our operations. Further, we believe Adjusted EBITDA provides a meaningful measure of operating profitability because we use it for evaluating our business performance, making budgeting decisions, and comparing our performance against that of other peer companies using similar measures.

We define Adjusted EBITDA as net income or loss adjusted for (i) interest, (ii) taxes, (iii) depreciation and amortization, including depreciation of subscriber system assets and other fixed assets and amortization of dealer and other intangible assets, (iv) amortization of deferred costs and deferred revenue associated with subscriber acquisitions, (v) share-based compensation expense, (vi) merger, restructuring, integration, and other, (vii) losses on extinguishment of debt, (viii) radio conversion costs, (ix) financing and consent fees, (x) foreign currency gains/losses, (xi) acquisition related adjustments, and (xii) other charges and non-cash items.

There are material limitations to using Adjusted EBITDA. Adjusted EBITDA does not take into account certain significant items, including depreciation and amortization, interest, taxes, and other adjustments which directly affect our net income or loss. These limitations are best addressed by considering the economic effects of the excluded items independently, and by considering Adjusted EBITDA in conjunction with net income or loss as calculated in accordance with GAAP.

Free Cash Flow

We believe that the presentation of Free Cash Flow is appropriate to provide additional information to investors about our ability to repay debt, make other investments, and pay dividends.

We define Free Cash Flow as cash flows from operating activities less cash outlays related to capital expenditures. We define capital expenditures to include accounts purchased through our network of authorized dealers or third parties outside of our authorized dealer network; subscriber system asset expenditures; and purchases of property and equipment. These items are subtracted from cash flows from operating activities because they represent long-term investments that are required for normal business activities.

Free Cash Flow adjusts for cash items that are ultimately within management’s discretion to direct, and therefore, may imply that there is less or more cash that is available than the most comparable GAAP measure. Free Cash Flow is not intended to represent residual cash flow for discretionary expenditures since debt repayment requirements and other non-discretionary expenditures are not deducted. These limitations are best addressed by using Free Cash Flow in combination with the cash flows as calculated in accordance with GAAP.

Adjusted EBITDA

The table below reconciles Adjusted EBITDA to net loss for the periods presented.

(in thousands)

(1) Represents costs, net of any incremental revenue earned, associated with replacing cellular technology used in many of our security systems pursuant to a replacement program.

(2) Represents fees expensed associated with financing transactions.

(3) Represents the conversion of intercompany loans that are denominated in Canadian dollars to U.S. dollars.

(4) Represents amortization of purchase accounting adjustments and compensation arrangements related to acquisitions.

(5) Represents other charges and non-cash items.

Three Months Ended June 30, 2020 Compared to Three Months Ended June 30, 2019

The decrease in Adjusted EBITDA was primarily related to (i) an increase in selling, general and administrative expenses, excluding items outside of our definition of Adjusted EBITDA, largely due to the Defenders Acquisition and (ii) the sale of ADT Canada. The decrease was partially offset by an increase from transactions in which equipment is sold outright to customers, net of the associated costs.

In connection with our transition back to a predominately Company-owned model for our residential transactions, we expect to experience a decrease in the volume of transactions in which equipment is sold outright to residential customers subsequent to June 30, 2020 as reported in our results of operations for the three months ended June 30, 2020.

Refer to the discussions above under “—Results of Operations” for further details.

Six Months Ended June 30, 2020 Compared to Six Months Ended June 30, 2019

The decrease in Adjusted EBITDA was primarily related to (i) an increase in selling, general and administrative expenses, excluding items outside of our definition of Adjusted EBITDA, largely due to the Defenders Acquisition and (ii) the sale of ADT Canada. The decrease was partially offset by an increase from transactions in which equipment is sold outright to customers, net of the associated costs.

In connection with our transition back to a predominately Company-owned model for our residential transactions, we expect to experience a decrease in the volume of transactions in which equipment is sold outright to residential customers subsequent to June 30, 2020 as reported in our results of operations for the six months ended June 30, 2020.

Refer to the discussions above under “—Results of Operations” for further details.

Free Cash Flow

The table below reconciles Free Cash Flow to cash flows from operating activities for the periods presented.

(in thousands)

Cash Flows from Operating Activities

Refer to the discussion below under “—Liquidity and Capital Resources” for further details regarding cash flows from operating activities.

Cash Outlays Related to Capital Expenditures

Dealer generated customer accounts and bulk account purchases, subscriber system asset expenditures, and purchases of property and equipment are included in cash flows from investing activities. Refer to the discussions below under “—Liquidity and Capital Resources” for further details regarding cash flows from investing activities.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity

We expect our ongoing sources of liquidity to include cash generated from operations, borrowings under our revolving credit facility and Receivables Facility, and the issuance of equity and/or debt securities as appropriate given market conditions. Our future cash needs are expected to include cash for operating activities, working capital, capital expenditures, strategic investments, periodic principal and interest payments on our debt, and potential dividend payments to our stockholders. We may, from time to time, seek to repay, redeem, repurchase, or refinance our indebtedness, or seek to retire or purchase our outstanding securities through cash purchases in the open market or through privately negotiated transactions or through a 10b5-1 repurchase plan or otherwise, and any such transactions may involve material amounts. We believe our cash position, borrowing capacity available under our revolving credit facility and Receivables Facility, and cash provided by operating activities are, and will continue to be, adequate to meet our operational and business needs in the next twelve months as well as our long-term liquidity needs.

We are a highly leveraged company with significant debt service requirements. As of June 30, 2020, we had $45 million in cash and cash equivalents and $400 million available under our revolving credit facility. In addition, we had an uncommitted available borrowing capacity of $181 million under our Receivables Facility, which is dependent on the volume of eligible retail installment contract receivables that can be sold under our Receivables Facility. The carrying amount of total debt outstanding was approximately $9.7 billion as of June 30, 2020.

Long-Term Debt

Significant changes in our debt during the six months ended June 30, 2020 were as follows:

First Lien Credit Agreement

As of June 30, 2020, we had an available borrowing capacity of $400 million under our first lien revolving credit facility (the “First Lien Revolving Credit Facility”), with no borrowings outstanding.

Second Lien Notes due 2028

During January 2020, we issued $1.3 billion aggregate principal amount of 6.250% second-priority senior secured notes due 2028 (the “Second Lien Notes due 2028”). The proceeds from the Second Lien Notes due 2028, along with cash on hand and borrowings under the First Lien Revolving Credit Facility, were used to redeem the outstanding $1.2 billion aggregate principal amount of our 9.250% second-priority senior secured notes due 2023 (the “Prime Notes”) and pay any related fees and expenses, including the call premium on the Prime Notes. The deferred financing costs incurred in connection with the issuance of the Second Lien Notes due 2028 were not material.

The Second Lien Notes due 2028 will mature on January 15, 2028 with semi-annual interest payment dates of January 15 and July 15, and may be redeemed at our option as follows:

• Prior to January 15, 2023, in whole at any time or in part from time to time, (a) at a redemption price equal to 100% of the principal amount of the Second Lien Notes due 2028 redeemed, plus a make-whole premium and accrued and unpaid interest as of, but excluding, the redemption date or (b) for up to 40% of the original aggregate principal amount of the Second Lien Notes due 2028 and in an aggregate amount equal to the net cash proceeds of any equity offerings, at a redemption price equal to 106.250%, plus accrued and unpaid interest, so long as at least 50% of the original aggregate principal amount of the Second Lien Notes due 2028 shall remain outstanding after each such redemption.
• On or after January 15, 2023, in whole at any time or in part from time to time, at a redemption price equal to 103.125% of the principal amount of the Second Lien Notes due 2028 redeemed and accrued and unpaid interest as of, but excluding, the redemption date. The redemption price decreases to 101.563% on or after January 15, 2024 and decreases to 100% on or after January 15, 2025.

Additionally, upon the occurrence of specified change of control events, we must offer to repurchase the Second Lien Notes due 2028 at 101% of the principal amount, plus accrued and unpaid interest, if any, to, but not including, the purchase date. The indenture governing the Second Lien Notes due 2028 also provides for customary events of default.

Prime Notes

The indenture underlying the outstanding $1.2 billion aggregate principal amount of the Prime Notes was discharged during January 2020 and the Prime Notes were redeemed during February 2020 for a total redemption price of approximately $1.3 billion, which included the related call premium.

Receivables Facility

During March 2020, we entered into the Receivables Facility. Under the terms of the Receivables Facility, we may receive up to $200 million of financing secured by retail installment contract receivables from transactions involving security systems that were sold under a customer-owned model. During April 2020, we amended the Receivables Facility to also permit financing secured by retail installment contract receivables from transactions occurring under our Company-owned model. The Receivables Facility has a one year revolving period until March 5, 2021, which may be extended, and bears interest at a variable rate. If the revolving period is not extended, we are required to repay the Receivables Facility in a manner consistent with the contractual collections of the underlying retail installment contract receivables. We may make voluntary prepayments on the Receivables Facility at any time prior to maturity at par.

We obtain financing by selling or contributing certain retail installment contract receivables to our wholly-owned consolidated bankruptcy-remote special purpose entity (the “SPE”), which, pursuant to the Receivables Facility, borrows funds secured by the transferred retail installment contract receivables. The SPE is a separate legal entity with its own creditors who will be entitled, prior to and upon the liquidation of the SPE, to be satisfied out of the SPE’s assets prior to any assets in the SPE becoming available to us (other than the SPE). Accordingly, the assets of the SPE are not available to pay our creditors (other than the SPE), although collections from the transferred retail installment contract receivables in excess of amounts required to repay the SPE’s creditors may be remitted to us during and after the term of the Receivables Facility. The SPE’s creditors have legal recourse to the transferred retail installment contract receivables owned by the SPE, but do not have any recourse to us (other than the SPE) for the payment of principal and interest on the SPE’s financing.

We service the transferred retail installment contract receivables and are responsible for ensuring that amounts collected from the transferred retail installment contract receivables are remitted to the SPE. We are required to deposit payments received from the transferred retail installment contract receivables into a segregated account maintained by a third party. On a monthly basis, the segregated account is utilized to make required principal, interest, and other payments due under the Receivables Facility.

During the three and six months ended June 30, 2020, we received proceeds of $20 million under the Receivables Facility and repaid $423 thousand. As of June 30, 2020, we had an outstanding balance of $19 million and an uncommitted available borrowing capacity of $181 million under the Receivables Facility.

Debt Covenants

As of June 30, 2020, we were in compliance with all financial covenant and other maintenance tests for all our debt obligations and we do not believe there is a material risk of future noncompliance with our financial covenant and other maintenance tests as a result of the COVID-19 Pandemic.

Agreement to Issue Class B Common Stock

On July 31, 2020, we entered into a securities purchase agreement (the “Securities Purchase Agreement”) with Google LLC (“Google”) pursuant to which the we have agreed to issue and sell in a private placement to Google 54,744,525 shares of Class B common stock, par value of $0.01 per share, of the Company (“Class B Common Stock”) for an aggregate purchase price of $450 million, subject to adjustment to limit Google’s investment to 9.9% of the issued and outstanding common stock of the Company on an as-converted basis. The shares of Class B Common Stock are being acquired at a per share purchase price of $8.22 (which is equal to the volume weighted average price of shares of our common stock for the fifteen trading days immediately prior to entry into the Securities Purchase Agreement), adjusted for the amount of any cash dividend declared by us after the date of the Securities Purchase Agreement and prior to the date of closing, to the extent that Google is not entitled to receive such dividend. Based on this number of shares, after closing, Google will hold approximately 6.6% of the issued and outstanding common stock of the Company on an as-converted basis. Prior to closing, Google has the unilateral right to purchase, for the same price per share, additional shares of Class B Common Stock such that, immediately following the closing, Google holds 9.9% of the issued and outstanding common stock on an as-converted basis. Google has indicated to us that it does not currently intend to exercise the option. We expect to use the net proceeds from the private placement to further growth initiatives and reduce debt over time.

We have agreed to amend our certificate of incorporation pursuant to the terms of the Securities Purchase Agreement prior to closing, to, among other things, authorize the issuance of shares of Class B Common Stock, which will constitute a new class of common stock of the Company. Each share of Class B Common Stock will have equal status and rights to dividends with a share of common stock. The holders of Class B Common Stock shall have one vote for each share of Class B Common Stock held of record by such holder on all matters on which stockholders are entitled to vote generally; provided, however, that holders of Class B Common Stock, as such, shall not be entitled to vote on the election, appointment or removal of directors of the Company. Additionally, each share of Class B Common Stock will immediately become convertible into one share of common stock, at the option of the holder thereof, at any time following the earlier of (i) the expiration or early termination of applicable waiting periods under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (“HSR Clearance”), required prior to such holder’s conversion of all such shares of Class B Common Stock, and (ii) to the extent HSR Clearance is not required prior to such holder’s conversion of such shares of Class B Common Stock, the date that such holder owns such shares of Class B Common Stock.

The Securities Purchase Agreement further specifies that, upon closing, we will enter into an Investor Rights Agreement with Google (the “Investor Rights Agreement”), pursuant to which Google will agree to be bound by customary transfer restrictions and drag-along rights, and be afforded customary registration rights with respect to shares of Class B Common Stock held directly by Google. Under the terms of the Investor Rights Agreement, Google will be prohibited, subject to certain exceptions, from transferring any shares of Class B Common Stock or any shares of common stock issuable upon conversion of the Class B Common Stock beneficially owned by Google until the earlier of (i) the three-year anniversary of closing, (ii) the date on which the Commercial Agreement (as defined below) has been terminated under certain specified circumstances and (iii) June 30, 2022 if the Company breaches certain of its obligations under the Commercial Agreement (as defined below).

Commercial Agreement

Concurrently with the execution of the Securities Purchase Agreement, ADT LLC, an indirect wholly owned subsidiary of the Company (“ADT LLC”), and Google entered into a Master Supply, Distribution, and Marketing Agreement (the “Commercial Agreement”), pursuant to which Google has agreed to supply ADT LLC with certain Google devices as well as certain Google video and analytics services (“Google Services”), for sale to ADT LLC’s customers. Subject to customary termination rights related to breach and change of control, the Commercial Agreement has an initial term of seven years from the date that the Google Service is successfully integrated into ADT LLC’s end-user security and automation platform, which is targeted for no later than June 30, 2022. If the integrated service is not launched by June 30, 2022 then ADT LLC will be required to offer Google Services without integration for professional installations except for existing customers who already have ADT Pulse or ADT Control interactive services until such integration has been made. Further, subject to certain carveouts, ADT LLC has agreed to exclusively sell certain devices and services of the Investor for end-user smart home, security or safety devices.

The Commercial Agreement also contains customary termination rights for both parties. In addition, Google has rights to terminate the Commercial Agreement if (i) ADT LLC divests any part of its direct to consumer business and the acquiring entity does not agree to assume all obligations under the Commercial Agreement, or (ii) ADT LLC breaches certain provisions of the Commercial Agreement and does not cure such breaches. In the event of a breach by ADT LLC of the Commercial Agreement in a manner reasonably likely to result in a material adverse effect on Google’s business or brand, or a breach by ADT LLC of certain data security and privacy obligations under the Commercial Agreement, ADT LLC must suspend the sale of Google Services and certain devices during the applicable cure period. Upon termination of the Commercial Agreement, ADT LLC will no longer have rights to sell the Google Service or devices to new customers, subject to an applicable transition period. In addition, the Google Services may not be accessible by ADT LLC customers through ADT’s integrated end-user application during any cure period for breach by ADT LLC of certain data security and privacy provisions of the Commercial Agreement or upon termination of the agreement for a breach of such provisions.

The Commercial Agreement specifies that each party will contribute $150 million towards the joint marketing of devices and services, customer acquisition, training of ADT LLC’s employees for the sales, installation, customer service, and maintenance for the product and service offerings, and technology updates for products included in such offerings. Each party will contribute such funds in three equal tranches, subject to the attainment of certain milestones.

Dividends

During the six months ended June 30, 2020, we declared the following dividends on common stock:

During the three months ended June 30, 2020, we declared dividends of $27 million (or $0.035 per share). The amount of dividends settled in shares of common stock during that period was not material.

During the six months ended June 30, 2020, we declared dividends of $54 million (or $0.07 per share). The amount of dividends settled in shares of common stock during that period was not material.

On August 5, 2020, we announced a dividend of $0.035 per share to common stockholders of record on September 18, 2020, which will be distributed on October 2, 2020.

Share Repurchase Program

On February 27, 2019, we approved a share repurchase program (the “Share Repurchase Program”), which permits us to repurchase up to $150 million of our shares of common stock through February 27, 2021. We announced the Share Repurchase Program on March 11, 2019. On March 23, 2020, we approved an increase of $75 million, inclusive of the amount then remaining under the Share Repurchase Program, in the authorized repurchase amount and an extension of the Share Repurchase Program through March 23, 2021.

We may effect these repurchases pursuant to one or more trading plans to be adopted in accordance with Rule 10b5-1 (each, a “10b5-1 plan”) under the Securities Exchange Act of 1934 (the “Exchange Act”), in privately negotiated transactions, in open market transactions, or pursuant to an accelerated share repurchase program. We intend to conduct the Share Repurchase Program in accordance with Rule 10b-18 under the Exchange Act. We are not obligated to repurchase any of our shares of common stock and the timing and amount of any repurchases will depend on legal requirements, market conditions, stock price, alternative uses of capital, and other factors.

During the three and six months ended June 30, 2020, there were no material repurchases of shares of our common stock under the Share Repurchase Program. As of June 30, 2020, we had approximately $75 million remaining in the Share Repurchase Program.

Cash Flow Analysis

The following table is a summary of our cash flow activity for the periods presented:

(in thousands)

Cash Flows from Operating Activities

The decrease in cash flows provided by operating activities was primarily due to (i) $81 million related to the settlement of a pre-existing relationship in connection with the Defenders Acquisition, (ii) an increase in selling, general and administrative expenses largely due to the Defenders Acquisition, (iii) an increase in the volume of transactions in which equipment was sold outright to residential customers, and (iv) the sale of ADT Canada. The decrease was partially offset by a decrease in interest payments of $34 million due to changes to the timing and amount of interest payments as a result of our recent financing transactions. The remainder of the activity in cash flows provided by operating activities related to changes in assets and liabilities due to the volume and timing of other operating cash receipts and payments with respect to when the transactions are reflected in earnings.

In connection with our transition back to a predominately Company-owned model for our residential transactions, we expect to experience a decrease in the volume of transactions in which equipment is sold outright to residential customers subsequent to June 30, 2020 as reported in our results of operations for the six months ended June 30, 2020.

Refer to the discussions above under “—Results of Operations” for further details.

Cash Flows from Investing Activities

The decrease in cash flows used in investing activities was primarily due to (i) a decrease in the volume of dealer and bulk account purchases and an advance payment received for dealer charge-backs in connection with the Defenders Acquisition, and (ii) a decrease in the volume of subscriber capital expenditures as a result of the Equipment Ownership Model Change and the sale of ADT Canada. These decreases were partially offset by an increase in cash used for business acquisitions, net of cash acquired, of $103 million primarily due to the Defenders Acquisition.

In connection with our transition back to a predominately Company-owned model for our residential transactions, we expect to experience an increase in the volume of subscriber capital expenditures subsequent to June 30, 2020 as compared to the volume of subscriber capital expenditures for the six months ended June 30, 2020.

Cash Flows from Financing Activities

During the six months ended June 30, 2020, net cash used in financing activities primarily consisted of (i) $53 million related to dividend payments on common stock, (ii) $34 million related to the net repayments of long-term borrowings, and (iii) $16 million related to the payment of deferred financing fees, partially offset by $19 million of net proceeds under the Receivables Facility.

During the six months ended June 30, 2019, net cash used in financing activities primarily consisted of (i) $293 million related to the net repayments of long-term borrowings, (ii) $150 million related to repurchases of common stock, (iii) $44 million related to the payment of deferred financing fees, and (iv) $30 million related to dividend payments on common stock.

COMMITMENTS AND CONTRACTUAL OBLIGATIONS

In our 2019 Annual Report, we disclosed our commitments and contractual obligations. There have been no material changes to these commitments and contractual obligations except for the changes to our long-term debt during the six months ended June 30, 2020, as described above. Refer to the discussion above under “—Liquidity and Capital Resources” for further details regarding significant changes to our long-term debt.

OFF-BALANCE SHEET ARRANGEMENTS

There have been no material changes to our off-balance sheet arrangements as disclosed in our 2019 Annual Report during the six months ended June 30, 2020.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The accompanying condensed consolidated financial statements are prepared in accordance with GAAP, which requires us to select accounting policies and make estimates that affect amounts reported in the condensed consolidated financial statements and the accompanying notes. Management’s estimates are based on the relevant information available at the end of each period. Actual results could differ materially from these estimates under different assumptions or market conditions. In our 2019 Annual Report, we identified our accounting policies that are based on, among other things, estimates and judgments made by management that include inherent risks and uncertainties.

Refer to Note 1 “Description of Business and Summary of Significant Accounting Policies” to the condensed consolidated financial statements for further information about recent accounting adoptions and pronouncements.

CAUTIONARY STATEMENTS REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report contains certain information that may constitute “forward-looking statements” within the meaning of the U.S. Private Securities Litigation Reform Act of 1995. While we have specifically identified certain information as being forward-looking in the context of its presentation, we caution you that all statements contained in this report that are not clearly historical in nature, including statements regarding anticipated financial performance, management’s plans and objectives for future operations, business prospects, market conditions, and other matters are forward-looking. Forward-looking statements are contained principally in the sections of this report entitled “Risk Factors,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Without limiting the generality of the preceding sentence, any time we use the words “expects,” “intends,” “will,” “anticipates,” “believes,” “confident,” “continue,” “propose,” “seeks,” “could,” “may,” “should,” “estimates,” “forecasts,” “might,” “goals,” “objectives,” “targets,” “planned,” “projects,” and similar expressions, we intend to clearly express that the information deals with possible future events and is forward-looking in nature. However, the absence of these words or similar expressions does not mean that a statement is not forward-looking.

Forward-looking information involves risks, uncertainties, and other factors that could cause actual results to differ materially from those expressed or implied in, or reasonably inferred from, such statements, including without limitation, the effects of the COVID-19 Pandemic on our results of operations and business, and the risks and uncertainties disclosed or referenced in Part II Item 1A. of this report under the heading “Risk Factors.” Therefore, caution should be taken not to place undue reliance on any such forward-looking statements. Much of the information in this report that looks toward future performance of the Company is based on various factors and important assumptions about future events that may or may not actually occur. As a result, our operations and financial results in the future could differ materially and substantially from those we have discussed in the forward-looking statements included in the Quarterly Report. We assume no obligation (and specifically disclaim any such obligation) to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise, except as required by law.

Our operations expose us to a variety of market risks, including the effects of changes in interest rates. We monitor and manage these financial exposures as an integral part of our overall risk management program. Our policies allow for the use of specified financial instruments for hedging purposes only. Use of derivatives for speculation purposes is prohibited.

Interest Rate Risk

We have both fixed-rate and variable-rate debt, and, as a result, we are exposed to fluctuations in interest rates on our debt. We have interest rate swap contracts to hedge our interest rate exposure on our variable-rate debt. However, certain of our variable-rate debt instruments are subject to a one-percent floor on interest payments while our interest rate swap contracts do not include a floor. If the one month LIBOR interest rate increases above one percent, the increase in our debt service obligations on most of our variable-rate indebtedness will be neutralized as we have entered into interest rate swaps that hedge any increase in the one month LIBOR rate above one percent. If one month LIBOR rates are below one percent, even though the amount borrowed remains the same, our net income and cash flows, including cash available for servicing our indebtedness, will decrease by the difference between one percent and the one month LIBOR rate because certain of our variable-rate debt has an interest floor of one percent while the corresponding interest rate swaps do not have a LIBOR floor.

As a result of changes in the interest rate environment in response to macroeconomic decline due to the ongoing COVID-19 Pandemic, our interest rate swap contracts designated as cash flow hedges with an aggregate notional amount of $3 billion were no longer highly effective beginning in March 2020. Accordingly, we de-designated the cash flow hedges and the changes in fair value for the period in which these cash flow hedges were no longer highly effective were recognized in interest expense. Amounts recognized as a component of AOCI prior to de-designation will be reclassified into interest expense in the same period in which the related interest on variable-rate debt affects earnings through the maturity dates of the interest rate swap contracts as the forecasted cash flows are probable of occurring.

The changes in fair value of interest rate swap contracts recognized in interest expense in the Condensed Consolidated Statements of Operations were losses of $28 million and $5 million during the three months ended June 30, 2020 and 2019, respectively, and losses of $98 million and $9 million during the six months ended June 30, 2020 and 2019, respectively.

As of June 30, 2020, the carrying amount of our debt, excluding finance leases, was $9.7 billion with a fair value of $9.8 billion. In addition, we had interest rate swap contracts with aggregate notional amounts of $3.2 billion with a fair value of $313 million as a net liability. As of June 30, 2020, a hypothetical 10% change in interest rates would change the fair value of our debt by approximately $230 million based on the implied yield from broker-quoted market prices on our debt, while a similar change in interest rates would change the fair value of our interest rate swap contracts by approximately $3 million based on a discounted cash flow analysis. Additionally, any 0.125% decrease in LIBOR rates below 1.0% would result in an increase of approximately $4 million in annualized interest expense on our variable-rate debt, including the impact of our interest rate swaps.

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this Quarterly Report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that as of June 30, 2020, our disclosure controls and procedures were effective in recording, processing, summarizing, and reporting, within the time periods specified in the SEC’s rules and forms, information required to be disclosed in the reports that we file or submit under the Exchange Act, and that such information was accumulated and communicated to the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting identified in our management’s evaluation pursuant to Rules 13a-15(d) and 15d-15(d) of the Exchange Act during the three months ended June 30, 2020 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Our significant business risks are described in Part I, Item 1A. in our 2019 Annual Report, as filed with the SEC on March 10, 2020 and in our Quarterly Reports on Form 10-Q and our Current Reports on Form 8-K filed with the SEC since such date. You should be aware that these risk factors and other information may not describe every risk facing the Company. In addition to the risks disclosed in such filings, following are additional updates to our risk factor disclosures with respect to our business.

The COVID-19 Pandemic could have a significant negative impact on our employees, our customers, our suppliers and our ability to carry on our normal operations given its impact on the economy generally, as well as the resulting “shelter in place” and other operational requirements we have or must continue to adhere to, or which could be reinstituted upon a re-emergence of COVID-19 in a particular jurisdiction, any of which could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

We continue to monitor the impact of the novel coronavirus (COVID-19) pandemic and the reactions resulting therefrom (the “COVID-19 Pandemic”) on all aspects of our business. This includes the health of our employees, the protection of our customers, and our ability to continue to operate all aspects of our operations. Our employees are susceptible to COVID-19 in the ordinary course of their work. While we seek to protect our employees’ health through various initiatives, we cannot be certain that our employees will not contract COVID-19, be required to quarantine as a result of coming in contact with others who have the disease, or be unable to work in order to care for someone with the disease. Any such instances, whether on a large scale basis or concentrated in any one area of the business could have a material adverse effect on our business, financial condition, results of operations, and cash flows. The health and safety of our customers is also a top priority and we similarly take precautions to protect their health and well-being. The refusal of customers to allow us to enter their residences or businesses due to the fear of COVID-19 could have a material impact on our business, and the spreading of the disease between our customers and our employees could interrupt our operations, result in legal claims and damage our brand. Any such result could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

We rely on monitoring centers and customer care centers as an integral part of our ongoing business operations. While we have taken steps to enable the majority of the employees who staff these operations to conduct their jobs from home, the closure of any such site or the widespread illness of the employees remaining in any such site could result in a material disruption to our business. Similarly, our new work from home environment could subject us to the failure of the communications networks serving our employees which we no longer control and who may not have sufficient back up capabilities. In addition, this new work from home environment results in more home access points that are susceptible to cybersecurity attacks, such as computer hacking, computer viruses, worms or other malicious software or malicious activities. In addition, our monitoring centers are listed by Underwriters Laboratories (“U.L.”) and must meet certain requirements to maintain that listing. Permitting some of our monitoring center employees to work from home during the duration of the COVID-19 Pandemic or for any period of time thereafter may impact our UL listing and our ability to provide our services in situations where a UL listing is required. Our employees who work from home may also experience a decrease in the quality of job performance, whether immediate or over time. Any such impact with respect to our employees who are working from home could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

Any continued widespread growth in infections could also result in additional, or the re-institution of prior, travel restrictions or “shelter-in-place” mandates that further impact the ability of our employees to reach our operations, be available to install new or repair existing systems within residential homes or commercial operations, or to enter such homes or commercial operations. Such inability to access residences, or any unwillingness of customers to allow us to enter their sites, to proactively continue our program to replace the 3G and CDMA cellular equipment used in many of our security systems could also negatively impact the pace of our 3G and CDMA radio replacement program, which could impair our ability to convert all of those radios across our system by the applicable technology sunset dates. In addition, the continuation of infections has resulted, and could continue to result, in a change in policy of emergency responders in certain jurisdictions who have declined, and may continue temporarily or permanently to decline, to respond to certain verified or non-verified burglar alarm calls from our monitoring centers or from our employees who are working from home, and bans on businesses may continue, or be re-instituted, or expand in certain jurisdictions with only limited exceptions. Such bans, which could impact us directly should we fail to fall within a permissible exception, and which could also result in future sustained business closures among our customer and potential customer bases, would magnify the negative impact already experienced across our operations and, most significantly, within our commercial operations. Any of the foregoing impacts on our employees, first responders, customers, operations, or business generally, could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

Our dealers and suppliers may be similarly impacted by the COVID-19 Pandemic. Our indirect channel customers are generated mainly through our network of agreements with third-party independent alarm dealers who sell alarm equipment and ADT Authorized Dealer-branded monitoring and interactive services to end users. These dealers face many of the same challenges we face due to the COVID-19 Pandemic and the impact on their respective employees, customers and operations generally. These dealers may not have sufficient financial strength or operational diversity to enable them to maintain their operations throughout the COVID-19 Pandemic. We may also find that it is difficult or impossible to receive equipment from our suppliers or that we have an impaired ability to deliver products and services to customers, or to even make repairs, on a timely basis. If we experience such disruptions, we may experience customer dissatisfaction and potential loss of confidence, and liabilities to customers or other third parties, each of which could harm our reputation and impact future revenues from these customers. We could also be subject to claims or litigation with respect to losses caused by such disruptions. Our property and business interruption insurance and our cyber liability insurance may not be sufficient to fully cover these losses, or any of the other losses we may experience as a result of the COVID-19 Pandemic, many of which we may not even be able to contemplate or quantify at this time, and such insurance may not cover a particular event at all. Any of these outcomes could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

The COVID-19 Pandemic has also caused significant disruption to and volatility within the financial markets. A long-term refusal of residential or commercial customers to allow us to access their premises, significant cancellations or non-payment of accounts, or an inability to obtain new customers, could impact our liquidity. We may not be able to timely access the financial markets or be able to do so on terms that are favorable to us, which could have a material adverse effect on our business, financial condition, results of operations, and cash flows.

We are also concerned with the impacts that have and could continue to result as cases of COVID-19 re-emerge in jurisdictions which have and will continue to reopen for business and / or no longer require social distancing. Some experts have predicted that the pre-mature re-opening of a jurisdiction could result in even more devastating consequences than existed at the time of the original closure. Even if current containment efforts lead to dramatic reductions in COVID-19 cases, we are also concerned with the uncertainty around subsequent re-emergence of COVID-19 in the Fall of 2020. Some experts have predicted that COVID-19 will re-emerge at that time and cause additional significant disruptions in the economy continuing into 2021. If any of these predictions prove accurate, we may experience a material adverse effect on our business, financial condition, results of operations, and cash flows.

The COVID-19 Pandemic may also exacerbate the risks disclosed in our Annual Report, including, but not limited to: our ability to comply with the terms of our indebtedness, our ability to generate revenues, earn profits and maintain adequate liquidity, our ability to service existing and attract new customers, maintain our overall competitiveness in the market, the potential for significant fluctuations in demand for our services, overall industry trends impacting our business, as well as potential volatility in our stock price.

If we fail to comply with constantly evolving laws, regulations, and industry standards addressing information and technology networks, privacy, and data security, we could face substantial penalties, liability, and reputational harm, and our business, operations, and financial condition could be materially adversely affected.

Along with our own confidential data and information in the normal course of our business, we or our partners collect and retain significant volumes of third party data, some of which is subject to certain laws and regulations. Our ability to analyze this data to present the subscriber with an improved user experience is a valuable component of our services, but we cannot ensure you that the data we require will be available from these sources in the future or that the cost of such data will not increase. If the data that we require is not available to us on commercially reasonable terms or at all, we may not be able to provide certain parts of our current or planned products and services, and our business, financial condition, results of operations and cash flows could be materially adversely affected.

In addition, we may also collect and retain other sensitive types of data, including audio recordings of telephone calls and video images of customer sites. We must comply with applicable federal and state laws and regulations governing the collection, retention, processing, storage, disclosure, access, use, security, and privacy of such information in addition to our own posted information security and privacy policies and applicable industry standards. The legal, regulatory, and contractual environment surrounding the foregoing continues to evolve, and there has been an increasing amount of focus on privacy and data security issues with the potential to affect our business. These privacy and data security laws, regulations, and standards, as well as contractual requirements, could increase our cost of doing business, and failure to comply with these laws, regulations, standards, and contractual requirements could result in government enforcement actions (which could include civil or criminal penalties), private litigation, and/or adverse publicity. In the event of a breach of personal information that we hold or that is held by third parties on our behalf, we may be subject to governmental fines, individual and class action claims, remediation expenses, and/or harm to our reputation. In April 2020, after investigating a customer inquiry, we disclosed that a Company technician had, during service visits, added his personal email address to 220 of our customers’ accounts, which provided this employee with varying levels of unauthorized personal access to such customers’ in-home security systems, including, in some cases, video streams, over a period of several years. We immediately terminated this employee. While we have notified all such customers of this activity, and have reached resolution with several of these customers, we cannot be certain that others impacted will not continue to make legal claims against us, either individually or as a class. Although we would vigorously defend any claim that we feel is unsupported by the facts or which seeks an unreasonable amount of damages, we could incur significant legal costs in defending such claims or in the ultimate resolution of such claims, and we may suffer reputational harm and damage to our brand as a result of such claims or any related publicity. Further, if we fail to comply with applicable privacy and security laws, regulations, policies, and standards; properly protect the integrity and security of our facilities and systems and the data located within them; or defend against cybersecurity attacks; or if our third-party service providers, partners, or vendors fail to do any of the foregoing with respect to data and information assessed, used, stored, or collected on our behalf; or if we fail to successfully defend against any matters that may arise as a result of the rogue conduct of the technician as described above or should we fail to prevent future rogue actors from undertaking similar actions, our business, reputation, financial condition, results of operations, and cash flows could be materially adversely affected.

For example, the data that we collect and retain includes personally identifiable information related to our customers and employees and may be protected health information subject to certain requirements under the Health Insurance Portability Accountability Act (“HIPAA”) and its implementing regulations, which regulate the use, storage, and disclosure of personally identifiable health information. We may change our processes or modify our product and service offerings in a manner that requires us to adopt additional or different policies and procedures to meet our obligations under HIPAA. Becoming fully HIPAA-compliant involves adopting and implementing privacy and security policies and procedures as well as administrative, physical, and technical safeguards. Additionally, HIPAA compliance requires certain agreements with contracting partners to be in place. Endeavoring to become fully HIPAA-compliant may be costly both financially and in terms of administrative resources. It may take substantial time and require the assistance of external resources, such as attorneys, information technology, and/or other consultants. We would have to be HIPAA-compliant to provide services pursuant to which we are required to collect or manage patient information for or on behalf of a health care provider or health plan. Thus, if we do not become fully HIPAA-compliant, our expansion opportunities may be limited. Furthermore, it is possible that HIPAA may be expanded in the future to apply to certain of our current products or services.

The California Consumer Privacy Act (“CCPA”), which became effective in 2020, gives California residents certain rights in relation to their personal information, requires that companies take certain actions, and applies to activities regarding personal information that is collected by us, directly or indirectly, from California residents. The CCPA creates and may continue to create, as its interpretation and enforcement evolves, a range of new compliance obligations, which could cause us to change our business practices, with the possibility for significant financial penalties for noncompliance that may materially adversely affect our business, reputation, financial condition, results of operations, and cash flows.

The General Data Protection Regulation (“GDPR”) applies to activities regarding personal data that are conducted by us, directly or indirectly through vendors and subcontractors, from an establishment in the European Union. As interpretation and enforcement of the GDPR evolves, it will create a range of new compliance obligations, which could cause us to change our business practices, with the possibility for significant financial penalties for noncompliance. The European Commission in July 2016 and the Swiss Government in January 2017 approved the EU-U.S. and the Swiss-U.S. Privacy Shield frameworks, respectively, which are designed to allow U.S. companies that self-certify to the U.S. Department of Commerce and publicly commit to comply with the Privacy Shield requirements to freely import personal data from the EU and Switzerland. However, these frameworks face a number of legal challenges and their validity remains subject to legal, regulatory, and political developments in both Europe and the U.S. This has resulted in some uncertainty, and compliance obligations could cause us to incur costs or require us to change our business practices in a manner adverse to our business and failure to comply could result in significant penalties that may materially adversely affect our business, reputation, financial condition, results of operations, and cash flows.