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  **UNITED STATES SECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549****FORM 10-Q**   þ **Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934****For the quarterly period ended June 30, 2006****or**   o **Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934******For the transition period from                      to**                    ****Commission File Number 0-22334****LodgeNet Entertainment Corporation**(Exact name of registrant as specified in its charter)   **Delaware** **46-0371161**   (State or other jurisdiction of (I.R.S. Employerincorporation or organization) Identification Number)   **3900 West Innovation Street, Sioux Falls, South Dakota** **57107** (Address of Principal Executive Offices) (ZIP code)**(605) 988-1000** (Registrant’s telephone number,including area code)(Former name, former address and former fiscal year, if changed since last report Indicate by check mark whether the Registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the Registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes þ No o.Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer ora non-accelerated filer (as defined in Exchange Act Rule 12b-2).Large accelerated filer o      Accelerated filer þ      Non-accelerated filer oIndicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o No þ.At August 3, 2006, there were 18,517,043 shares outstanding of the Registrant’s common stock, $0.01par value.  

 
**LodgeNet Entertainment Corporation and Subsidiary****Index**       Page  No.**Part I. Financial Information**         Item 1 — Financial Statements:    Consolidated Balance Sheets (Unaudited) as of June 30, 2006 and December 31, 2005   3 Consolidated Statements of Operations (Unaudited) forthe Three Months and Six Months Ended June 30, 2006 and 2005   4 Consolidated Statements of Cash Flows (Unaudited) forthe Six Months Ended June 30, 2006 and 2005   5 Notes to Consolidated Financial Statements (Unaudited)  6 Item 2 — Management’s Discussion and Analysis of Financial Conditionand Results of Operations  16 Item 3 — Quantitative and Qualitative Disclosures About Market Risk  36 Item 4 — Controls and Procedures   36      **Part II. Other Information**         Item 1 — Legal Proceedings  37 Item 1A — Risk Factors  37 Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds   37 Item 3 — Defaults Upon Senior Securities  37 Item 4 — Submission of Matters to a Vote of Security Holders  37 Item 5 — Other Information  38 Item 6 — Exhibits   38      **Signatures**  39  Rule 13a-14(a)/15(d)-14(a) Certification of CFO Rule 13a-14(a)/15(d)-14(a) Certification of CEO Section 1350 Certifications As used herein (unless the context otherwise requires) “LodgeNet” and/or the “Registrant,” as wellas the terms “we,” “us” and “our” refer to LodgeNet Entertainment Corporation and its consolidatedsubsidiary. “LodgeNet ”, the LodgeNet logo, “SigNETure TV”, “SigNETure PC”, “SigNETure HDTV, and “HotelSportsNET” are service marks or registered trademarks of LodgeNet Entertainment Corporation; allother trademarks or service marks used herein are the property of their respective owners.     Page 2
 

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**Part I — Financial Information****Item 1 — Financial Statements****LodgeNet Entertainment Corporation and Subsidiary****Consolidated Balance Sheets (Unaudited)**(Dollar amounts in thousands, except share data)           June 30,  December 31,   2006  2005 Assets        Current assets:        Cash and cash equivalents $23,266  $20,742 Accounts receivable, net  29,770   29,617 Prepaid expenses and other  4,707   2,629        Total current assets  57,743   52,988          Property and equipment, net  193,511   199,882 Debt issuance costs, net  6,537   7,423 Intangible assets, net  1,280   2,007 Other assets  2,815   772        Total assets $261,886  $263,072                 Liabilities and Stockholders’ Deficiency        Current liabilities:        Accounts payable $18,383  $16,036 Current maturities of long-term debt  2,599   2,749 Accrued expenses  15,489   15,322 Deferred revenue  6,656   5,143        Total current liabilities  43,127   39,250          Long-term debt  278,340   289,251 Other long-term liabilities  4,872   2,541 Derivative instruments  1,966   2,263        Total liabilities  328,305   333,305                 Commitments and contingencies                 Stockholders’ deficiency:        Preferred stock, $.01 par value, 5,000,000 shares authorized;no shares issued or outstanding        Common stock, $.01 par value, 50,000,000 shares authorized;18,474,206 and 18,165,643 shares outstanding at June 30,2006 and December 31, 2005, respectively  185   182 Additional paid-in capital  235,777   232,327 Accumulated deficit  (304,528)  (304,307)Accumulated other comprehensive income  2,147   1,565        Total stockholders’ deficiency  (66,419)  (70,233)       Total liabilities and stockholders’ deficiency $261,886  $263,072        The accompanying notes are an integral part of these consolidated financial statements.
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**LodgeNet Entertainment Corporation and Subsidiary****Consolidated Statements of Operations (Unaudited)**(Dollar amounts in thousands, except share data)                   Three Months Ended June 30,  Six Months Ended June 30,   2006  2005  2006  2005 Revenues:                Guest Pay $69,149  $66,282  $137,357  $130,434 Other  2,722   1,833   4,707   3,670              Total revenues  71,871   68,115   142,064   134,104                               Costs and Expenses:                Direct costs (exclusive of operating expenses anddepreciation and amortization shown separatelybelow):                Guest Pay  31,010   28,352   61,696   56,696 Other  1,270   731   2,179   1,647 Operating expenses:                Guest Pay operations  9,064   8,827   17,850   17,449 Selling, general and administrative  7,128   6,239   14,020   12,311 Depreciation and amortization  16,868   17,888   33,783   35,880 Other operating income, net  (198)  —   (198)  —              Total costs and operating expenses  65,142   62,037   129,330   123,983                               Income from operations  6,729   6,078   12,734   10,121                  Other Income and Expenses:                Interest expense  (6,548)  (7,425)  (13,081)  (14,879)Write-off of debt issuance costs  —   (143)  (129)  (143)Other income (expense)  434   (51)  560   (126)                              Income (loss) before income taxes  615   (1,541)  84   (5,027)Provision for income taxes  (182)  (114)  (305)  (232)                              Net income (loss) $433  $(1,655) $(221) $(5,259)                              Net income (loss) per common share (basic) $0.02  $(0.09) $(0.01) $(0.30)                              Net income (loss) per common share (diluted) $0.02  $(0.09) $(0.01) $(0.30)                              Weighted average shares outstanding (basic)  18,245,841   17,937,777   18,186,064   17,809,537                               Weighted average shares outstanding (diluted)  18,579,380   17,937,777   18,186,064   17,809,537              The accompanying notes are an integral part of these consolidated financial statements.
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**LodgeNet Entertainment Corporation and Subsidiary****Consolidated Statements of Cash Flows (Unaudited)**(Dollar amounts in thousands)           Six Months Ended June 30,   2006  2005 Operating activities:        Net loss $(221) $(5,259)Adjustments to reconcile net loss to net cash providedby operating activities:        Depreciation and amortization  33,783   35,880 Investment (gains) losses  (238)  — Write-off of debt issuance costs  129   143 Share-based compensation  927   115 Gain due to insurance proceeds  (200)  — Insurance proceeds related to business interruption  200   — Change in operating assets and liabilities:        Accounts receivable  (84)  (1,020)Prepaid expenses and other  (1,524)  (384)Accounts payable  2,325   2,484 Accrued expenses and deferred revenue  3,791   1,016 Other  (2,597)  265        Net cash provided by operating activities  36,291   33,240                 Investing activities:        Property and equipment additions  (25,157)  (28,104)Note receivable repayment  238   —        Net cash used for investing activities  (24,919)  (28,104)                Financing activities:        Repayment of long-term debt  (10,750)  (9,750)Proceeds from lease transaction  —   1,022 Payment of capital lease obligations  (716)  (686)Exercise of stock options  2,526   3,052        Net cash used for financing activities  (8,940)  (6,362)                Effect of exchange rates on cash  92   (25)       Increase (decrease) in cash and cash equivalents  2,524   (1,251)Cash and cash equivalents at beginning of period  20,742   24,995                 Cash and cash equivalents at end of period $23,266  $23,744        The accompanying notes are an integral part of these consolidated financial statements.
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**LodgeNet Entertainment Corporation and Subsidiary****Notes to Consolidated Financial Statements (Unaudited)**Note 1 — Basis of PresentationThe accompanying consolidated financial statements as of June 30, 2006, and for the three and sixmonth periods ended June 30, 2006 and 2005, have been prepared by us, without audit, pursuant tothe rules and regulations of the Securities and Exchange Commission (the “Commission”). Theinformation furnished in the accompanying consolidated financial statements reflects alladjustments, consisting of normal recurring adjustments, which, in our opinion, are necessary for afair statement of such financial statements.Certain information and footnote disclosures, normally included in annual financial statementsprepared in accordance with generally accepted accounting principles, have been condensed oromitted pursuant to the rules and regulations of the Commission. Although we believe that thedisclosures are adequate to make the information presented herein not misleading, it is recommendedthat these unaudited consolidated financial statements be read in conjunction with the moredetailed information contained in our Annual Report on Form 10-K for 2005, as filed with theCommission. The results of operations for the three and six month periods ended June 30, 2006 and2005 are not necessarily indicative of the results of operations for the full year due to inherentseasonality within the business, among other factors.The consolidated financial statements include the accounts of LodgeNet Entertainment Corporationand its wholly-owned subsidiary. All significant inter-company accounts and transactions have beeneliminated in consolidation. We manage our operations as one reportable segment.Note 2 — Share-Based CompensationThe LodgeNet Entertainment Corporation 2003 Stock Option and Incentive Plan (the “2003 Plan”)provides for the award of incentive stock options, non-qualified stock options, restricted stock(non-vested shares), stock appreciation rights and phantom stock units. The stockholders approvedand adopted this plan at the 2003 Annual Meeting and approved an amendment to the plan at theAnnual Meeting in May of 2006. As of June 30, 2006, there were 1,500,000 shares authorized underthis plan and 722,238 shares available for grant. In addition to the stock option and non-vestedshare awards currently outstanding under the 2003 Plan, we have stock options outstanding underpreviously approved plans, which are inactive.Certain officers, directors and key employees have been awarded non-vested shares (restrictedstock) and options to purchase common stock of LodgeNet under the 2003 Plan and other prior plans.Stock options issued under the plans have an exercise price equal to the fair market value, asdefined by the terms of the plan, on the date of grant. The options become exercisable inaccordance with vesting schedules determined by the Compensation Committee of the Board ofDirectors, and expire ten years after the date of grant. Restrictions applicable to non-vestedshares (restricted stock) lapse based either on performance or service standards as determined bythe Compensation Committee of the Board of Directors. We currently do not have a stock repurchaseprogram, which would allow us to issue awards from treasury shares, therefore stock optionexercises and non-vested share awards are new issues of common stock.Prior to January 1, 2006, we accounted for our stock option and incentive plans under therecognition and measurement provisions of APB Opinion No. 25, *Accounting for Stock Issued toEmployees*, and related Interpretations, as permitted by FASB Statement No. 123, *Accounting forStock-Based Compensation*. Accordingly, compensation costs for stock options were measured as theexcess, if any, of the quoted market price of our stock at the date of grant over the amount anemployee must pay to acquire the stock. Stock options were issued at an exercise price equal tothe fair market value on the date of grant therefore no compensation cost was recognized.Effective January 1, 2006, we adopted FASB Statement No. 123(R), *Share-Based Payment*, whichrequires the measurement and recognition of compensation expense for all stock-based awards basedon estimatedfair values. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”) providing
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supplemental implementation guidance for Statement 123(R). We have applied the provisions of SAB107 in our adoption of Statement 123(R). We adopted Statement 123(R) using the modifiedprospective transition method. In accordance with that method, the consolidated financialstatements for prior periods have not been restated to reflect, and do not include, the impact ofStatement 123(R). Share-based compensation expense recognized in 2006 under Statement 123(R)includes: (a) compensation cost for all share-based payments granted prior to, but not yet vestedas of January 1, 2006 and (b) compensation cost for all share-based payments granted subsequent toJanuary 1, 2006, based on the grant-date fair value estimated in accordance with the provisions ofStatement 123(R).The following amounts were recognized in our consolidated statement of operations for share-basedcompensation plans for the periods ended June 30 (dollar amounts in thousands, except per sharedata):                   Three Months Ended  Six Months Ended   June 30,  June 30,   2006  2005  2006  2005 Compensation Cost:                Stock options $(78) $—  $415  $— Non-vested shares  336   58   512   115              Total share based compensation expense $258  $58  $927  $115                               Compensation expense per share: $0.01  $0.00  $0.05  $0.01              During the first quarter of 2006, we recorded $369,000 of share-based compensation expense relatedto non-employee stock options that were expected to be awarded in May 2006. In May 2006,non-employee share-based awards for stock options and non-vested shares (restricted stock) weregranted. The actual quantity, requisite service period and fair value of the awards were measuredand determined in accordance with the provisions of Statement 123(R), and the compensation cost wascumulatively adjusted to reflect the actual cost of the grant. The compensation cost recognized inthe second quarter of 2006 related to the actual grant was $317,000 resulting in a net reversal of$52,000.Cash received from stock option exercises for the six months ended June 30, 2006 and 2005 was$2,526,000 and $3,052,000, respectively. Statement 123(R) requires that the cash retained as aresult of the tax deductibility of employee share-based awards be presented as a component of cashflows from financing activities in the consolidated statement of cash flows. Due to our netoperating loss position, we did not recognize a tax benefit from options exercised under theshare-based payment arrangements. Cash flow from operating activities for the six months endedJune 30, 2006 included non-cash compensation expense related to stock options of $415,000 andnon-cash compensation expense in the amount of $512,000 related to non-vested shares (restrictedstock).
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*Pro Forma Information under Statement 123*The following table illustrates the effect on net income and earnings per share if we had appliedthe fair value recognition provisions of Statement 123 to options granted under our stock optionplan for the three and six months ended June 30, 2005. For purposes of this pro forma disclosure,the value of the options was estimated using the Black-Scholes-Merton option-pricing formula atdate of grant and amortized to expense over the options’ vesting periods (dollar amounts inthousands, except per share data).           Three Months  Six Months   Ended  Ended   June 30, 2005  June 30, 2005 Net loss, as reported $(1,655) $(5,259)Add: stock based employee compensationexpense included in reported net loss  58   115 Less: stock based employee compensationexpense determined under fair valuemethod, net ofrelated tax effects  (536)  (1,252)       Net loss, pro forma $(2,133) $(6,396)                Loss per share (basic and diluted)        As reported $(0.09) $(0.30)Pro forma  (0.12)  (0.36)*Stock Option Valuation and Expense Information under Statement 123(R)*For the quarter ended June 30, 2006 we did not grant stock options to employees and granted 25,000stock options to non-employee directors of the Company. The valuation methodology used todetermine the fair value of the options issued during the quarter was the Black-Scholes-Mertonoption-pricing model, an acceptable model in accordance with Statement 123(R). TheBlack-Scholes-Merton model requires the use of exercise behavior data and the use of a number ofassumptions including volatility of the stock price, the weighted average risk-free interest rate,and the weighted average expected life of the options. We do not pay dividends therefore thedividend rate variable in the Black-Scholes-Merton model is zero.The risk-free interest rate assumption is based upon observed interest rates on zero coupon U.S.Treasury bonds whose maturity period is appropriate for the term of our stock options and iscalculated by using the average monthly yield for the twelve months preceding the grant date.The volatility assumption is calculated as the annualized standard deviation of the naturallogarithms of relative stock prices over the option’s expected term and is based on monthlyhistorical stock prices through the month preceding the grant date.The expected life of stock options granted to employees represents the weighted average of theresult of the “simplified” method applied to “plain vanilla” options granted during the period, asprovided within Staff Accounting Bulletin No. 107 (“SAB 107”). The expected life of stock optionsgranted to non-employee directors represents the weighted average period that those options areexpected to remain outstanding and is based on analysis of historical behavior of non-employeedirector option holders. Prior to the adoption of Statement 123(R), we used five years as theexpected term for the purposes of pro forma information under Statement 123, as disclosed in ourNotes to Consolidated Financial Statements for the related periods.Share-based compensation expense recognized in our results for the three and six months ended June30, 2006 is based on awards ultimately expected to vest and has been reduced for estimatedforfeitures. Statement 123(R)requires forfeitures to be estimated at the time of grant and revised in subsequent periods ifactual forfeitures differ
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from those estimates. Our forfeiture rates were estimated based on ourhistorical experience. Prior to adoption of Statement 123(R), we accounted for forfeitures as theyoccurred for the purposes of our pro forma information under Statement 123, as disclosed in theNotes to Consolidated Financial Statements for the related periods.The weighted average fair value of options granted and the assumptions used in theBlack-Scholes-Merton model during the quarter ended June 30 are set forth in the table below.           June 30, June 30,  2006 2005Weighted average fair value of options granted $12.23  $8.47          Dividend yield  0.0%  0.0%Weighted average risk-free interest  4.4%  3.7%Weighted average expected volatility  53.5%  55.2%Weighted average expected life – employee 6.25 years  5.0 years Weighted average expected life – non-employee director 8.47 years  5.0 years The following is a summary of the stock option activity for the six months ended June 30, 2006:                   Six Months Ended         June 30, 2006                 Weighted          Weighted  Average          Average  Remaining  Aggregate       Exercise  Term  Intrinsic   Options  Price  in Years  Value Outstanding, beginning of period  2,492,075  $16.33         Granted  25,000   19.09         Exercised  (191,863)  13.16         Forfeited/canceled  (36,800)  22.48                         Outstanding, end of period  2,288,412  $16.53   5.4  $6,513,396                                  Outstanding, net of expectedforfeiture  2,284,244  $16.54   5.7  $6,483,735                                  Options exercisable, end of period  2,174,622  $16.73   5.3  $5,824,363                 The aggregate intrinsic value in the table above represents the difference between the closingstock price on June 30, 2006 and the exercise price, multiplied by the number of in-the-moneyoptions that would have been received by the option holders had all option holders exercised theiroptions on June 30, 2006. The total intrinsic value of options exercised during the quarter wasapproximately $1,053,000.In the first six months of 2006, 35,050 of vested options to purchase shares with a weightedaverage exercise price of $23.09 expired. The remaining outstanding share options expire in 2007though 2016.*Non-Vested Shares (Restricted Stock)*For the six months ended June 30, 2006 and for the years ended December 31, 2005 and 2004, weawarded 24,500, 21,500 and 22,500 shares of time-based restricted stock (non-vested shares),respectively, to certain officers pursuant to our 2003 Stock Option and Incentive Plan. The sharesvest over four years from the date of grant with 50% vested at the end of year three and 50% at theend of year four. The fair value of the non-vested shares is equal to the fair market value, asdefined by the terms of the 2003 Plan, on the date of grant and is amortizedratably over the vesting period.
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Also in 2006, we awarded 92,200 shares of performance-based restricted stock (non-vested shares) tocertain officers that vest according to the terms of our Restricted Stock Agreement forPerformance-Based Vesting. The fair value of the Performance-Based restricted stock is currentlybeing amortized ratably over the period that the performance metric is being measured. Wecurrently expect to achieve these performance goals. If such goals are not met, no compensationcost is ultimately recognized and any amount of previously recognized compensation cost will bereversed.We recorded the following amounts in our consolidated statement of income related to non-vestedshares (restricted stock) for the three and six months ended June 30 (dollar amounts in thousands):                   Three Months Ended  Six Months Ended   June 30,  June 30,   2006  2005  2006  2005 Compensation cost — non-vested shares:                Time-based vesting $234  $58  $314  $115 Performance-based vesting  102   —   198   —              Total share based compensationexpense  — non-vested shares $336  $58  $512  $115              A summary of the status of non-vested shares and changes as of June 30, 2006 is set forth below:                   Six Months Ended   June 30, 2006   Time Based  Performance Based       Weighted      Weighted       Average      Average   Non-vested  Grant-date  Non-vested  Grant-date   Shares  Fair Value  Shares  Fair Value Non-vested sharesoutstanding, beginning ofperiod  44,000  $18.01   —   — Granted  24,500   14.32   92,200  $14.08 Vested  —   —   —   — Forfeited/canceled  —   —   —   —                Non-vested shares outstanding,end of period  68,500  $16.69   92,200  $14.08                *Unrecognized Compensation Expense*As of June 30, 2006 unrecorded compensation costs related to awards issued under the Company’svarious share-based compensation plans are as follows (dollar amounts in thousands):               Weighted average   June 30,  recognition period   2006  (months) Unrecognized compensation cost:        Stock options, net of expected forfeitures $449   11.4 Non-vested shares — time based vesting  631   30.6 Non-vested shares — performance based vesting  1,101   30.4         Total unrecognized compensation cost $2,181             
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Note 3 — Property and Equipment, NetProperty and equipment was comprised as follows (in thousands of dollars):           June 30,  December 31,   2006  2005 Land, building and equipment $84,827  $83,267 Free-to-guest equipment  34,465   33,989 Guest Pay systems:        Installed system costs  449,355   450,754 Customer acquisition costs  52,651   52,264 System components  25,643   25,336 Software costs  21,840   21,889        Total  668,781   667,499 Less — depreciation and amortization  (475,270)  (467,617)       Property and equipment, net $193,511  $199,882        Note 4 — Intangible AssetsWe have intangible assets consisting of certain acquired technology, patents, trademarks andlicensee fees. We account for these assets on an ongoing basis in accordance with SFAS No. 142,“Goodwill and Other Intangible Assets”. The intangible assets have been deemed to have definiteuseful lives based on several factors including our anticipation of technological changesassociated with increasing accessibility to the Internet by the traveler, the economic viability ofcharging a hotel guest to access the Internet through the television, and a finite market potentialfor the products acquired. Intangible assets are amortized over their current estimated usefullives ranging from three to five years.We have the following intangible assets (in thousands of dollars):                   June 30, 2006  December 31, 2005   Carrying  Accumulated  Carrying  Accumulated   Amount  Amortization  Amount  Amortization Assets subject to amortization:                Acquired technology $10,280  $10,280  $14,291  $14,150 Acquired intangibles  5,774   4,523   5,774   3,945 Other  454   425   497   460                $16,508  $15,228  $20,562  $18,555              In the first quarter of 2006, we retired an asset no longer in service and reduced both thecarrying amount and the related accumulated amortization by $4.0 million. We recorded amortizationexpense of $728,000 and $1,310,000, respectively, for the six months ended June 30, 2006 and 2005.We estimate amortization expense for the six months remaining in 2006 to be $585,000 and for thefull year ending December 31, 2007 to be $695,000. Actual amounts may change from such estimatedamounts due to additional intangible asset acquisitions, potential impairment, acceleratedamortization, or other events.Note 5 — Earnings Per Share ComputationWe calculate earnings per share (EPS) in accordance with SFAS No. 128, “Earnings Per Share” asamended by SFAS 123(R) “Share Based Payment”, which requires the computation and disclosure of twoEPS amounts, basic and diluted. Basic EPS is computed based on the weighted average number ofcommon shares outstanding during the period. Diluted EPS is computed based on the weighted averagenumber of common shares outstanding plus all
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potentially dilutive common shares outstanding duringthe period. Such potential dilutive common shares consist of stock options, non-vested shares(restricted stock) and warrants and are calculated using the ‘treasury stock method’ as defined bySFAS 128. Potential common shares that have an anti-dilutive effect are excluded from dilutedearnings per share.The following table reflects the calculation of weighted average basic and fully diluted shares forthe periods ended June 30. Potential common shares with exercise prices greater than the averagemarket price of our common stock during the quarter ended June 30, 2006 are excluded from thediluted earnings per share calculation, as their inclusion would have been anti-dilutive. For thethree months ended June 30, 2005, and the six months ended June 30, 2006 and 2005, potentialdilutive common shares were not included in the computation of diluted earnings per share as wewere in a loss position and their inclusion would have been anti-dilutive.                   Three Months Ended  Six Months Ended   June 30,  June 30,   2006  2005  2006  2005 Average shares outstanding – basic  18,245,841   17,937,777   18,186,064   17,809,537 Dilutive effect of stock options,non-vested shares and warrants  333,539   —   —   —              Average shares outstanding –diluted  18,579,380   17,937,777   18,186,064   17,809,537                               Antidilutive securities excludedfrom calculation  2,451,005   —   —   —              The total number of potential dilutive common shares outstanding at June 30 is set forth below:           June 30,  June 30,   2006  2005 Potential dilutive common shares  4,210,667   4,525,320        Note 6 — Accrued ExpensesAccrued expenses were comprised as follows (in thousands of dollars):           June 30,  December 31,   2006  2005 Accrued taxes $4,100  $3,679 Accrued compensation  4,864   5,803 Accrued interest  1,435   1,100 Accrued programming related  1,819   1,637 Other  3,271   3,103          $15,489  $15,322        
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Note 7 — Long-term Debt and Credit FacilitiesLong-term debt was comprised as follows (in thousands of dollars):           June 30,  December 31,   2006  2005 Bank Credit Facility:        Bank term loan $78,875  $89,625 Revolving credit facility  **—**   **—** 9.50% senior notes  200,000   200,000 Capital leases  2,064   2,375           280,939   292,000 Less current maturities  (2,599)  (2,749)         $278,340  $289,251        *Bank Credit Facility*3⁄4 In August 2001, we entered into a $225.0 million bank Credit Facility,comprised of a $150.0 million term loan and a $75.0 million revolving credit facility that may beincreased to $100.0 million, subject to certain limitations. The term loan matures in August 2008and quarterly repayments of $375,000 began in December 2001. The term loan bears interest at ouroption of (1) the bank’s base rate plus a margin of 1.50% or (2) LIBOR plus a margin originallyestablished at 4.00%. In January 2004, LodgeNet and the holders of the term loan amended the LIBORpricing to be LIBOR plus a margin of 3.50%. In April 2004, LodgeNet and the holders of the termloan executed another amendment to establish the LIBOR pricing at LIBOR plus a margin of 2.75%. InJuly 2005, LodgeNet and the holders of the term loan again executed an amendment to establish theLIBOR pricing at LIBOR plus a margin of 2.25%. The term loan interest rate as of June 30, 2006 was7.88%. The revolving credit facility matures in August 2007 and loans bear interest at our optionof (1) the bank’s base rate plus a margin of 1.00% to 2.00%, or (2) LIBOR plus a margin of 2.25% to3.25%. As of June 30, 2006, there were no amounts outstanding under the revolving credit facility.Loans under the Credit Facility are collateralized by a first priority interest in all of ourassets. As of June 30, 2006, we had $69.2 million of borrowing available under the revolverportion of the bank Credit Facility.The facility provides for the issuance of letters of credit up to $10.0 million, subject tocustomary terms and conditions. As of June 30, 2006, we had outstanding letters of credit totaling$1.9 million.The facility includes terms and conditions which require compliance with a material adverse effectcovenant as well as the maintenance of certain financial ratios and places limitations on capitalexpenditures, additional indebtedness, liens, investments, guarantees, asset sales and certainpayments or distributions in respect of the common stock. Our consolidated total leverage ratiowas 2.99 compared to the maximum allowable of 3.75, the consolidated senior secured leverage ratiowas 0.86 compared to the maximum allowable of 2.25 and the consolidated interest coverage ratio was3.55 compared to the minimum allowable of 2.75. As of June 30, 2006, we were in compliance withthe financial covenants of the bank Credit Facility.*9.50% Senior Notes*3⁄4 In June 2003, we issued $200.0 million of unsecured 9.50% SeniorSubordinated Notes (the “9.50% Notes”), due June 15, 2013. The 9.50% Notes are unsecured, aresubordinated in right of payment to all existing and future senior debt of LodgeNet and rank *paripassu*in right of payment with any future senior subordinated indebtedness of LodgeNet. The 9.50%Notes require semi-annual interest payments and contain covenants which restrict our ability toincur additional indebtedness, create liens, pay dividends or make certain distributions withrespect to our common stock, redeem capital stock, issue or sell stock of subsidiaries in certaincircumstances, effect certain business combinations and effect certain transactions with affiliatesor stockholders. As of June 30, 2006, we were in compliance with the financial covenants of the9.50% Notes.The 9.50% Notes are redeemable at our option, in whole or in part, on or after June 15, 2008,initially at 104.75% of their principal amount (plus accrued and unpaid interest), decliningratably to 100% of their principal amount (plus accrued and unpaid interest) on or after June 15,2011. At any time prior to June 15, 2006, the 9.50% Notes were
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redeemable up to 35% of theaggregate principal amount at 109.50% of the principal amount (plus accruedand unpaid interest) with the cash proceeds of certain equity offerings.*Capital Leases*— As of June 30, 2006, we have total capital lease obligations of $2,255,000.Equipment acquired under capital lease arrangements during the six months ended June 30, 2006totaled $402,000.Long-term debt has the following scheduled maturities for the six months remaining in 2006 and thefull years ending December 31, 2007 and after (in thousands of dollars):                           2006  2007  2008  2009  2010  Thereafter Long-term debt $750  $1,500  $76,625  $—  $—  $200,000 Capital leases  680   955   407   178   35   —                       1,430   2,455   77,032   178   35   200,000 Less amount representinginterest on capital leases  (67)  (78)  (32)  (11)  (3)  —                      $1,363  $2,377  $77,000  $167  $32  $200,000                    During the first half of 2006, we prepaid $10.0 million on our term loan and wrote-off $129,000 ofrelated debt issuance costs. In July 2006, we prepaid an additional $5.0 million on our term loanand wrote-off $52,000 of related debt issuance costs.We do not utilize special purpose entities or off-balance sheet financial arrangements.Note 8 3⁄4 Comprehensive Income (Loss)Statement of Financial Accounting Standard No. 130, “Reporting Comprehensive Income,” providesstandards for reporting and disclosure of comprehensive income (loss) and its components.Comprehensive income (loss) reflects the changes in equity during a period from transactions andother events and circumstances. Comprehensive income (loss) was as follows for the periods endedJune 30 (in thousands of dollars):                   Three Months Ended  Six Months Ended   June 30,  June 30,   2006  2005  2006  2005 Net income (loss) $433  $(1,655) $(221) $(5,259)Foreign currency translation adjustment  415   (106)  426   (201)Unrealized gain on derivative instruments  —   672   156   1,926              Comprehensive income (loss) $848  $(1,089) $361  $(3,534)             Components of accumulated other comprehensive income (loss) as shown on our consolidated balancesheets were as follows (in thousands of dollars):           June 30,  December 31,   2006  2005 Unrealized loss on derivative instruments $—  $(156)Foreign currency translation adjustment  2,147   1,721        Accumulated other comprehensive income $2,147  $1,565        Note 9 3⁄4 Statements of Cash FlowsCash equivalents are comprised of demand deposits and temporary investments in highly liquidsecurities having original maturities of 90 days or less at the date of purchase. Cash paid forinterest was $12,746,000 and $14,626,000, respectively, for the six months ended June 30, 2006 and2005. Cash paid for taxes was $217,000 and $284,000 for the six months ended June 30, 2006 and2005, respectively.
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Note 10 3⁄4 Effect of Recently Issued Accounting StandardsIn September 2005, the American Institute of Certified Public Accountants (AICPA) has issuedStatement of Position (SOP) 05-1, “Accounting by Insurance Enterprises for Deferred AcquisitionCosts in Connection with Modifications or Exchanges of Insurance Contracts”. This SOP providesguidance on accounting by insurance enterprises for deferred acquisition costs on internalreplacements of insurance and investment contracts other than those specifically described in FASBStatement No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-DurationContracts and for Realized Gains and Losses from the Sale of Investments”. The provisions in SOP05-1 are effective for internal replacements occurring in fiscal years beginning after December 15,2006. The SOP is applicable to us as it relates to the accounting treatment of long-term contractsand customer acquisition costs. We believe the adoption of SOP 05-1 will not have a materialimpact on our consolidated financial position or results of operations.In July 2006, FASB issued Interpretation No. 48, *Accounting for Uncertainty in Income Taxes — AnInterpretation of FASB Statement No. 109*. FIN 48 clarifies the accounting treatment (recognitionand measurement) for an income tax position taken in a tax return and recognized in a company’sfinancial statement. The new standard also contains guidance on “de-recognition, classification,interest and penalties, accounting in interim periods, disclosure, and transition”. The provisionsof FIN 48 are effective for fiscal years beginning after December 15, 2006. We are currentlyevaluating the impact of this statement. We believe the adoption of FIN 48 may require expandeddisclosure related to the classification of certain tax assets and/or liabilities, and we believethe adoption will not have a material impact on our consolidated financial position or results ofoperations.In June 2006, the EITF reached consensus on and ratified EITF Issue 06-03, *How Taxes Collected fromCustomers and Remitted to Governmental Authorities Should Be Presented in the Income Statement(That Is, Gross versus Net Presentation)*. The scope of this Issue includes any tax assessed by agovernmental authority that is directly imposed on a revenue-producing transaction between a sellerand a customer and may include, but is not limited to, sales, use, value added, and some excisetaxes. The Task Force concluded that the presentation of taxes within the scope of the Issue oneither a gross (included in revenues and costs) or a net (excluded from revenues) basis is anaccounting policy decision that should be disclosed pursuant to Opinion 22. In addition, for anysuch taxes that are reported on a gross basis, a company should disclose the amounts of those taxesin interim and annual financial statements for each period for which an income statement ispresented if those amounts are significant. The disclosure of those taxes can be done on anaggregate basis. The consensus in this Issue should be applied to financial reports for interimand annual reporting periods beginning after December 15, 2006. We believe the adoption of EITF06-03 will not have a material impact on our consolidated financial position or results ofoperations.Note 11 — Insurance Proceeds from the Impact of Hurricane KatrinaOn August 29, 2005, Hurricane Katrina swept through the Gulf of Mexico region, causing severedamage to properties located in Louisiana, Alabama, Mississippi, and Florida. LodgeNet sustainedproperty damage to its systems installed at the hotels located within those states. The initialdamage estimate included 121 hotels or approximately 21,000 rooms served by the LodgeNetinteractive systems. In December 2005, we received insurance proceeds associated with theHurricane Katrina recovery of $788,000 offset by a $280,000 charge for equipment impairment during2005. In April 2006, we received $200,000 from our insurance carrier related to businessinterruption indemnification. The insurance proceeds were recorded within Other Operating Income.As of June 30, 2006, approximately 5,400 rooms remain out of service, and no amounts have beenrecognized for future recoveries.Note 12 — Gamet Note SettlementIn June 2006, we received a settlement of $238,000 and recorded within Other Income related to theChapter 7 liquidation of Gamet Technology, Inc. In 2003, we advanced $1.0 million to GametTechnology, Inc. pursuant to a written promissory note in connection with our effort to support thedevelopment of technology, which could utilizeour interactive system. We fully reserved for the $1.0 million promissory note in the fourthquarter of 2004.
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**Item 2 — Management’s Discussion and Analysis of Financial Condition and Results ofOperations***The following discussion and analysis provides information concerning our results of operations andfinancial condition. This discussion should be read in conjunction with the accompanyingconsolidated financial statements and the notes thereto.****Special Note Regarding Forward-Looking Statements****Certain statements in this Quarterly Report on**Form 10-Q**constitute “forward-looking statements”.When used in this Quarterly Report, the words “expects,” “intends,” “anticipates,” “estimates,”“believes,” “no assurance” and similar expressions and statements which are made in the futuretense, are intended to identify such forward-looking statements. Such ”forward-looking statements”within the meaning of the Securities Act of 1933, as amended, and the Securities Exchange Act of1934, as amended, are subject to risks, uncertainties, and other factors that could cause ouractual results, performance or achievements to be materially different from any future results,performance or achievements expressed or implied by such forward-looking statements. In additionto the risks and uncertainties discussed elsewhere in this Report, such factors include, amongothers, the following: the effects of economic conditions, including in particular the economiccondition of the lodging industry, competition, demand for our products and services, programmingavailability and quality, technological developments, developmental difficulties and delays,relationships with clients and property owners, the availability of capital to finance growth, theimpact of government regulations, international crises, acts of terrorism, public health issues,risks related to the security of our data systems, and other factors detailed, from time to time,in our filings with the Securities and Exchange Commission. These forward-looking statements speakonly as of the date of this Quarterly Report. We expressly disclaim any obligation or undertakingto release publicly any updates or revisions to any forward-looking statements contained herein toreflect any change our expectations with regard thereto or any change in events, conditions orcircumstances on which any such statement is based.***Executive Overview**We are one of the world’s largest providers of interactive television and broadband solutions tohotels throughout the United States and Canada, as well as select international markets. It isestimated that, currently, more than 300 million domestic and international travelers have accessto our interactive television network annually, which is designed to make their hotel stay moreenjoyable, productive and convenient, and to allow our hotel customers to provide greater guestservices and promote hotel brand loyalty. As of June 30, 2006, we provided interactive and basiccable television services to approximately 6,100 hotel properties serving over one million rooms.LodgeNet also delivers on-demand patient education, information and entertainment to healthcarefacilities. In addition, we began selling our interactive system, licensing software anddelivering entertainment and service options to travel centers in the United States.In the second quarter of 2006, we continued to execute on our strategic plan focused on growth,profitability and the generation of net free cash flow, which we define as cash provided byoperating activities less cash used for investing activities, including growth-related capital. Weincreased our digital room base during the quarter by more than 28,000 net digital rooms. As ofJune 30, 2006, more than 68% of our Guest Pay interactive room base, or 686,000 rooms, wereequipped with a digital system. In addition, we continued to make progress with respect to ourprofitability goal, achieving net income in a second quarter for the first time in our company’shistory. During the quarter, we had net income of $433,000, a $2.1 million increase from a net lossof $1.7 million in the second quarter of 2005. Year to date, we reduced our net loss from $5.3million last year to $221,000 in the current six months. Our operating income was up 10.7% to $6.7million in the second quarter of 2006 from $6.1 million in the second quarter of 2005. During thefirst six months of 2006, we generated $11.4 million of net free cash flow. This represents a $6.3million improvement over the first six months of last year.During the second quarter of 2006, total revenue increased 5.5%, or $3.8 million, as compared tothe second quarter of 2005. The growth was driven in part by our expanding digital room base, andin part by a 2.2% increase in revenue realized per average Guest Pay room. On a per room basis,monthly Guest Pay revenue increased to$22.87 in the second quarter of 2006 as compared to $22.38 for the second quarter of 2005. Movierevenue per room increased 0.8% to $17.02 this quarter as compared to $16.89 in the prior yearquarter. Revenue per room from other
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interactive services increased 6.6%, from $5.49 per month inthe second quarter of 2005 to $5.85 in the current year quarter. This change was primarily due toprice increases associated with basic cable services and our TV on-demand and music services,offset in part by a decrease in revenue from games and TV Internet.During the quarter, our Guest Pay direct costs varied directly with our revenue growth andincreased to $10.26 per room as compared to $9.57 per room for the second quarter of 2005. Theincrease was primarily due to higher royalties for content due to the mix of products sold, highercosts associated with basic cable services and higher hotel commissions resulting from our “pay forperformance” commission structure whereby an increase in revenue per room may result in a highercommission paid to the hotel. Our Guest Pay operations expenses were $3.00 per average Guest Payroom versus $2.98 in the second quarter of 2005. Our selling, general, and administrative expensesincreased to 9.9% of revenue for the second quarter of 2006 compared to 9.2% for the prior yearquarter. Per average Guest Pay room, SG&A expenses increased to $2.36 per month in the secondquarter of 2006 from $2.11 per month in the prior year quarter. The increase was primarily due tocompensation expense, including the expensing of share-based compensation required under FinancialAccounting Standard 123(R) and an increase in professional and consulting fees. Share-basedcompensation expenses were $258,000 for the second quarter of 2006, compared to $58,000 in the sameperiod of last year. Professional and consulting fees were $512,000 during this year’s secondquarter, compared to $119,000 last year. A significant part of that increase was related to thevarious strategic initiatives of the company. Our depreciation and amortization decreased 5.7%, or$1.0 million, primarily driven by reductions in Guest Pay system depreciation as higher-cost assetscontinue to become fully depreciated while the cost basis of our more recently deployed Guest Paysystems is lower. We expect this trend to level off during the second half of 2006 as most of ourolder systems become fully depreciated. Per average Guest Pay room, depreciation and amortizationexpenses decreased to $5.58 in the second quarter of 2006 compared to $6.04 in the prior yearquarter.We continue to de-leverage our balance sheet with the reduction of our investment of equipment intohotels through market and product segmentations and engineering development, reduction of interestcosts by prepaying on our long-term debt, and prudent management of working capital. Cash at June30, 2006 was $23.3 million compared to $20.7 million at December 31, 2005. The increase in cash isdue to cash from operations offset by the $10.0 million prepayment on our term loan made during thefirst half of 2006. We made another prepayment of $5.0 million on our term loan in early July2006.We continue to promote our industry-leading SigNETure HDTVSM solution that enables us todeliver high-definition guest room entertainment content to the hotels we serve that are equippedto receive and display HDTV. We have programming agreements with DIRECTV, ESPN, Lion’s Gate, andParamount to provide high-definition television content. Additionally, we have partnered withSharp Electronics Corporation and Panasonic Broadcast & Television Systems Company to integratetheir television displays with our HDTV platform. As part of the integration effort, Panasonic andSharp will also adoptPro:Idiom(TM) premium content copy protection technology enabling LodgeNetserved hotels with Panasonic plasma screens and Sharp AQUOS LC-TVs to display HD premium satelliteand VOD entertainment licensed by satellite programmers and movie studios that have accepted thePro:Idiom security standard. Our SigNETure HDTVSM solution coupled with our LodgeNetMedia Management System (LMMS) helped us recently secure Global Hyatt Corporation as a customer.We were selected as the exclusive provider of interactive TV and HDTV services for Global Hyatt’snew upscale select service brand Hyatt Place. During 2005, two key contracts with Starwood Hotels& Resorts Worldwide, Inc., and The Ritz-Carlton Hotel Company, L.L.C., a wholly-owned subsidiary ofMarriott International, Inc., were secured as a result of our SigNETure HDTVSMsolution.We continue to explore revenue growth opportunities within our core lodging business. Theseinclude, but are not limited to, new content and products such as Hotel SportsNETSM (ourdaily subscription of sports programming), which recently added MLB EXTRA INNINGS to itsprogramming line up. Other Hotel SportsNETSM programming includes NHL Center Ice, NBALEAGUE PASS, NFL SUNDAY TICKET and ESPN’s GamePlan and Full Court packages. As of June 30 2006,Hotel SportsNETSM was installed in approximately 13,000 rooms. We expect to haveapproximately 80,000 rooms installed by the end of 2006. In addition, we continue to focus onmarketing directly to the hotel guest through the capabilities of LMMS. LMMS allows us to refreshinteractive menus, promote different products and different titles to different demographics andchange pricing of our products, selection and promotions based on time-of-day or day-of week, amongother marketing efforts to the guest.
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Our Healthcare initiative continues to expand with five new hospitals installed during the secondquarter of 2006. As of June 30, 2006, our interactive system is installed at ten healthcare sites.We offer our interactive television system and content and sell our interactive systems to McKessonCorporation for resale to their customers, and also contract directly with healthcare facilitiessold by LodgeNet or through MDM Commercial, a licensed sales agent. Revenue comes from the initialsale of system hardware, software licensing, and implementation services, and we additionally earnrecurring revenues, under long-term contracts, by providing entertainment content, softwaremaintenance and technical field service.In the second quarter of 2006, we began selling our digital system combined with a multi-yearmaintenance contract to IdleAire Technologies for installation into travel centers. As of June 30,2006, 51 interactive systems had been sold to IdleAire, with 175 targeted for 2006. IdleAirepurchases our interactive television platform, licenses our software, and contracts with us for avariety of entertainment and service options as part of its overall service offering. IdleAire isplanning to install its patented Advanced Truckstop Electrification (ATE) systems in approximately230 travel centers, having more than 13,000 total spaces, over the next twelve months.As we move through 2006, we will continue to execute on our strategic plan and maximize on theflexible technology aspects of our platform which has allowed us to diversify our customer base,tap new revenue opportunities with additional content offerings and enter vertical markets such ashealthcare and travel centers with business models that require little or no incremental capitalinvestment on our part. We are committed to prudently leveraging our technology, content expertiseand nationwide service presence to expand our overall customer base, and we remain focused ondriving growth, improving profitability and increasing cash flow.*Guest Pay Interactive Services.*Our primary source of revenue is providing in-room, interactivetelevision services to the lodging industry, for which the hotel guest pays on a per-view, hourlyor daily basis. Our services include on-demand movies, network-based video games, music and musicvideos, Internet on television (which does not require a laptop), and television on-demandprogramming.Our total guest generated revenue depends on a number of factors, including:**•** *The number of rooms on our network.*We can increase revenue overtime by increasing the number of rooms served by our interactivesystems. Our ability to expand our room base is dependent on anumber of factors, including the attractiveness of our technology,service and support to hotels currently operating without aninteractive television system, newly constructed hotel properties,and hotels with expiring contracts currently served by ourcompetitors. **•** *The variety of services offered at the hotel.*Rooms equipped withour digital system generate higher revenue than rooms equippedwith our tape-based system primarily because they offer a greatervariety of services and content choices. We plan to continue togrow the revenue we generate per average room by the installationof our digital system in all newly contracted rooms and byconverting selected tape-based rooms to our digital system inexchange for long-term contract extensions. **•** *The popularity, timeliness and amount of content offered at thehotel.*Our revenues vary to a certain degree with the number,timeliness and popularity of movie content available for viewing.Historically, a decrease in the availability of popular moviecontent has adversely impacted revenue. Although not completelywithin our control, we seek to program and promote the mostpopular available movie content and other content to maximizerevenue and gross profit. **•** *The price of the service purchased by the hotel guest.*Generally,we control the prices charged for our products and services andmanage pricing in an effort to maximize revenue and overall grossprofit. Weestablish pricing based on such things as the demographics of the property served, thepopularity of the content and overall economic conditions. Our technology enables us to measurepopularity of our content and make decisions to best position such content and optimize revenuefrom such content. **•** *The occupancy rate at the property.*Our revenue also varies depending on hotel occupancyrates, which are subject to a number of factors, including seasonality, general economicconditions and world events, such as
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  terrorist threats or public health issues. Occupancyrates are typically higher during the second and third quarters due to seasonal travelpatterns. We target higher occupancy properties in diverse demographic and geographiclocations in an effort to mitigate occupancy-related risks.The primary direct costs of providing Guest Pay interactive services are: Ø license fees paid to major motion picture studios, which are based on a percent ofguest-generated revenue, for non-exclusive distribution rights of recently released majormotion pictures;  Ø commissions paid to our hotel customers, which are also based on a percent ofguest-generated revenue;  Ø fixed monthly programming charges paid primarily to DIRECTV for satellite-deliveredbasic and premium television programming;  Ø internet connectivity costs;  Ø license fees, which are based on a percent of guest-generated revenue, for television ondemand, music, music video, video games and sports programming; and  Ø one-time license fees paid for independent films, most of which are non-rated andintended for mature audiences.*Other Services.*In addition to the sales of equipment to our international markets, we continuedto promote the sale and installation of high-speed Internet equipment coupled with maintenance andcustomer support services. While this is a highly competitive area, we believe we have importantadvantages as a result of our existing hotel customer relationships, our nationwide field servicenetwork, and our 24-hour call center which provides service seven days a week**.**We also generate revenue from the sale of content and services directly to our hotel customers,which are generally provided free to hotel guests. Included in these services issatellite-delivered basic and premium television programming for which the hotel pays us a fixedmonthly charge per room. We compete with local cable television operators by tailoring differentprogramming packages to provide specific channels desired by the hotel subscriber, which typicallyreduces the overall cost to the hotel for the services provided.
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*Key Metrics:**Rooms Served*One of the metrics we monitor is the growth, net of de-installations, of our interactive televisionnetwork. Historically, de-installation activity has not had a material effect on our growth,averaging between 2% to 3% of total installed rooms per year over the last five years. In thesecond quarter of 2006, net new room growth was impacted by the deinstallation of certain Red RoofInn properties as a result of their transition to a competitor. Additionally, as lower revenuetape-based systems come up for contract renewal the overall economics may not support upgrading thesite to our digital system. A certain number of these sites will be removed from our interactiveroom base. We expect this trend to continue as we focus on the quality of rooms installed andupgraded with greater returns when investing our capital expenditure dollars. We installed oursystems in the following number of net new rooms and had the following total rooms installed as ofJune 30:           June 30,  2006 2005Total rooms served (3) (4)  1,055,854   1,051,010 Total Guest Pay interactive rooms (2) (4)  1,006,613   995,507 New Guest Pay interactive rooms for thethree months ended (1)  100   9,483 New Guest Pay interactive rooms for thesix months ended (1)  4,684   20,709  (1) Amounts shown are net of de-installations during the period. The gross number of new roomsinstalled was 17,244 and 20,237 for the three months ended June 30, 2006 and 2005,respectively, and 29,869 and 38,746 for the six months ended June 30, 2006 and 2005,respectively. (2) Guest Pay interactive rooms are equipped with our interactive television system, whichincludes high-definition (HD), digital and tape-based systems. (3) Total rooms served include guest pay interactive rooms, rooms served by internationallicensees, and properties receiving only basic and premium television services. (4) As a result of Hurricane Katrina, room count as of June 30, 2006 was reduced by 5,419 rooms.*Digital Room Growth*We continue to expand our digital base as we install our digital system in all newly contractedrooms as well as converting select tape-based served rooms to the digital system in exchange forlong-term contract extensions. Rooms equipped with our digital system typically generate higherrevenue since the range of services is greater than rooms equipped with our tape-based systems.Our goal is to have approximately 75% of our room base installed with a digital system by the endof 2006.           June 30,  2006 2005Digital room installations for the three months ended  28,377   31,848 Digital room installations for the six months ended  57,468   63,836 Total Digital rooms installed  686,553   572,815 Digital rooms as a percent of total Guest Payinteractive rooms  68.2%  57.5%
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*Capital Investment Per Room*The average investment per-room associated with a digital installation has continued to declineover the past several years due to our ongoing engineering efforts, while adding enhancements,lower component costs, product segmentation, and reduced cost of assembly and installation. Thecost of installation can fluctuate from quarter to quarter due to the mix of services installed,average property size, certain fixed costs, and the expanding number of high-definitioninstallations, which have a higher cost per room. The following table sets forth our averageinstallation and conversion investment cost per room during the periods ended:                       Three Months Ended Years Ended  June 30, June 30, December 31, December 31, December 31,  2006 2005 2005 2004 2003Average cost per room –new installation $346  $335  $340  $364  $405 Average cost per room –conversion $240  $265  $262  $284  $337 *Direct Costs*Guest Pay direct costs (exclusive of operating expenses and depreciation and amortization discussedseparately below) for interactive services include movie license fees, license fees for otherinteractive services, the commission retained by the hotel, programming and other related costs.The following table sets forth our Guest Pay direct expenses per room and as a percent of revenueduring the three and six months ended June 30:                   Three Months Ended  Six Months Ended   June 30,  June 30,   2006  2005  2006  2005 Guest Pay direct costs per room $10.26  $9.57  $10.23  $9.61                               Guest Pay direct costs as a percent of total revenue  43.1%  41.6%  43.4%  42.3%Guest Pay direct costs increased to 43.1% in the second quarter of 2006 from 41.6% in the secondquarter of 2005. The increase was due to higher royalties for content due to mix of products sold,higher costs associated with basic cable services and higher hotel commissions resulting from our“pay for performance” commission structure whereby an increase in revenue per room may result in ahigher commission paid to the hotel. In the second quarter of 2006, Guest Pay direct costs wereoffset by a recovery of approximately $280,000 of connectivity costs as a result of atelecommunications audit.*Operating Expense Per Room*We plan to continue to monitor and manage the operating expenses per room in order to increase thelevel of cash flow our business generates. Guest Pay operations expenses consist of costs directlyrelated to the operation and maintenance of systems at hotel sites. Selling, general andadministrative expense (SG&A) primarily includes administrative payroll costs, engineeringdevelopment costs and legal, professional and compliance costs. The following table sets forth ouroperating expenses per room and SG&A as a percent of revenue during the three and six months endedJune 30:
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                   Three Months Ended  Six Months Ended   June 30,  June 30,   2006  2005  2006  2005 Guest Pay operating expenses $3.00  $2.98  $2.96  $2.96 SG&A expense  2.36   2.11   2.32   2.09 Depreciation and amortization (D&A)  5.58   6.04   5.60   6.08 Other operating income, net (1)  (0.07)  —   (0.03)  —                $10.87  $11.13  $10.85  $11.13                               Guest Pay operations as a percentof total revenue  12.6%  13.0%  12.6%  13.0%SG&A as a percent of total revenue  9.9%  9.2%  9.9%  9.2%D&A as a percent of total revenue  23.5%  26.3%  23.8%  26.8% (1) Insurance proceeds received for business interruption losses due to hurricane Katrina.The following table sets forth share-based compensation expense included in SG&A during the threeand six months ended June 30:                   Three Months Ended Six Months Ended  June 30, June 30,  2006 2005 2006 2005Share-based compensation $258,000  $58,000  $927,000  $115,000 Share-based compensation as a percent of total revenue  0.4%  0.1%  0.7%  0.1%Share-based compensation per room $0.09  $0.02  $0.15  $0.02 *Net Income/(Loss)*We focused on attaining profitability by improving room and revenue growth coupled with reducingdirect costs, overhead expenses, installation costs resulting in decreases in depreciation andamortization expenses, and interest costs. The following table sets forth our net income (loss)for the three and six months ended June 30 (in thousands of dollars):                   Three Months Ended  Six Months Ended   June 30,  June 30,   2006  2005  2006  2005 Net income (loss) $433  $(1,655) $(221) $(5,259)*Free Cash Flow*One of our goals is to generate net free cash flow, which we define as cash provided by operatingactivities less cash used for investing activities, including growth-related capital. In additionto increasing revenue and controlling expenses, we can manage our actions related to this goal byreducing the per-room installation cost of a digital room and by varying the number of rooms weinstall with the digital system in any given period. Over the past twelve months, we havegenerated $19.1 million of net free cash flow while having simultaneously installed more than119,000 digital rooms. Since existing operations more than fully funded our growth capital needsduring the quarter, we strengthened our balance sheet by reducing long-term debt to $280.9 million.
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Our progress toward the goal of continuing to generate increased levels of net free cash flow isset forth in the following table (in thousands of dollars):                   Three Months Ended  Six Months Ended   June 30,  June 30,   2006  2005  2006  2005 Cash provided by operating activities $14,325  $15,027  $36,291  $33,240 Cash used for investing activities  (12,401)  (15,551)  (24,919)  (28,104)             Difference $1,924  $(524) $11,372  $5,136                               Expansion capital investment $5,784  $6,776  $9,684  $13,183 *New Revenue Sources*In 2005, we began offering our interactive television systems into the healthcare industry througha sales and marketing relationship with McKesson Corporation. In this market, we sell ourinteractive system and license our software to McKesson or individual healthcare facilities, andearn recurring revenues from the provision of hardware and software service and maintenanceactivities, and the sale of entertainment content. In addition to McKesson, we have entered intoan agreement with MDM Commercial, a leading distributor of audio-visual equipment and systems tothe healthcare industry. The agreement designates MDM Commercial as a sales representative for ourLodgeNet Interactive healthcare solution.In addition, we continued investigating other adjacent markets into which we can sell ourinteractive television system. In the second quarter of 2006, we began selling our digital systemcombined with a multi-year maintenance contract to IdleAire Technologies for installation intotravel centers. IdleAire purchases our interactive television platform, licenses our software, andcontracts with us for a variety of entertainment and service options as part of its overall serviceoffering. IdleAire is planning to install its patented Advanced Truckstop Electrification (ATE)systems in approximately 230 travel centers, having more than 13,000 total spaces, over the nexttwelve months.Another adjacent market where we have opportunities to generate new revenue growth is the timesharemarket. We estimate that the timeshare market has approximately 158,000 units in the UnitedStates, most of which do not have interactive television services. In these markets, we intend tosell our system and license our software, and earn recurring revenue from the provision of hardwareand software maintenance and sale of entertainment content.
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**Liquidity and Capital Resources**Historically, we have required substantial amounts of capital to fund operations, expand ourbusiness and service existing indebtedness. Since 2003, we have transitioned to a net free cashflow position. We define net free cash flow as cash provided by operating activities less cashused for investing activities, including growth-related capital. For the second quarter of 2006,cash provided by operating activities was $14.3 million while cash used for investing activities,including growth-related capital investments, was $12.4 million, resulting in a net difference of$1.9 million. During the second quarter of 2005, cash provided by operating activities was $15.0million while cash used for investing activities, including growth-related capital investments, was$15.5 million, resulting in a net change of $(0.5) million. Cash as of June 30, 2006 was $23.3million versus $20.7 million as of December 31, 2005.For the first six months of 2006, cash provided by operating activities was $36.3 million whilecash used for investing activities, including growth-related capital investments, was $24.9million, resulting in a net change of $11.4 million. For the first six months of 2005, cashprovided by operating activities was $33.2 million while cash used for investing activities,including growth-related capital investments, was $28.1 million, resulting in a net change of $5.1million. Typically, net free cash flow by quarter is affected by the seasonality of our businessand the payment of interest on our outstanding debt. The first quarter and the third quarternormally generate higher net free cash flow while the second quarter and the fourth quartergenerate lower to negative net free cash flow however over the course of a year, net free cash flowis expected to be positive. For 2006, we expect net free cash flow to be positive in the range of$17.0 million to $19.0 million.Our principal sources of liquidity are our cash on hand, operating cash flow and the revolverportion of our Credit Facility, which matures in 2007. Over the past twelve months we havegenerated $19.1 million of net free cash flow while having simultaneously installed more than119,000 digital rooms. Since existing operations more than fully funded our growth capital needsduring the first half of 2006, we reduced long-term debt by $11.1 million. We believe that ourcash on hand, operating cash flow and borrowing available under the Credit Facility will besufficient for the foreseeable future to fund our future growth and financing obligations. As ofJune 30, 2006, working capital was $14.6 million, compared to $13.7 million at December 31, 2005.In order to continue to operate and expand our business, we must remain in compliance withcovenants imposed by our Credit Facility and Senior Notes. As of June 30, 2006, we were incompliance with all covenants, terms and conditions related to our Credit Facility and SeniorNotes. We are not aware of any events that qualify under the material adverse effect clause of theCredit Facility. The total amount of long-term debt outstanding, including that portion of debtclassified as current, as of June 30, 2006 was $280.9 million versus $292.0 million as of December31, 2005.Our leverage and interest coverage ratios were as follows for the periods ended June 30:           2006 2005Actual consolidated total leverage ratio (1) (4)  2.99   3.31 Maximum per covenant  3.75   4.25          Actual senior secured leverage ratio (2) (4)  0.86   1.13 Maximum per covenant  2.25   2.25          Actual consolidated interest coverage ratio (3) (4)  3.55   2.93 Minimum per covenant  2.75   2.50  (1) Our maximum consolidated leverage ratio is a function of total indebtedness divided byoperating income exclusive of depreciation and amortization and other miscellaneousnon-recurring items as defined by the covenant.
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(2) Our maximum consolidated senior secured leverage ratio is a function of total indebtednessless total unsecured indebtedness, divided by operating income exclusive of depreciation andamortization and other miscellaneous non-recurring items as defined by the covenant. (3) Our minimum consolidated interest coverage ratio is a function of operating income exclusiveof depreciation and amortization and other miscellaneous non-recurring items divided byinterest expense as defined by the covenant. (4) Maximum consolidated total leverage ratio, maximum consolidated senior secured leverageratio, and minimum consolidated interest coverage ratios are not based on generally acceptedaccounting principles and are not presented as alternative measures of operating performanceor liquidity. They are presented here to demonstrate compliance with the covenants in ourCredit Facility, as noncompliance with such covenants could have a material adverse effect onus.We do not utilize special purpose entities or off balance sheet financial arrangements.Certain of our future debt covenant ratios will change as follows:       Q4 2006Maximum consolidated total leverage ratio  3.50  Maximum senior secured leverage ratio  2.25  Minimum consolidated interest coverage ratio  2.75 In January 2004, LodgeNet and the holders of the term loan amended the LIBOR pricing to be LIBORplus a margin of 3.50%. In April 2004, LodgeNet and the holders of the term loan executed anotheramendment to establish the LIBOR pricing at LIBOR plus a margin of 2.75%. In July 2005, LodgeNetand the holders of the term loan again executed an amendment to establish the LIBOR pricing atLIBOR plus a margin of 2.25%. The term loan interest rate as of June 30, 2006 was 7.88%. Therevolving credit facility matures in August 2007 and loans bear interest at our option of (1) thebank’s base rate plus a margin of 1.00% to 2.00%, or (2) LIBOR plus a margin of 2.25% to 3.25%. Asof June 30, 2006, our senior secured debt rating from Standard and Poor’s was B+ and our ratingfrom Moody’s was B1. The maturity dates of the term loan and the revolver loan under our CreditFacility are August 2008 and August 2007, respectively.In June 2003, we issued $200.0 million, principal amount of unsecured 9.50% Senior SubordinatedNotes (the “9.50% Notes”), due June 15, 2013. The proceeds of the 9.50% Notes, which were issuedat par, after underwriter fees and offering expenses, were approximately $192.5 million.Approximately $154.8 million of such proceeds were used to redeem the outstanding principal amountof the 10.25% Senior Notes, pay accrued interest, pay call premiums, and pay related fees.Approximately $35.0 million of the proceeds were used to reduce outstanding amounts under ourCredit Facility. The remaining proceeds of approximately $2.7 million were for use in fundinggeneral corporate purposes.The 9.50% Notes are unsecured, are subordinated in right of payment to all of our existing andfuture senior debt and rank *pari passu*in right of payment with any future senior subordinatedindebtedness. The 9.50% Notes require semi-annual interest payments and contain covenants whichrestrict our ability to incur additional indebtedness, create liens, pay dividends or make certaindistributions in respect to our common stock, redeemcapital stock, issue or sell stock of subsidiaries in certain circumstances, effect certainbusiness combinations and effect certain transactions with affiliates or stockholders. As of June30, 2006, we were in compliance with all covenants, terms, and conditions of the 9.50% Notes.The 9.50% Notes are redeemable at our option, in whole or in part, on or after June 15, 2008,initially at 104.75% of
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their principal amount (plus accrued and unpaid interest) declining ratablyto 100% of their principal amount (plus accrued and unpaid interest) on or after June 15, 2011. Atany time prior to June 15, 2006, the 9.50% Notes were redeemable up to 35% of the aggregateprincipal amount at 109.50% of the principal amount (plus accrued and unpaid interest) with thecash proceeds of certain equity offerings.Obligations and Commitments as of June 30, 2006 (dollar amounts in thousands):                           Payments due by period       Less than  2 – 3  4 – 5  Over   Total  1 year  years  years  5 years Contractual obligations:                    Long-term debt(s) $280,939  $2,599  $78,254  $86  $200,000 Interest on fixed rate debt  133,000   19,000   38,000   38,000   38,000 Interest on bank term loan (1)  12,594   6,004   6,590   —   —                      Other long-term obligations                    Acquired intangible asset (2)  3,750   1,250   2,500   —   — Operating lease payments  1,677   605   878   194   — Purchase obligations  4,221   4,221   —   —   — Nintendo minimum royalty (3)  29,050   4,200   8,400   8,400   8,050 Programming related minimumroyalties and commissions (4)  10,389   2,912   4,562   2,915   —                 Total contractual obligations $475,620  $40,791  $139,184  $49,595  $246,050                                            Amount of commitment expiration per period       Less than  2 – 3  4 – 5  Over   Total  1 year  years  years  5 years Other commercial commitments:                    Standby letters of credit $1,867  $1,867  $**—**  $**—**  $**—**                  (1) Interest payments are estimates based on current LIBOR and scheduled amortization. (2) In July 2002, we acquired from Hilton Hotels Corporation the right to provide Internet ontelevision access and television on-demand programming services to participating hotels andthe right to independently pursue and further develop interactive television contentthroughout our entire room base. (3) Nintendo video games pursuant to a non-exclusive license agreement with Nintendo, whichexpires in May 2013. Under the terms of the agreement, we pay a monthly royalty equal to apercent of revenue generated from the sale of Nintendo video game services, subject to amonthly minimum. (4) In connection with our programming related agreements, we may guarantee minimum royalties forspecific periods or by individual programming content.**Seasonality**Our quarterly operating results are subject to fluctuation depending upon hotel occupancy rates andother factors.Our hotel customers typically experience higher occupancy rates during the second and thirdquarters due to seasonal travel patterns and, accordingly, we historically have higher revenue inthose quarters. However, quarterly revenue can be affected by the availability of popular contentduring those quarters. We have no control over when new content is released or how popular it willbe.
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**Discussion and Analysis of Results of Operations**