**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

** **

** **

### **FORM 10-Q**

** **

**ý  Quarterly Report Pursuant to Section 13 or15(d) of the Securities Exchange Act of 1934**

** **

**Forthe quarterly period ended June 30, 2002**

** **

**CommissionFile Number 0-22334**

** **

**LodgeNetEntertainment Corporation**

(Exact name ofregistrant as specified in its charter)

 

 

| **Delaware**                     |   | **46-0371161**          |
|----------------------------------|--------|-------------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer        |
| incorporation or  organization)  |   | Identification  Number) |

 

 

**3900 West Innovation Street, SiouxFalls, South Dakota 57107**

(Address ofPrincipal Executive Offices)                (ZIP code)

 

 

**(605) 988-1000**

(Registrant’stelephone number,

including areacode)

 

 

 

(Former name,former address and former fiscal year, if changed since last report

 

 

 

 

 

                Indicate by check mark whether the Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the Registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  Yes  ý    No  o

 

                At July 24, 2002, there were 12,392,804 sharesoutstanding of the Registrant’s common stock, $0.01 par value.

 

 

----

 

 

**LodgeNet Entertainment Corporation**

 

**Index**

 

 
| **Part I.  Financial Information**                                                                     |
|-------------------------------------------------------------------------------------------------------------|
|                                                                                                        |   |   |   |
| Item 1 — Financial  Statements:                                                                        |
|                                                                                                        | Consolidated  Balance Sheets (Unaudited) as of June 30, 2002 and December 31, 2001 |   |
|                                                                                                        | Consolidated  Statements of Operations (Unaudited) for the Three Months and Six Months  Ended June 30, 2002 and 2001 |   |
|                                                                                                        | Consolidated  Statements of Cash Flows (Unaudited) for the Six Months Ended June 30, 2002  and 2001 |   |   |
|                                                                                                        | Notes  to Consolidated Financial Statements (Unaudited) |   |   |
| Item  2 — Management’s Discussion and Analysis of Financial Condition and Results  of Operations. |
|                                                                                                        |   |   |   |
| Item  3 — Quantitative and Qualitative Disclosures About Market Risk.                                  |
|                                                                                                        |   |   |   |
| **Part II.  Other Information**                                                                        |
|                                                                                                        |   |   |   |
| Item  1 — Legal Proceedings                                                                            |   |
| Item  2 — Changes in Securities and Use of Proceeds                                                    |   |   |
| Item 3 —  Defaults Upon Senior Securities                                                              |   |   |
| Item  4 — Submission of Matters to a Vote of Security Holders                                          |   |   |
| Item  5 — Other Information                                                                            |   |   |
| Item 6 —  Exhibits and Reports on Form 8-K                                                             |   |   |
|                                                                                                        |   |   |   |
| **Signatures**                                                                                              |   |   |

 

 

        As used herein (unless the contextotherwise requires) “LodgeNet”,  “theCompany” and/or “the Registrant” means LodgeNet Entertainment Corporation andits majority-owned subsidiaries.

 

2

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**Part I — Financial Information**

 

**Item 1 — Financial Statements**

 

**LodgeNetEntertainment Corporation**

**Consolidated Balance Sheets(Unaudited)**

(Dollar amounts in thousands, except share data)

 

 
|                                                                                                                                                            |   | **June 30,** |    | **December  31,** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------|---------|-------------------|--------|
|                                                                                                                                                            |   | **2002**     |    | **2001**          |   |
| Assets                                                                                                                                                          |   |         |    |              |   |
| Current assets:                                                                                                                                                 |   |         |    |              |   |
| Cash and cash  equivalents                                                                                                                                      |   | $            | 1,153   |              | $      | 1,528 |   |
| Accounts receivable,  net                                                                                                                                       |   | 33,437       |    | 26,677            |   |
| Prepaid expenses  and other                                                                                                                                     |   | 3,789        |    | 2,864             |   |
| Total current assets                                                                                                                                            |   | 38,379       |    | 31,069            |   |
|                                                                                                                                                            |   |         |    |              |   |
| Property and  equipment, net                                                                                                                                    |   | 244,156      |    | 240,274           |   |
| Investments in  and advances to unconsolidated affiliates                                                                                                       |   | 3⁄4       |    | 484               |   |
| Debt issuance  costs, net                                                                                                                                       |   | 8,170        |    | 9,176             |   |
| Other assets,  net                                                                                                                                              |   | 9,418        |    | 10,482            |   |
|                                                                                                                                                            |   | $            | 300,123 |              | $      | 291,485 |   |
|                                                                                                                                                            |   |         |    |              |   |
| Liabilities and Stockholders’ Equity (Deficit)                                                                                                             |   |         |    |              |   |
| Current  liabilities:                                                                                                                                           |   |         |    |              |   |
| Accounts payable                                                                                                                                                |   | $            | 16,292  |              | $      | 14,502 |   |
| Current  maturities of long-term debt                                                                                                                           |   | 9,159        |    | 8,168             |   |
| Accrued expenses  and other                                                                                                                                     |   | 10,531       |    | 10,251            |   |
| Deferred revenue                                                                                                                                                |   | 3,177        |    | 3,100             |   |
| Total current  liabilities                                                                                                                                      |   | 39,159       |    | 36,021            |   |
|                                                                                                                                                            |   |         |    |              |   |
| Long-term debt                                                                                                                                                  |   | 333,731      |    | 317,663           |   |
| Derivative  instruments                                                                                                                                         |   | 7,078        |    | 5,369             |   |
| Total liabilities                                                                                                                                               |   | 379,968      |    | 359,053           |   |
|                                                                                                                                                            |   |         |    |              |   |
| Commitments and  contingencies                                                                                                                                  |   |         |    |              |   |
|                                                                                                                                                            |   |         |    |              |   |
| Stockholders’  equity (deficit):                                                                                                                           |   |         |    |              |   |
| Common stock,  $.01 par value, 50,000,000 shares authorized; 12,392,804 and 12,284,998  shares outstanding at June 30, 2002 and December 31, 2001, respectively |   | 124          |    | 123               |   |
| Additional  paid-in capital                                                                                                                                     |   | 153,178      |    | 151,990           |   |
| Accumulated  deficit                                                                                                                                            |   | (224,754     | )       | (212,389          | )      |
| Accumulated  other comprehensive loss                                                                                                                           |   | (8,393       | )       | (7,292            | )      |
| Total  stockholders’ equity (deficit)                                                                                                                      |   | (79,845      | )       | (67,568           | )      |
|                                                                                                                                                            |   | $            | 300,123 |              | $      | 291,485 |   |

 

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

3

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### **LodgeNetEntertainment Corporation**

**Consolidated Statements of Operations(Unaudited)**

(Dollar amounts,except per share amounts, in thousands)

 
|                                                                               |   | **Three  Months Ended** |   | **Six Months  Ended** |   |
|------------------------------------------------------------------------------------|--------|-------------------------|--------|-----------------------|--------|
|                                                                               |   | **June 30,**            |   | **June 30,**          |   |
|                                                                               |   | **2002**                |   | **2001**              |   | **2002** |   | **2001** |   |
| Revenues:                                                                          |   |                    |   |                  |   |   |   |   |   |
| Guest Pay                                                                          |   | $                       | 56,181 |                  | $      | 52,323 |   | $ | 108,818 |   | $ | 101,104 |   |
| Other                                                                              |   | 2,520                   |   | 2,775                 |   | 4,892 |   | 5,032 |   |
| Total revenues                                                                     |   | 58,701                  |   | 55,098                |   | 113,710 |   | 106,136 |   |
|                                                                               |   |                    |   |                  |   |   |   |   |   |
| Direct costs:                                                                      |   |                    |   |                  |   |   |   |   |   |
| Guest Pay                                                                          |   | 23,852                  |   | 21,418                |   | 45,213 |   | 41,067 |   |
| Other                                                                              |   | 1,397                   |   | 1,834                 |   | 2,678 |   | 3,208 |   |
| Total direct  costs (exclusive of other operating expenses shown separately below) |   | 25,249                  |   | 23,252                |   | 47,891 |   | 44,275 |   |
|                                                                               |   |                    |   |                  |   |   |   |   |   |
| Gross profit  (exclusive of other operating expenses shown separately below)       |   | 33,452                  |   | 31,846                |   | 65,819 |   | 61,861 |   |
|                                                                               |   |                    |   |                  |   |   |   |   |   |
| Operating  expenses:                                                               |   |                    |   |                  |   |   |   |   |   |
| Guest Pay operations                                                               |   | 7,468                   |   | 7,120                 |   | 14,460 |   | 14,464 |   |
| Selling, general  and administrative                                               |   | 4,960                   |   | 5,417                 |   | 10,720 |   | 10,710 |   |
| Depreciation and  amortization                                                     |   | 18,899                  |   | 16,371                |   | 37,292 |   | 32,872 |   |
| Total operating  expenses                                                          |   | 31,327                  |   | 28,908                |   | 62,472 |   | 58,046 |   |
|                                                                               |   |                    |   |                  |   |   |   |   |   |
| Operating income                                                                   |   | 2,125                   |   | 2,938                 |   | 3,347 |   | 3,815 |   |
|                                                                               |   |                    |   |                  |   |   |   |   |   |
| Investment gains  (losses)                                                         |   | 546                     |   | (418                  | )      | 826 |   | (898 | ) |
| Interest expense                                                                   |   | (8,275                  | )      | (7,230                | )      | (16,401 | ) | (14,361 | ) |
| Other income  (expense), net                                                       |   | 73                      |   | (11                   | )      | 157 |   | 55 |   |
|                                                                               |   |                    |   |                  |   |   |   |   |   |
| Loss before  income taxes                                                          |   | (5,531                  | )      | (4,721                | )      | (12,071 | ) | (11,389 | ) |
| Provision for  income taxes                                                        |   | (170                    | )      | (207                  | )      | (294 | ) | (320 | ) |
| Net loss                                                                           |   | $                       | (5,701 | )                     | $      | (4,928 | ) | $ | (12,365 | ) | $ | (11,709 | ) |
|                                                                               |   |                    |   |                  |   |   |   |   |   |
| Net loss per  common share (basic and diluted)                                     |   | $                       | (0.46  | )                     | $      | (0.40 | ) | $ | (1.00 | ) | $ | (0.96 | ) |
| Weighted average  shares outstanding                                               |   | 12,381,234              |   | 12,230,234            |   | 12,341,323 |   | 12,221,272 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

4

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**LodgeNetEntertainment Corporation**

**Consolidated Statements of Cash Flows(Unaudited)**

(Dollar amounts inthousands)

 

 
|                                                                             |   | **Six Months  Ended June 30,** |    |
|----------------------------------------------------------------------------------|--------|--------------------------------|---------|
|                                                                             |   | **2002**                       |    | **2001** |   |
| Operating  activities:                                                           |   |                           |    |   |   |
| Net loss                                                                         |   | $                              | (12,365 | ) | $ | (11,709 | ) |
| Adjustments to  reconcile net loss to net cash provided by operating activities: |   |                           |    |   |   |
| Depreciation and  amortization                                                   |   | 37,292                         |    | 32,872 |   |
| Investment  (gains) losses                                                       |   | (826                           | )       | 898 |   |
| Other, net                                                                       |   | 3⁄4                         |    | 88 |   |
| Change in  operating assets and liabilities:                                     |   |                           |    |   |   |
| Accounts  receivable, net                                                        |   | (6,685                         | )       | (1,232 | ) |
| Prepaid expenses  and other                                                      |   | (878                           | )       | 551 |   |
| Accounts payable                                                                 |   | 1,770                          |    | (194 | ) |
| Accrued expenses  and other                                                      |   | 312                            |    | (990 | ) |
| Other                                                                            |   | (48                            | )       | (806 | ) |
| Net cash  provided by operating activities                                       |   | 18,572                         |    | 19,478 |   |
|                                                                             |   |                           |    |   |   |
| Investing  activities:                                                           |   |                           |    |   |   |
| Property and  equipment additions                                                |   | (37,265                        | )       | (39,152 | ) |
| Proceeds from  sale of investments                                               |   | 3⁄4                         |    | 1,393 |   |
| Proceeds from  affiliates, net                                                   |   | 1,360                          |    | 1,482 |   |
| Net cash used  for investing activities                                          |   | (35,905                        | )       | (36,277 | ) |
|                                                                             |   |                           |    |   |   |
| Financing  activities:                                                           |   |                           |    |   |   |
| Borrowings under  revolving credit facility                                      |   | 20,000                         |    | 21,000 |   |
| Repayments of  revolving credit facility                                         |   | (3,000                         | )       | 3⁄4 |   |
| Repayment of  long-term debt                                                     |   | (771                           | )       | (7,520 | ) |
| Repayment of  capital lease obligations                                          |   | (302                           | )       | (240 | ) |
| Debt issuance  costs                                                             |   | 3⁄4                         |    | (78 | ) |
| Exercise of  stock options                                                       |   | 973                            |    | 340 |   |
| Net cash  provided by financing activities                                       |   | 16,900                         |    | 13,502 |   |
|                                                                             |   |                           |    |   |   |
| Effect of  exchange rates on cash                                                |   | 58                             |    | (12 | ) |
| Decrease in cash  and cash equivalents                                           |   | (375                           | )       | (3,309 | ) |
| Cash and cash  equivalents at beginning of period                                |   | 1,528                          |    | 4,059 |   |
| Cash and cash  equivalents at end of period                                      |   | $                              | 1,153   |   | $ | 750 |   |
|                                                                             |   |                           |    |   |   |
| Supplemental  cash flow information:                                             |   |                           |    |   |   |
| Cash paid for  interest                                                          |   | $                              | 16,226  |   | $ | 15,756 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

### ** **

5

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### **LodgeNet Entertainment Corporation**

**Notes to Consolidated FinancialStatements (Unaudited)**

 

 

Note 1 — Basis ofPresentation

 

The accompanyingconsolidated financial statements as of June 30, 2002, and for the three andsix month periods ended June 30, 2002 and 2001, have been prepared by LodgeNetEntertainment Corporation (the “Company”), without audit, pursuant to the rulesand regulations of the Securities and Exchange Commission (the “Commission”).  The information furnished in theaccompanying consolidated financial statements reflects all adjustments,consisting only of normal recurring adjustments, which, in the opinion ofmanagement, are necessary for a fair presentation of such financial statements.

 

Certain information andfootnote disclosures, normally included in financial statements prepared inaccordance with generally accepted accounting principles, have been condensedor omitted pursuant to the rules and regulations of the Commission. Althoughthe Company believes that the disclosures are adequate to make the informationpresented herein not misleading, it is recommended that these unauditedconsolidated financial statements be read in conjunction with the more detailedinformation contained in the Company’s Annual Report on Form 10-K for 2001, asfiled with the Commission. The results of operations for the three and sixmonth periods ended June 30, 2002 and 2001 are not necessarily indicative ofthe results of operations for the full year due to inherent seasonality withinthe business among other factors.

 

The consolidatedfinancial statements include the accounts of LodgeNet Entertainment Corporationand its majority-owned subsidiaries. All significant intercompany accounts and transactions have beeneliminated in consolidation.

 

Note 2 — Property andEquipment, Net

 

Property and equipmentwas comprised as follows (in thousands):

 
|                                       |   | **June 30,** |    | **December  31,** |   |
|--------------------------------------------|--------|--------------|---------|-------------------|--------|
|                                       |   | **2002**     |    | **2001**          |   |
| Land, building  and equipment              |   | $            | 71,123  |              | $      | 68,007 |   |
| Free-to-guest  equipment                   |   | 26,384       |    | 24,798            |   |
| Guest Pay  systems:                        |   |         |    |              |   |
| Installed                                  |   | 427,503      |    | 399,520           |   |
| System  components                         |   | 28,199       |    | 27,548            |   |
| Software costs                             |   | 15,902       |    | 14,793            |   |
| Total                                      |   | 569,111      |    | 534,666           |   |
| Less —  depreciation and amortization |   | (324,955     | )       | (294,392          | )      |
| Property and  equipment, net               |   | $            | 244,156 |              | $      | 240,274 |   |

 

6

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Note 3 — Loss Per CommonShare

 

Basic earnings per shareis computed based only on the weighted average number of common shares actuallyoutstanding during the period. Diluted earnings per share is computed based onthe weighted average number of common shares outstanding plus all potentiallydilutive common shares outstanding during the period.  Potential dilutive common shares that have an anti-dilutive effectare excluded from diluted earnings per share.

 

The loss per common sharefor the three months ended June 30, 2002 and 2001 and for the six months endedJune 30, 2002, and 2001 is based on 12,381,234, 12,230,234, 12,341,323, and12,221,272 weighted average shares outstanding during the respectiveperiods.  Potential common shares werenot included in the computation of diluted earnings per share because theirinclusion would be anti-dilutive. As of June 30, 2002 and 2001, the number of potential common shares wasapproximately 4,629,000 and 4,255,000, respectively.  Such potential dilutive common shares consist of stock optionsand warrants.  The foregoing potentialdilutive common share amounts do not take into account the assumed number ofshares that would be repurchased by the Company upon the exercise of stockoptions or warrants.

 

Note 4 — Long-term Debtand Credit Facilities

 

Long-term debt was comprised as follows (in thousands):

 
|                       |   | **June 30,  2002** |    | **December  31, 2001** |   |
|----------------------------|--------|--------------------|---------|------------------------|--------|
| Bank Credit  Facility:     |   |               |    |                   |   |
| Bank term loan             |   | $                  | 148,875 |                   | $      | 149,625 |   |
| Revolving credit  facility |   | 17,000             |    | 3⁄4                 |   |
| 10.25% senior  notes       |   | 150,000            |    | 150,000                |   |
| 11.50% senior  notes       |   | 24,000             |    | 24,000                 |   |
| Less unamortized  discount |   | (251               | )       | (333                   | )      |
| Capital leases             |   | 2,444              |    | 1,697                  |   |
| Other                      |   | 822                |    | 842                    |   |
|                       |   | 342,890            |    | 325,831                |   |
| Less current  maturities   |   | (9,159             | )       | (8,168                 | )      |
|                       |   | $                  | 333,731 |                   | $      | 317,663 |   |

 

*Bank Credit Facility*3⁄4 On August 29, 2001, the Companyentered into a $225 million bank credit facility, comprised of a $150 millionterm loan and a $75 million revolving credit facility which may be increased to $100 million,subject to certain limitations.  Theterm loan matures in June 2006 and quarterly repayments began in December2001.  The term loan bears interest atthe Company’s option of (1) the bank’s base rate plus a margin of 2.75% or (2)LIBOR plus a margin of 4.00%.  The termloan interest rate as of June 30, 2002 was 5.86%.  The revolving credit facility matures in June 2006, and loansbear interest at the Company’s option of (1) the bank’s base rate plus a marginof from 1.00% to 1.75%, or (2) LIBOR plus a margin of from 2.25% to 3.00%.  The weighted average interest rate for therevolving credit facility as of June 30, 2002 was 4.86%.  Loans under the credit facility arecollateralized by a first priority security interest in all of the Company’sassets.

 

The facility provides for the issuance of lettersof credit up to $10 million, subject to customary terms and conditions.  As of June 30, 2002, the Company hadoutstanding letters of credit totaling $2.0 million.

 

The facility includes terms and conditions whichrequire compliance in accordance with a material adverse effect covenant aswell as the maintenance of certain financial ratios and place limitations oncapital expenditures, additional indebtedness, liens, investments, guarantees,asset sales and certain payments or distributions in respect of the commonstock.  As of June 30, 2002, the Companywas in compliance with all covenants, terms and conditions of the bank creditfacility.

 

7

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*10.25% SeniorNotes***—**In December 1996, the Companyissued $150 million of unsecured 10.25% senior notes (the “10.25% Notes”), dueDecember 15, 2006.  The 10.25% Notes areunsecured, rank *pari passu* in right of payment with future unsubordinatedunsecured indebtedness and rank senior in right of payment to all subordinatedindebtedness of the Company.  The 10.25%Notes require semi-annual interest payments and contain certain restrictivecovenants.  As of June 30, 2002, theCompany was in compliance with all covenants, terms, and conditions of the10.25% Notes.

 

The 10.25% Notes are redeemable at the option of the Company, in wholeor in part, after December 15, 2001, initially at 105.125% of their principalamount (plus accrued and unpaid interest) declining ratably to 100% of theirprincipal amount (plus accrued and unpaid interest) on or after December 15,2003.

 

*11.50% SeniorNotes***—**During 1995, the Company issued$30 million principal amount of unsecured 11.50% senior notes (the “11.50%Notes”).  Mandatory annual principalpayments of $6 million commenced in July 2001 and continue through July2005.  Semi-annual interest payments arerequired.  The Company issued a total of480,000 warrants to purchase common stock of the Company in connection with theissuance of the 11.50% Notes and the value of the warrants, $1.68 million, wasrecorded as additional paid-in capital and shown as a discount on the 11.50%Notes.  As part of the refinancingtransaction in which the 10.25% Notes were issued, the holders of the 11.50%Notes adopted the covenants and ranking of the 10.25% Notes.

 

Long-term debt has the following scheduled principal maturities for the12 month periods ended June 30 (in thousands of dollars): 2003 — $9,159; 2004 —$8,257; 2005 — $8,056; 2006 — $167,418; 2007 — $150,000.

 

The Company does not utilize special purposeentities or off-balance sheet financial arrangements.

 

Note 5 3⁄4Accounting for Derivative Instruments and Hedging Activities

 

In March 2002, the Company entered into a $50 million interest rateswap agreement, which expires in March 2006. In addition, the Company had existing interest rate swap agreements on$100 million of long-term debt, of which $50 million expire in March 2003 and$50 million expire in December 2005. The Company is required by its bank creditfacility to have in place a minimum of $100 million swap agreements thatconvert variable rate interest debt into fixed interest rate loans.  The swap agreements have been designated as,and meet the criteria for, cash flow hedges and are not considered speculativein nature.  Note 6 3⁄4Comprehensive Income (Loss)

 

Statement of Financial Accounting Standard No. 130, “ReportingComprehensive Income,” provides standards for reporting and disclosure ofcomprehensive income and its components. Comprehensive income reflects the changes in equity during a period fromtransactions and other events and circumstances from non-owner sources.  For the Company, comprehensive loss was asfollows for the periods ended June 30 (in thousands):

 
|                                                                                           |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended June 30,** |   |
|------------------------------------------------------------------------------------------------|--------|----------------------------------------|--------|--------------------------------|--------|
|                                                                                           |   | **2002**                               |   | **2001**                       |   | **2002** |   | **2001** |   |
| Net loss                                                                                       |   | $                                      | (5,701 | )                              | $      | (4,928 | ) | $ | (12,365 | ) | $ | (11,709 | ) |
| Foreign currency  translation adjustment                                                       |   | 628                                    |   | 492                            |   | 608 |   | (90 | ) |
| Unrealized gain  on marketable securities                                                      |   | 3⁄4                                 |   | 330                            |   | 3⁄4 |   | 3⁄4 |   |
| Cumulative  effect of adoption of SFAS No. 133                                                 |   | 3⁄4                                 |   | 3⁄4                         |   | 3⁄4 |   | (1,287 | ) |
| Unrealized gain  (loss) on derivative instruments instrum instrument derivativediinsnstruments |   | (2,939                                 | )      | 654                            |   | (1,709 | ) | (1,687 | ) |
| Comprehensive  loss                                                                            |   | $                                      | (8,012 | )                              | $      | (3,452 | ) | $ | (13,466 | ) | $ | (14,773 | ) |

 

8

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Note 7 3⁄4 Effect of Recently Issued AccountingStandards

 

In July 2001, the Financial Accounting Standards Board issued SFAS No.142, “Goodwill and Other Intangible Assets” which eliminates the currentrequirement to amortize goodwill and indefinite-lived intangible assets,addresses the amortization of intangible assets with a defined life andaddresses the impairment testing and recognition for goodwill and intangibleassets.  Effective January 1, 2002, theCompany adopted the provisions of this statement, which had no impact on itsconsolidated financial statements.

 

In June 2001, the Financial Accounting Standards Board issued SFAS No.143, “Accounting for Obligations Associated with the Retirement of Long-LivedAssets”. SFAS No. 143 primarily establishes accounting standards for therecognition and measurement of an asset retirement obligation and itsassociated asset retirement costs. The provisions of SFAS No. 143 will beeffective for fiscal years beginning after June 15, 2002.  The Company has determined the adoption ofthis statement will not significantly impact its consolidated financial statements.

 

In October 2001, the Financial Accounting Standards Board issued SFASNo. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. SFASNo. 144 supercedes SFAS 121, “Accounting for the Impairment of Long-LivedAssets and for Long-Lived Assets to Be Disposed Of”. SFAS No. 144 primarilyaddresses significant issues relating to the implementation of SFAS No. 121 anddevelops a single accounting model for long-lived assets to be disposed of,whether previously held and used or newly acquired.  Effective January 1, 2002, the Company adopted the provisions ofSFAS No. 144, which had no impact on its consolidated financial statements.

 

In April 2002, theFinancial Accounting Standards Board issued SFAS No. 145, “Rescission of FASBStatements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and TechnicalCorrections”, effective for fiscal years beginning after June 15, 2002.  SFAS No. 145 will require gains and losseson extinguishments of debt to be classified as income or loss from continuingoperations rather than as extraordinary items as previously required under SFASNo. 4. Extraordinary treatment will be required for certain extinguishments asprovided in APB Opinion No. 30.  SFASNo. 145 also amends SFAS No. 13 to require certain modifications to capitalleases be treated as a sale-leaseback and modifies the accounting forsub-leases when the original lessee remains a secondary obligor (orguarantor).  In addition, the FASBrescinded SFAS No. 44, which addressed the accounting for intangible assets ofmotor carriers and made numerous technical corrections.  The Company is currently evaluating theeffect of the adoption of this statement, however the Company does not believethat it will have an impact on its consolidated financial statements.

 

In November 2001, the FASB Emerging Issues Task Force issued EITF 01-9,“Accounting for Consideration Given by a Vendor to a Customer or a Reseller ofthe Vendor’s Products”.  The EITFconcluded that certain consideration from a vendor to a customer is to bereported as a reduction of revenue. Effective January 1, 2002, the Company adopted the provisions of EITF01-9, which had no impact on its consolidated financial statements.

 

9

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Note 8 3⁄4 Contract Terminations

 

On April 12, 2002, theCompany terminated the InnMedia Distribution and Carriage Agreement, datedOctober 9, 2000, and the InnMedia Services Agreement, dated October 9, 2000,with InnMedia.  The terminationsfollowed the institution of legal proceedings by InnMedia against theCompany.  The agreements were terminateddue to, among other things, InnMedia’s repudiation of the agreements andInnMedia’s failure to perform under the agreements.   As a result of the dispute with InnMedia, the Company continuedto incur the costs associated with the provisioning of InnMedia’s services,totaling $805,000 during the second quarter of 2002.  As of June 30, 2002, the Company had a receivable balance fromInnMedia of approximately $2.8 million and a payable to InnMedia ofapproximately $1.6 million, the net of which was fully reserved.  (See Part II - Legal Proceedings)

 

Note 9 3⁄4 Subsequent Event

 

Effective August 2, 2002,the Company and InnMedia’s co-owner, Hilton Hotels Corporation (“Hilton”),mutually agreed to dissolve InnMedia. At that time, InnMedia and the Company mutually released their claimsagainst each other, and the lawsuit filed by InnMedia against the Company hasbeen dismissed with prejudice.  TheCompany also expanded its Master Services Agreement with Hilton to provide television-basedInternet access and time-shifted TV programming services to participatinghotels.  Additionally, the existingseven-year contracts with certain installed Hilton-owned properties,encompassing approximately 24,000 rooms, were extended by six months.  In return for the extension of the Hiltonproperty contracts and certain other economic benefits the Company receivedunder the revised agreement, including the right to independently pursue anddevelop interactive television content throughout the Company’s entire roombase, the Company agreed to pay Hilton $9 million in six payments over a fiveyear period, which have a present value of approximately $6.5 million.

 

 

10

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**Item2 —****Management’s Discussion and Analysis of FinancialCondition and Results of Operations**

 

*The following discussion andanalysis provides information concerning our results of operations andfinancial condition.  This discussionshould be read in conjunction with the accompanying consolidated financialstatements and the notes thereto.*

 

***Special Note Regarding Forward-Looking Statements***

 

*Certain statements in this Quarterly Report on Form10-Q constitute “forward-looking statements”. When used in this Quarterly Report, the words “expects,” “anticipates,”“estimates,” “believes,” “intends,” “no assurance” and similar expressions andstatements which are made in the future tense, are intended to identify suchforward-looking statements.  Suchforward-looking statements involve known and unknown risks, uncertainties andother factors, which may cause the Company’s actual results, performance orachievements to be materially different from any future results, performance orachievements expressed or implied by such forward-looking statements.  In addition to the risks and uncertaintiesdiscussed elsewhere herein, such factors include, among others, the following:the impact of competition and changes to the competitive environment for theCompany’s products and services, changes in technology, reliance on strategicpartners, uncertainty of litigation, changes in government regulation and otherfactors detailed, from time to time, in the Company’s filings with theSecurities and Exchange Commission. These forward-looking statements speak only as of the date of thisQuarterly Report.  The Company expresslydisclaims any obligation or undertaking to release publicly any updates orrevisions to any forward-looking statements contained herein to reflect anychange in the Company’s expectations with regard thereto or any change inevents, conditions or circumstances on which any such statement is based.*

 

 

**Overview —**

 

LodgeNet, theworld’s largest provider of television-based broadband services to thehospitality industry, specializes in the delivery of interactive television andtelevision-based Internet access services to the lodging industry throughoutthe United States, Canada and select international markets. As of June 30,2002, the Company provided interactive and television services to approximately5,600 hotel properties, more properties than any other broadband serviceprovider in the world. The Company’s services are designed to serve the needsof the lodging industry and the traveling public and include on-demand movies,music and music videos, Nintendo® video games, Internet-enhanced television,which does not require a laptop for access, high-speed Internet access, andother interactive services, all of which are referred to as Guest Payinteractive services. The Company has installed its interactive televisionsystem in more than 847,000 of its rooms, which host more than 260 millionguests on an annual basis.

 

*Guest PayInteractive Services.* Guest Pay interactive services are purchased byguests on a per-view, hourly, or daily basis and include on–demandmovies, music and music videos, network–based video games,Internet-enabled television, and high-speed Internet access services. Guest Paypackages may also include video review of room charges, video checkout, guestsurveying, and merchandising services that are paid for by the hotel andprovided to guests at no charge.

 

The Company’s Guest Pay interactive revenues depend on a number offactors, including the number of rooms equipped with the Company’s systems,hotel occupancy rates and guest demographics, and the popularity, pricing, andavailability of programming.  Theprimary direct costs of providing Guest Pay interactive services are(i) license fees paid to studios for non–exclusive distributionrights to recently–released major motion pictures; (ii) one–timelicense fees paid for independent films; (iii) license fees for otherinteractive services; (iv) Internet connectivity costs; and (v) thecommission retained by the hotel.  GuestPay operating expenses include costs of system maintenance and support,programming delivery and distribution, data retrieval, insurance, and personalproperty taxes.

 

11

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The room installations for the twelve months endedJune 30, 2002 represent an increase of 10.2% for Guest Pay interactive rooms ascompared to June 30, 2001. Additionally, Digital services rooms, as describedbelow, increased 303.2% over the number of installed rooms at June 30, 2001.De-installation activity for the year has been less than 1% of the installednumber of rooms.

 

The Company’s baseof installed rooms was comprised as follows at June 30:

 
|                             |   | **2002** |   | **2001** |   |
|----------------------------------|--------|----------|--------|----------|--------|
|                             |   |     |   |     |   |
| Guest Pay  interactive rooms (1) |   | 847,380  |   | 769,213  |   |
| Digital services  rooms (2)      |   | 184,554  |   | 45,777   |   |
| Total rooms  served (3)          |   | 929,696  |   | 849,769  |   |

 

(1) — 100% ofGuest Pay interactive rooms are served by the Company’s on-demand movie system(as compared to a scheduled movie system that shows movies at predeterminedtimes).

 

(2) — Digitalservices rooms are equipped with theinteractive digital systems where on-demand movies and music content areupdated and delivered via satellite to the Company’s systems within respectivehotels. Digital rooms are included with the total Guest Pay interactiverooms and represent nearly 22% of the Guest Pay interactive rooms served.

 

(3) — Total roomsserved represent rooms receiving one or more of the Company’s services,including rooms served by international licensees.

 

*Free-to-Guestand Other Services.* In addition to Guest Pay interactive services, theCompany provides satellite-delivered basic and premium cable televisionprogramming and other interactive entertainment and information services thatare paid for by the hotel and provided to guests at no charge, all of which arereferred to as free-to-guest services. The hotel pays the Company a fixedmonthly charge per room for each programming channel provided. The Companyobtains its free–to–guest programming pursuant to multi–yearagreements and pays a monthly fee per room, which varies depending on incentiveprograms in effect from time to time.

 

To meet the needs of its hotel customers related to the Company’sservice offerings, the Company provides a variety of other services to itshotel customers including the sale of system equipment and service parts andlabor. Results from these other services and free-to-guest services deliveredto rooms not receiving Guest Pay interactive services are included in the“other” components of revenues and direct costs in the statements of operations.

 

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*InnMediaLLC.*  In October of 2000, the Company created ajoint venture with Hilton Hotels Corporation, named InnMedia LLC, to provideinteractive television and television-based Internet access services fordistribution to the lodging industry. At that time the Company entered into various agreements with InnMediapursuant to which the Company agreed to obtain interactive television andtelevision-based Internet access services exclusively from InnMedia and toprovide InnMedia with equipment and services necessary to distribute suchcontent.  InnMedia and Hilton alsoentered into an agreement whereby InnMedia became the exclusive provider ofinteractive television content and Internet access services to various Hiltonhotels.  At that time, the Company alsoentered into a Master Services Agreement with Hilton pursuant to which theCompany was named the exclusive guest-pay provider to Hilton owned hotels andthe preferred guest pay provider to various Hilton managed and franchisedhotels of movies, games and music content.

 

On April 12, 2002, theCompany terminated the InnMedia Distribution and Carriage Agreement, datedOctober 9, 2000, and the InnMedia Services Agreement dated October 9, 2000, withInnMedia.  The terminations followed theinstitution of legal proceedings by InnMedia against the Company.  The agreements were terminated due to, amongother things, InnMedia’s repudiation of the agreements and InnMedia’s failureto perform under the agreements.   As aresult of the dispute with InnMedia, the Company continued to incur the costsassociated with the provisioning of InnMedia’s services, totaling $805,000during the second quarter of 2002.  Asof June 30, 2002, the Company had a receivable balance from InnMedia ofapproximately $2.8 million and a payable to InnMedia of approximately $1.6million, the net of which was fully reserved. ..  Effective August 2, 2002, theCompany and Hilton mutually agreed to dissolve InnMedia.  In connection with the dissolution ofInnMedia, the lawsuit filed by InnMedia against the Company has been dismissedwith prejudice  and InnMedia and theCompany mutually released their claims against each other.

 

**Critical Accounting Policies**

 

*Propertyand Equipment***—**Propertyand equipment is stated at cost, net of accumulated depreciation andamortization.  Installed Guest Pay andfree-to-guest systems consist of equipment and related costs of installation,including certain payroll costs. Maintenance costs, which do not significantly extend the useful lives ofthe respective assets, and repairs, are charged to operations as incurred.  Depreciation of Guest Pay and free-to-guestsystems begins when such systems are installed and activated.  Depreciation of other equipment begins whensuch equipment is placed in service. The Company attributes no salvage value toequipment. Depreciation and amortization is computed using the straight-linemethod over the following useful lives, not to exceed the life of a contract:

 
|                |   | **Years** |   |
|---------------------|--------|-----------|--------|
| Buildings           |   | 30        |   |
| Guest Pay  systems: |   |      |   |
| System  components  |   | 5 - 7     |   |
| In-room  equipment  |   | 2 - 5     |   |
| Other equipment     |   | 3 - 10    |   |

 

*SoftwareDevelopment***—**TheCompany has capitalized certain costs of developing software for its Guest Paysystems in accordance with AICPA Statement of Position 98-1, “Accounting forthe Costs of Computer Software Developed or Obtained for Internal Use”.Capitalized costs are reported at the lower of unamortized cost or netrealizable value, and are amortized over the system’s estimated useful life,not to exceed five years.

 

*RevenueRecognition***—**Revenuefrom the sale of interactive television services is recognized in the periodthe services are provided.  Revenue fromthe sale of system equipment and service parts and labor is recognized when theequipment is delivered or the service has been provided. Deferred revenueconsists of advance billings for certain interactive television services thatare recognized in the periods that services are provided.

 

 

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### **Discussion and Analysis of Results of Operations**

**Three Months Ended June 30, 2002 and2001**

 

 

*Revenue Analysis*.  TheCompany’s total revenue for the second quarter of 2002 increased 6.5%, or $3.6million, in comparison to the second quarter of 2001. The following table setsforth the components of revenue (in thousands) for the quarter ending June 30:

** **
|         |   | **2002**   |   | **2001**     |   |
|--------------|--------|------------|--------|--------------|--------|
|         |   |       |   | **Percent**  |   |   |   | **Percent** |   |
|         |   |       |   | **of Total** |   |   |   | **of Total** |   |
| **Revenue:** |   | **Amount** |   | **Revenue**  |   | **Amount** |   | **Revenue** |   |
| Guest Pay    |   | $          | 56,181 |         | 95.7   |   | $ | 52,323 |   | 95.0 |   |
| Other        |   | 2,520      |   | 4.3          |   | 2,775 |   | 5.0 |   |
|         |   | $          | 58,701 |         | 100.0  |   | $ | 55,098 |   | 100.0 |   |

 

Guest Pay interactiverevenue increased 7.4% or $3.9 million, in the second quarter of 2002 ascompared to the second quarter of 2001. ** **Thisincrease was attributable to a 10.8% increase in the average number ofinstalled Guest Pay interactive rooms, offset by a 3.1% decrease in averagemonthly revenue per room.  The followingtable sets forth information in regard to average monthly Guest Pay interactiverevenue per room for the quarter ending June 30:

** **
|                               |   | **2002** |   | **2001** |   |
|------------------------------------|--------|----------|--------|----------|--------|
| Average monthly  revenue per room: |   |     |   |     |   |
| Movie revenue                      |   | $        | 18.20  |     | $      | 18.55 |   |
| Other  interactive service revenue |   | 4.22     |   | 4.59     |   |
| Total per Guest  Pay room          |   | $        | 22.42  |     | $      | 23.14 |   |

 

Average movie revenue perroom decreased 1.9% as a result of a 110 basis point decrease in occupancy levels versus the second quarterof 2001. Other interactive service revenue per room decreased by 8.1% due tothe termination of the InnMedia agreement. As a result of the termination, the Company did not recognize systemaccess revenue from InnMedia in the second quarter of 2002. In the secondquarter of 2001, the Company recognized $597,000 of Internet related revenue.

 

Revenue from other sources includes revenue from free-to-guest servicesprovided to hotels not receiving Guest Pay services and the sales of systemequipment and service parts and labor. Other revenue decreased $255,000 or 9.2% due to decreased equipment salesto international licensees.

 

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*Gross Profit (exclusive of other operating expensesdiscussed separately below).*  Gross profittotaled $33.5 million for the second quarter ended June 30, 2002, an increaseof 5.0% over the second quarter of 2001 on a 6.5% increase in revenue (dollaramounts in thousands).

 
|                  |   | **2002** |   | **2001** |   |
|-----------------------|--------|----------|--------|----------|--------|
| Gross profit:         |   |     |   |     |   |
| Guest Pay             |   | $        | 32,329 |     | $      | 30,905 |   |
| Other                 |   | 1,123    |   | 941      |   |
|                  |   | $        | 33,452 |     | $      | 31,846 |   |
|                  |   |     |   |     |   |
| Gross profit  margin: |   |     |   |     |   |
| Guest Pay             |   | 57.5     | %      | 59.1     | %      |
| Other                 |   | 44.6     | %      | 33.9     | %      |
| Composite             |   | 57.0     | %      | 57.8     | %      |

 

Gross profit on Guest Payinteractive services increased 4.6%, or $1.4 million, on a 7.4% increase inrelated revenue.  Guest Pay direct costs(primarily studio license fees, license fees for other interactive services,Internet connectivity fees, and the commission retained by the hotel) areprimarily based on related revenue, and such costs generally vary directly withrevenue.  As a percentage of revenue,the decrease in gross profit margin from 59.1% to 57.5% was primarily due toadditional costs absorbed as a result of the termination of the InnMediaDistribution and Carriage Agreement. The additional costs, net of proceedsderived from the InnMedia programming content, totaled $805,000.

 

Gross profit on otherservices increased $182,000 or 19.3% in the second quarter of 2002 from theprior year quarter and the gross profit margin increased from 33.9% to44.6%.  These increases were due to lower costs related to cable programming services,which resulted from favorable pricing and incentive arrangements.

 

As a percentage ofrevenue, the Company’s overall gross profit margin decreased from 57.8% to57.0%.  The decrease in gross marginfrom Guest Pay interactive services was partially offset by an increase inother gross margin as described above.

 

*Operating Expenses.*  The followingtable sets forth information in regard to the Company’s operating expenses forthe quarter ending June 30 (dollar amounts in thousands):

 
|                                 |   | **2002**   |   | **2001**     |   |
|--------------------------------------|--------|------------|--------|--------------|--------|
|                                 |   |       |   | **Percent**  |   |   |   | **Percent** |   |
|                                 |   |       |   | **of Total** |   |   |   | **of Total** |   |
|                                 |   | **Amount** |   | **Revenues** |   | **Amount** |   | **Revenues** |   |
| Operating  expenses:                 |   |       |   |         |   |   |   |   |   |
| Guest Pay  operations                |   | $          | 7,468  |         | 12.7   |   | $ | 7,120 |   | 13.0 |   |
| Selling, general  and administrative |   | 4,960      |   | 8.5          |   | 5,417 |   | 9.8 |   |
| Depreciation and  amortization       |   | 18,899     |   | 32.2         |   | 16,371 |   | 29.7 |   |
| Total operating  expenses            |   | $          | 31,327 |         | 53.4   |   | $ | 28,908 |   | 52.5 |   |

 

Guest Pay operations expenses consist of costs directly related to theoperation of systems at hotel sites. Guest Pay operations expenses increased 4.9%, or $348,000 in the secondquarter of 2002, compared to the second quarter of 2001. The increase resultedfrom the additional 81,600 average rooms in operation, offset by improved costcontrols and greater operating efficiencies. Per average installed room, Guest Pay operations expenses decreased 5.4%from $3.15 per month during the second quarter of 2001 to $2.98 per monthduring the second quarter of 2002.

 

Selling, general and administrative expensesdecreased $457,000 or 8.4% in the second quarter of 2002 compared to the prioryear quarter.  The decrease was due tostrong cost control measures implemented by the Company.  As a percentage of revenue, such expensesdecreased to 8.4% in the second quarter of 2002 from 9.8% in the prior yearquarter.

 

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Depreciationand amortization expenses increased to $18.9 million in the second quarter of2002 from $16.4 million in the year earlier quarter.  This increase was due to the 10.8% increase in the average numberof rooms in operation driven by the installation of the digital platform. Atthe end of second quarter of 2002, the interactive digital system had beeninstalled in more than 184,000 rooms. Additionally, the increase was due to theassociated software costs and other capitalized costs including service vans,equipment, and computers that are related to the increased number of rooms inservice since the prior year.  As apercentage of revenue, depreciation and amortization expenses increased to32.2% in the current quarter from 29.7% in the second quarter of 2001.

 

*Operating Income.*  For thereasons previously described, the Company generated operating income of $2.1million in the second quarter of 2002 compared to $2.9 million in the secondquarter of 2001.

 

*InvestmentGains (Losses)*.  Prior to the second quarter of 2001, theCompany owned a minority interest in Global Interactive CommunicationsCorporation (“GICC”) resulting from the merger transaction involving ResNetCommunications LLC (formerly the Company’s majority-owned subsidiary) in 1998. In the second quarter of 2001, the Company transferred its equityinterest in GICC back to GICC and has no further financing obligation to GICC. Asof December 31, 2001, the Company had an investment balance in GICC of$316,000. During the second quarter of 2002, the Company received $598,000 in cashfrom GICC and recognized an investment gain of $596,000.

 

*Interest Expense.*  Interestexpense increased $1.0 million or 14.5%, to $8.3 million during the secondquarter of 2002 due to increases in long-term debt to fund the Company’scontinuing expansion of its digital platform and other businessactivities.  Average principal amount oflong-term debt outstanding during the quarter ended June 30, 2002 wasapproximately $335 million at an average interest rate of approximately 9.9% ascompared to an average principal amount outstanding of approximately $297million****atan average interest rate of approximately 9.7% during the comparable period of2001.

 

*Net Loss.*  For thereasons previously described, the Company’s net loss increased to $5.7 millionin the second quarter of 2002 from a net loss of $4.9 million in the prior yearquarter.

 

*EBITDA.*  EBITDA (defined by the Company as earnings beforeinterest, income taxes, depreciation and amortization) increased 8.9% to $21.0million in the second quarter of 2002 as compared to $19.3 million in the prioryear quarter. This increase is primarily due to a 10.8% increase in the averagenumber of installed rooms receiving Guest Pay interactive services,  and greater operating efficiencies asdescribed above.  As a percentage oftotal revenue, EBITDA increased to 35.8% in the current quarter compared to35.0% in the prior year quarter.

 

EBITDA is notintended to represent an alternative to net income, operating income or cashflows from operating, financing or investing activities (as determined inaccordance with generally accepted accounting principles) as a measure ofperformance, and is not representative of funds available for discretionary usedue to the Company’s financing obligations. EBITDA, as defined by the Company,may not be calculated consistently among other companies reporting similarlytitled measures. EBITDA is included herein because it is a widely acceptedfinancial indicator used by certain investors and financial analysts to assessand compare companies on the basis of operating performance. Managementbelieves that EBITDA provides an important additional perspective on theCompany’s operating results and the Company’s ability to service its long–termdebt and to fund the Company’s continuing growth.

 

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### **Discussion and Analysis of Results of Operations**

**Six Months Ended June 30, 2002 and2001**

 

 

*Revenue Analysis*.  TheCompany’s total revenue for the first six months of 2002 increased 7.1%, or$7.6 million, in comparison to the same period of 2001. The following tablesets forth the components of revenue (in thousands) for the six months endingJune 30:

** **
|         |   | **2002**   |    | **2001**     |   |
|--------------|--------|------------|---------|--------------|--------|
|         |   |       |    | **Percent**  |   |   |   | **Percent** |   |
|         |   |       |    | **of Total** |   |   |   | **of Total** |   |
| **Revenue:** |   | **Amount** |    | **Revenue**  |   | **Amount** |   | **Revenue** |   |
| Guest Pay    |   | $          | 108,818 |         | 95.7   |   | $ | 101,104 |   | 95.3 |   |
| Other        |   | 4,892      |    | 4.3          |   | 5,032 |   | 4.7 |   |
|         |   | $          | 113,710 |         | 100.0  |   | $ | 106,136 |   | 100.0 |   |

 

Guest Pay interactiverevenue increased 7.6% or $7.7 million, in the first half of 2002 in comparisonto the same period of 2001.  Thisincrease was attributable to an 11.3% increase in the average number ofinstalled Guest Pay interactive rooms, offset by a 3.3% decrease in averagemonthly revenue per room.  The followingtable sets forth information in regard to average monthly Guest Pay interactiverevenue per room for the six months ending June 30:

** **
|                               |   | **2002** |   | **2001** |   |
|------------------------------------|--------|----------|--------|----------|--------|
| Average monthly  revenue per room: |   |     |   |     |   |
| Movie revenue                      |   | $        | 17.63  |     | $      | 18.29 |   |
| Other  interactive service revenue |   | 4.31     |   | 4.40     |   |
| Total per Guest  Pay room          |   | $        | 21.94  |     | $      | 22.69 |   |

 

Average movie revenue perroom decreased 3.6% as a result  of a a210 basis point decrease in occupancy levels versus the second quarter of2001.  Other interactive service revenueper room decreased by 2.1% primarily due to the termination of the InnMediaDistribution and Carriage Agreement.  Asa result of the termination, the Company did not recognize system accessrevenue from InnMedia in the second quarter of 2002.  System access revenue recognized during the first six months of2002 totaled $633,000 versus Internet related revenue of $925,000 recognized bythe Company in the first six months of 2001.

 

Revenue from other sources includes revenue from free-to-guest servicesprovided to hotels not receiving Guest Pay services and sales of systemequipment and service parts and labor. Other revenue decreased $140,000 or 2.8%due to decreased equipment sales to international licensees.

 

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*Gross Profit (exclusive of other operating expensesdiscussed separately below).*  Gross profittotaled $65.8 million for the six months ended June 30, 2002, an increase of6.4% over the first half of 2001 on a 7.1% increase in revenue (dollar amountsin thousands).

 
|                  |   | **2002** |   | **2001** |   |
|-----------------------|--------|----------|--------|----------|--------|
| Gross profit:         |   |     |   |     |   |
| Guest Pay             |   | $        | 63,605 |     | $      | 60,037 |   |
| Other                 |   | 2,214    |   | 1,824    |   |
|                  |   | $        | 65,819 |     | $      | 61,861 |   |
|                  |   |     |   |     |   |
| Gross profit  margin: |   |     |   |     |   |
| Guest Pay             |   | 58.5     | %      | 59.4     | %      |
| Other                 |   | 45.3     | %      | 36.2     | %      |
| Composite             |   | 57.9     | %      | 58.3     | %      |

 

Gross profit on Guest Payinteractive services increased 5.9%, or $3.6 million, on a 7.6% increase inrelated revenue.  Guest Pay direct costs(primarily studio license fees, license fees for other interactive services,Internet connectivity fees, and the commission retained by the hotel) areprimarily based on related revenue, and such costs generally vary directly withrevenue.  As a percentage of revenue,the decrease in gross profit margin from 59.4% to 58.5% was primarily due toadditional costs absorbed  as a resultof the termination of the InnMedia Distribution and Carriage Agreement. Theadditional costs, net of proceeds derived from the InnMedia programmingcontent, totaled $1.4 million.

 

Gross profit on otherservices increased $390,000 or 21.4% in the first half of 2002 from the prioryear six months and the gross profit margin increased from 36.2% to 45.3%.  These increases were due to lower costs related to cable programming services,which resulted from favorable pricing.

 

As a percentage ofrevenue, the Company’s overall gross profit margin decreased from 58.3% to57.9%.  The nominal decrease in grossmargin from Guest Pay interactive services was partially offset by an increasein other gross margin as described above.

 

*Operating Expenses.*  The followingtable sets forth information in regard to the Company’s operating expenses forthe six months ending June 30 (dollar amounts in thousands):

 
|                                 |   | **2002**   |   | **2001**     |   |
|--------------------------------------|--------|------------|--------|--------------|--------|
|                                 |   |       |   | **Percent**  |   |   |   | **Percent** |   |
|                                 |   |       |   | **of Total** |   |   |   | **of Total** |   |
|                                 |   | **Amount** |   | **Revenues** |   | **Amount** |   | **Revenues** |   |
| Operating  expenses:                 |   |       |   |         |   |   |   |   |   |
| Guest Pay  operations                |   | $          | 14,460 |         | 12.7   |   | $ | 14,464 |   | 13.6 |   |
| Selling, general  and administrative |   | 10,720     |   | 9.4          |   | 10,710 |   | 10.1 |   |
| Depreciation and  amortization       |   | 37,292     |   | 32.8         |   | 32,872 |   | 31.0 |   |
| Total operating expenses             |   | $          | 62,472 |         | 54.9   |   | $ | 58,046 |   | 54.7 |   |

 

Guest Pay operations expenses consist of costs directly related to theoperation of systems at hotel sites. Guest Pay operations expenses of $14.5 million were equal to the prioryear six months, due primarily to improved cost controls and greater operatingefficiencies.  Per average installedroom, Guest Pay operations expenses decreased to $2.92****per month in the first halfof 2002 as compared to $3.25 per month in the comparable period of 2001.

 

Selling, general and administrative expenses of$10.7 million were equal to the year prior six months. As a percentage ofrevenue, such expenses decreased to 9.4% in the second half of 2002 from 10.1%in the prior year period due to strong cost control measures.

 

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Depreciationand amortization expenses increased to $37.3 million in the first half of 2002from $32.9 million in the year earlier six months.  This increase was due to the 11.3% increase in the average numberof rooms in operation driven by the installation of the digital platform. As ofJune 30, 2002, the interactive digital system had been installed in more than184,000 rooms as compared to 45,700 rooms at June 30, 2002. Additionally, theincrease was due to the associated software costs and other capitalized costsincluding service vans, equipment, and computers that are related to theincreased number of rooms in service since the prior year.  As a percentage of revenue, depreciation andamortization expenses increased to 32.8% in the first half of 2002 from 31.0%in the first half of 2001.

 

*Operating Income.*  For thereasons previously described, the Company generated operating income of $3.3million in the first six months of 2002 compared to $3.8 million in the sameperiod of 2001.

 

*InvestmentGains (Losses)*.  Prior to the second quarter of 2001, theCompany owned a minority interest in Global Interactive CommunicationsCorporation (“GICC”) resulting from the merger transaction involving ResNetCommunications LLC (formerly the Company’s majority-owned subsidiary) in 1998. In the second quarter of 2001, the Company transferred its equityinterest in GICC back to GICC and has no further financing obligation toGICC.  As of December 31, 2001,the Company had an investment balance in GICC of $316,000.  Duringthe first half of 2002, the Company received $1.4 million in cash from GICC andrecognized an investment gain of $1.1 million.

 

*Interest Expense.*  Interestexpense increased $2.0 million or 14.2%, to $16.4 million during the first halfof 2002 due to increases in long-term debt to fund the Company’s continuingexpansion of its digital platform and other business activities.  Average principal amount of long-term debtoutstanding during the six months ended June 30, 2002 was approximately $332million at an average interest rate of approximately 9.9% as compared to anaverage principal amount outstanding of approximately $294 million****atan average interest rate of approximately 9.8% during the comparable period of2001.

 

*Net Loss.*  For thereasons previously described, the Company’s net loss increased to $12.4 millionin the first half of 2002 from a net loss of $11.7 million in the prior yearsix months.

 

*EBITDA.*  EBITDA (defined by the Company as earnings beforeinterest, income taxes, depreciation and amortization) increased 10.8% to $40.6million in the first six months of 2002 as compared to $36.7 million in theprior year period.  This increase isprimarily due to an 11.3% increase in the average number of installed roomsreceiving Guest Pay interactive services, and greater operating efficiencies as described above.  As a percentage of total revenue, EBITDAincreased to 35.7% in the current six months compared to 34.6% in the first sixmonths of 2001.

 

EBITDA is notintended to represent an alternative to net income, operating income or cashflows from operating, financing or investing activities (as determined inaccordance with generally accepted accounting principles) as a measure ofperformance, and is not representative of funds available for discretionary usedue to the Company’s financing obligations. EBITDA, as defined by the Company, may not be calculated consistentlyamong other companies reporting similarly titled measures. EBITDA is includedherein because it is a widely accepted financial indicator used by certaininvestors and financial analysts to assess and compare companies on the basisof operating performance.  Managementbelieves that EBITDA provides an important additional perspective on theCompany’s operating results and the Company’s ability to service its long–termdebt and to fund the Company’s continuing growth.

 

 

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**Recent Accounting Developments**

 

See Note 6 in the notesto consolidated financial statements.

 

**Seasonality**

 

The Company’squarterly operating results are subject to fluctuation depending upon hoteloccupancy rates and other factors. Typically, occupancy rates are higher during the second and thirdcalendar quarters due to seasonal travel patterns.

 

## **Liquidity and Capital Resources —**

 

The Company historically has required substantial amounts of capital tofund operations, expand the Company’s business and to service existingindebtedness.  Commencing in 2001, netcash flow from operations was sufficient to cover all debt service,  capital expenditures classified as renewal,general corporate,or maintenance capital as well as  a portion of growth capital. The funding of the remaining portion of growth capital expenditures wasprovided by the Company’s bank facility. For 2001, capital expenditures were $78.4 million and net cash providedby operating activities was $46.5 million. During the first six months of 2002, cash flow from operations wassufficient to cover all debt service, capital expenditures classified asrenewal, general corporate, or maintenance capital as well as  a portion of growth capital.  The funding for growth capital expenditureswas provided by the Company’s bank facility. For the six-months ended June 30, 2002, capital expenditures were $37.3million as compared to $39.2 million in the same period of 2001.  Net cash provided by operating activitieswas $18.6 million as compared to $19.5 million in the first half of 2001.

 

Depending on the rate of growth of its business and other factors, theCompany expects to incur capital expenditures of $73 to $75 million in 2002 ascontemplated under its 2002 business plan. The Company’s cash requirements for the balance of 2002 include $6.75million of payments for principal maturities of long-term debt.  The Company was in compliance with allcovenants related to its bank debt and its Senior notes as of June 30,2002.  The Company is not aware of anyevents that qualify under the Material Adverse Effect clause of the currentcredit facility.

 

The Companybelieves that its operating cash flows and borrowings available under therevolving credit facility will be sufficient to fund the Company’s futuregrowth, financing obligations, and its negative working capital, ascontemplated under its 2002 business plan. However, if operating cash flows are significantly below the amountanticipated in its current business plan, the Company intends to cover theshort fall through any combination of additional borrowings available under itscurrent revolving credit facility and a reduction in capital spending.  The total debt to EBITDA leverage covenantof the bank facility is schedule to decline from 4.5X to 4.25X as of December31, 2002.  While the Company believesthat it will be in compliance with the reduced covenant requirement, it hasrequested an amendment to the facility deferring the reduction in the aforesaidleverage ratio among other items. Although no assurance can be given, the Company believes that it will besuccessful in obtaining such an amendment on acceptable terms to the Company.

 

In May 2002, the Company filed a universal shelf registration statementwith the Securities and Exchange Commission (“SEC”) providing for the offeringfrom time to time of debt securities, common stock or preferred stock withaggregate proceeds of up to $225 million. The Company may use the proceeds from possible sale of securities forgeneral corporate purposes, which include additions to working capital,repayment or redemption of existing indebtedness, financing of capitalexpenditures, research and development of new technologies, future acquisitionsand strategic investment opportunities. The timing and amount of any offering under the registration statementwill depend on the market and general business conditions.  The registration statement was declaredeffective by the SEC on June 18, 2002. No securities have been issued under this registration statement as ofJune 30, 2002.

 

The foregoing statements regarding capital expenditures and cashrequirements are forward-looking statements and there can be no assurance inthis regard.  The Company’s actual cashflow and cash requirements will vary (and such variations could be material)depending upon the number of new contracts for services entered into by theCompany, the cost of installations, demand for the Company’s services,competitive factors, hotel occupancy rates, general economic factors and otherfactors.

 

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*Obligationsand Commitments.*

 
|                           |   |      |    | **Payments  due by period**                    |   |
|--------------------------------|--------|-----------|---------|------------------------------------------------|--------|
|                           |   | **Total** |    | **Less  than  1 year**                    |   | **1 — 3  years** |   | **4 — 5  years** |   | **Over 5  years** |   |
| Contractual  obligations:      |   |      |    |                                           |   |   |   |   |   |   |   |
| Long-term  debt(s)             |   | $         | 340,446 |                                           | $      | 8,322 |   | $ | 15,000 |   | $ | 317,124 |   | 3⁄4 |   |
| Interest on  senior notes      |   | 74,712    |    | 17,791                                         |   | 33,512 |   | 23,409 |   | 3⁄4 |   |
| Other long-term  obligations   |   | 12,656    |    | 2,281                                          |   | 4,803 |   | 3,042 |   | 2,530 |   |
| Total  contractual obligations |   | $         | 427,814 |                                           | $      | 28,394 |   | $ | 53,315 |   | $ | 343,575 |   | 2,530 |   |
|                           |   |      |    |                                           |   |   |   |   |   |   |   |
|                           |   |      |    | **Amount of commitment expiration per period** |   |
|                           |   | **Total** |    | **Less than  1 year**                     |   | **1 — 3 years** |   | **4 — 5 years** |   | **Over 5 years** |   |
| Other commercial  commitments: |   |      |    |                                           |   |   |   |   |   |   |   |
| Standby letters  of credit     |   | $         | 2,000   |                                           | $      | 2,000 |   | 3⁄4 |   | 3⁄4 |   | 3⁄4 |   |
|                           |   |      |    |                                           |   |   |   |   |   |   |   |

 

**Performance of Lodging Industry**

 

The overall travel industry, initially impacted by the tragic events ofSeptember 11th, continues to be adversely effected by the weakergeneral economic climate and uncertain financial markets.  Occupancy rates from the properties servedby the Company during the second quarter of 2002 were 110 basis points belowthe same period in the prior year. While the average occupancy rate for the Company’s served hotels istypically higher than the average of the entire lodging industry, the Company’sbusiness is clearly linked to the continued effects of changes in occupancylevels.

 

Geographically, theCompany’s room base is diversified with more than two-thirds of propertiesserved being in highway or suburban locations. In addition, less than 5% of the room base is concentrated in the topten urban areas of the United States. By serving a wide variety ofgeographically dispersed properties, the Company mitigates reliance on any onegeographic sector.

 

Occupancy rates have been improving but remain below the levelsexperienced in the prior year.  Duringthe third quarter of 2002, occupancy rates are forecasted to slowlyimprove.  To help mitigate the impact ofoccupancy levels on operating profit and EBITDA, the Company continues tofirmly control operating expenses and capital spending.  The Company plans to reassess its operatingand capital expenditure plans periodically to respond to changes in theeconomic environment.

 

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**Item 3 — Quantitative and Qualitative Disclosures AboutMarket Risk**

 

The Company is exposed to various market risks, including potentiallosses resulting from adverse changes in interest rates and foreign currencyexchange rates. The Company does not enter into derivatives or other financialinstruments for trading or speculative purposes.

 

*Interest.* At June 30, 2002, the Company had debttotaling $343 million. The Company has interest rate swap arrangements coveringdebt with a notional amount of $150 million to effectively change theunderlying debt from a variable interest rate to a fixed interest rate for theterm of the swap agreements. After giving effect to the interest rate swaparrangements, the Company had fixed rate debt of $277 million and variable ratedebt of $66 million at June 30, 2002. For fixed rate debt, interest ratechanges affect the fair market value but do not impact earnings or cash flows.Conversely, for variable rate debt, interest rate changes generally do notaffect the fair market value but do impact future earnings and cash flows,assuming other factors are held constant. Assuming other variables remainconstant (such as debt levels), a one percentage point increase in interestrates would decrease the unrealized fair market value of the fixed rate debt byan estimated $24.6 million.  The impacton earnings and cash flow for the next year resulting from a one percentagepoint increase in interest rates would be approximately $659,000 assuming othervariables remain constant.

 

*ForeignCurrency Transactions.*  A portionof the Company’s revenues are derived from the sale of Guest Pay services inCanada. The results of operations and financial position of the Company’soperations in Canada are measured in Canadian dollars and translated into U.S.dollars. The effects of foreign currency fluctuations in Canada are somewhatmitigated by the fact that expenses and liabilities are generally incurred inCanadian dollars. The reported income of the Company’s Canadian subsidiary willbe higher or lower depending on a weakening or strengthening of the U.S. dollaragainst the Canadian dollar. In addition, a portion of the Company’s assets arebased in Canada and are translated into U.S. dollars at foreign currencyexchange rates in effect as of the end of each period. Accordingly, theCompany’s consolidated assets will fluctuate depending on the weakening orstrengthening of the U.S. dollar against the Canadian dollar. No significantforeign currency fluctuations occurred in the first quarter of 2002 tomaterially impact consolidated results of operations or financial condition.

 

 

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**PartII — Other Information**

 

**Item 1 — Legal Proceedings**

 

On April 11, 2002,InnMedia LLC, filed a complaint in the Superior Court of the State ofCalifornia, County of Los Angeles alleging that the Company breached theDistribution and Carriage Agreement and Services Agreement between the Companyand InnMedia.  Effective August 2, 2002,the Company and Hilton  mutually agreedto dissolve InnMedia.  In connectionwith the dissolution of InnMedia, the lawsuit filed by InnMedia against theCompany has been dismissed with prejudice. See note 9 to financial statements.

 

 

**Item2 — Changes in Securities and Use of Proceeds**

 

                Not applicable.

 

 

**Item3 — Defaults Upon Senior Securities**

 

                Not applicable.

 

 

**Item4  — Submission of Matters to a Vote ofSecurity Holders**

 

 

a.               The Annual Meeting of Stockholders of the Company(“Meeting”) was held on May 8, 2002, for the following purposes:

 

1.               Election of a director to serve a three-year termexpiring in 2005; and

 

2.               Action on such other matters as may properly comebefore the Meeting.

 

b.              The director elected at the meeting was Rodney F.Leyendecker.

 

c.               The results of voting at the Meeting were as follows:

 
| Election of Director  — |   | **For**    |   | **Against** |   | **Withheld** |   | **Abstentions** |
|-----------------------------------|--------|------------|--------|-------------|--------|--------------|--------|-----------------|
|                              |   |       |   |        |   |         |   |            |
| Rodney F. Leyendecker             |   | 11,854,892 |   | —      |   | 17,986       |   | —          |

 

 

# **Item 5 — OtherInformation**

 

On May 28, 2002, theCompany’s Board of Directors elected Jarl Mohn, aka Lee Masters, to fill apreexisting vacancy on the Board.  Mr.Mohn’s term will expire in 2005.

 

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**Item6 — Exhibits and Reports on Form 8-K**

 

**a.****              ****Exhibits:**

 

                                99.1         Certification Pursuant to Section 906of the Sarbanes-Oxley Act of 2002.

 

**b. Reports on Form 8-K:**

 

                                                The Company filed a Current Report onForm 8-K with the SEC on April 15, 2002, to file as an exhibit under Item 7 acopy of the Company’s press release dated April 12, 2002, announcing thetermination of the Company’s agreements with InnMedia LLC and announcing thaton April 11, 2002, Inn Media filed a complaint in California Superior Courtnaming the Company as defendant.

 

The Company filed a Current Report on Form 8-K withthe SEC on May 29, 2002, under Item 5 announcing the filing of a universalshelf registration statement with the SEC providing for the offering to thepublic from time to time of debt securities, common stock or preferred stockwith aggregate proceeds of up to $225 million.   The Company also filed as an exhibit under Item 7 a copy of theCompany’s press release dated May 24, 2002.

 

The Company filed a Current Report on Form 8-K withthe SEC on June 3, 2002, under Item 4 announcing the appointment ofPricewaterhouseCoopers LLP as the Company’s independent auditor for the fiscalyear 2002 and filed as exhibits under Item 7 (a) a copy of a letter dated May31, 2002, from Arthur Andersen LLP to the SEC, and (b) a copy of the Company’spress release dated May 31, 2002.

 

The Company filed a Current Report on Form 8-K withthe SEC on August 5, 2002, to file as an exhibit under Item 7 a copy of theCompany’s press release dated August 5, 2002, announcing that the Company hadexpanded its Master Services Agreement with Hilton, that the Company hadmutually agreed with Hilton to dissolve InnMedia and that the lawsuit filed byInnMedia against the Company had been dismissed.

 

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**LodgeNet Entertainment Corporation**

 

 

**Signatures**

 

 

 

                Pursuant to therequirements of the Securities and Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
|                        |   | **LodgeNet Entertainment Corporation**         |
|-----------------------------|--------|------------------------------------------------|
|                        |   | (Registrant)                                   |
|                        |   |                                           |   |   |
|                        |   |                                           |   |   |
|                        |   |                                           |   |   |
| Date:  August  8, 2002 |   | /s/ Scott C.  Petersen                    |
|                        |   | Scott C. Petersen                              |   |   |
|                        |   | President and Chief Executive Officer          |
|                        |   | (Principal Executive Officer)                  |
|                        |   |                                           |   |   |
| Date:  August  8, 2002 |   | /s/  Gary H.  Ritondaro                   |
|                        |   | Gary H. Ritondaro                              |   |   |
|                        |   | Senior Vice President, Chief Financial Officer |
|                        |   | (Principal Financial & Accounting Officer) |
|                             |        |                                                |  |  |  |

 

 

 

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