##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 
 FORM 10-Q
 
 (Mark One)
 þ
    
    Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended September 30, 2006
 or
 o
    
    Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from  to
 Commission File Number 1-13806
 
 REWARDS NETWORK INC.
 (Exact name of registrant as specified in its charter)
 
 DELAWARE
(State or other jurisdiction of 
incorporation or organization)
    
    84-6028875
(I.R.S. Employer
Identification No.)
 Two North Riverside Plaza, Suite 950, Chicago, Illinois 60606
(Address of principal executive offices) (Zip code)
 312-521-6767
(Registrants telephone number, including area code)
 N/A
(Former name, former address and former fiscal year, if changed since last report)
 
 days.  þ Yes  o No
  Large accelerated filer o
    
    Accelerated filer þ
    
    Non-accelerated filer o
 Act).  o Yes  þ No




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##### 



INDEX
 REWARDS NETWORK INC. AND SUBSIDIARIES
 Page No.PART I.
    
    FINANCIAL INFORMATIONItem 1.
    
    Financial Statements:Condensed Consolidated Balance SheetsSeptember 30, 2006 and December 31, 2005 (unaudited)
    
    3Condensed Consolidated Statements of OperationsThree and nine months ended September 30, 2006 and 2005 (unaudited)
    
    4Condensed Consolidated Statements of Cash FlowsNine months ended September 30, 2006 and 2005 (unaudited)
    
    5Notes to Unaudited Condensed Consolidated Financial Statements
    
    6-14Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    15-28Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    29Item 4.
    
    Controls and Procedures
    
    29PART II.
    
    OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    30Item 1A.
    
    Risk Factors
    
    30Item 6.
    
    Exhibits
    
    31SIGNATURES
    

32Exhibit 31.1Exhibit 31.2Exhibit 32.1Exhibit 32.2
   2




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REWARDS NETWORK INC. AND SUBSIDIARIES
 
 PART IFINANCIAL INFORMATION
 
 Item 1  Financial Statements
 
 Condensed Consolidated Balance Sheets
 (Unaudited)
 (in thousands, except per share data)
 September 30,
    
    
    December 31,2006
    
    
    2005AssetsCurrent assets:Cash and cash equivalents
    
    $
    64,560
    
    
    $
    31,585Short-term available for sale securities
    
    
    20,000
    
    
    
    Accounts receivable, net of allowance for doubtful
accounts of $1,518 and $2,498, respectively
    
    
    6,672
    
    
    
    7,240Dining credits, net of allowance for doubtful accounts
of $11,796 and $21,192, respectively
    
    
    77,929
    
    
    
    121,026Deferred income taxes
    
    
    5,727
    
    
    
    7,322Prepaid expenses
    
    
    3,191
    
    
    
    2,532Income taxes receivable
    
    
    2,433
    
    
    
    2,666Total current assets
    
    
    180,512
    
    
    
    172,371Property and equipment, net of accumulated depreciation and
amortization of $20,313 and $17,137, respectively
    
    
    8,715
    
    
    
    8,565Other assets
    
    
    1,887
    
    
    
    1,834Goodwill
    
    
    8,117
    
    
    
    8,117Total assets
    
    $
    199,231
    
    
    $
    190,887Liabilities and Stockholders EquityCurrent liabilities:Accounts payabledining credits
    
    $
    6,548
    
    
    $
    8,434Accounts payablemember benefits
    
    
    8,596
    
    
    
    6,399Accounts payabletrade
    
    
    2,462
    
    
    
    3,800Accrued compensation
    
    
    3,638
    
    
    
    1,783Other current liabilities
    
    
    4,665
    
    
    
    3,693Deferred membership fee income
    
    
    999
    
    
    
    1,226Total current liabilities
    
    
    26,908
    
    
    
    25,335Convertible subordinated debentures
    
    
    70,000
    
    
    
    70,000Deferred income taxes
    
    
    61
    
    
    
    1,006Other long-term liabilities
    
    
    407
    
    
    
    358Total liabilities
    
    
    97,376
    
    
    
    96,699Stockholders equity:Common stock, par value $0.02 per share; authorized
70,000 shares; issued 26,862 and 26,625 shares,
respectively; and outstanding 26,580 and 26,343 shares,
respectively
    
    
    537
    
    
    
    533Additional paid-in capital
    
    
    65,225
    
    
    
    61,725Cumulative other comprehensive income:Foreign currency translation, net of income taxes
    
    
    510
    
    
    
    359Retained earnings
    
    
    37,793
    
    
    
    33,781Treasury stock, at cost (282 shares of common stock)
    
    
    (2,210
    )
    
    
    (2,210
    )Total stockholders equity
    
    
    101,855
    
    
    
    94,188Total liabilities and stockholders equity
    
    $
    199,231
    
    
    $
    190,887
   3




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REWARDS NETWORK INC. AND SUBSIDIARIES
 
 Condensed Consolidated Statements of Operations
(Unaudited)
(in thousands, except per share data)
 Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Operating revenues:Sales
    
    $
    60,389
    
    
    $
    70,317
    
    
    $
    194,347
    
    
    $
    218,122Cost of sales
    
    
    30,802
    
    
    
    36,709
    
    
    
    100,488
    
    
    
    111,572Provision for losses
    
    
    1,682
    
    
    
    7,024
    
    
    
    2,379
    
    
    
    19,782Member benefits
    
    
    8,812
    
    
    
    8,831
    
    
    
    27,211
    
    
    
    34,382Total direct expenses
    
    
    41,296
    
    
    
    52,564
    
    
    
    130,078
    
    
    
    165,736Net revenue
    
    
    19,093
    
    
    
    17,753
    
    
    
    64,269
    
    
    
    52,386Membership fees and other income
    
    
    504
    
    
    
    680
    
    
    
    1,624
    
    
    
    2,180Total operating revenues
    
    
    19,597
    
    
    
    18,433
    
    
    
    65,893
    
    
    
    54,566Operating expenses:Salaries and benefits
    
    
    5,626
    
    
    
    4,610
    
    
    
    17,535
    
    
    
    14,149Sales commissions and expenses
    
    
    4,452
    
    
    
    5,948
    
    
    
    13,838
    
    
    
    16,144Professional fees
    
    
    4,038
    
    
    
    1,880
    
    
    
    8,162
    
    
    
    5,640Member and merchant marketing
    
    
    1,429
    
    
    
    1,699
    
    
    
    3,800
    
    
    
    4,470Goodwill impairment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,554General and administrative
    
    
    4,881
    
    
    
    4,064
    
    
    
    14,837
    
    
    
    14,855Patent litigation settlement
    
    
    
    
    
    
    
    
    
    
    1,000
    
    
    
    Total operating expenses
    
    
    20,426
    
    
    
    18,201
    
    
    
    59,172
    
    
    
    56,812Operating (loss) income
    
    
    (829
    )
    
    
    232
    
    
    
    6,721
    
    
    
    (2,246
    )Other income (expense):Interest and other income
    
    
    771
    
    
    
    99
    
    
    
    1,924
    
    
    
    334Interest expense and financing costs
    
    
    (715
    )
    
    
    (994
    )
    
    
    (2,170
    )
    
    
    (2,510
    )(Loss) income before income tax (benefit) provision
    
    
    (773
    )
    
    
    (663
    )
    
    
    6,475
    
    
    
    (4,422
    )Income tax (benefit) provision
    
    
    (365
    )
    
    
    (179
    )
    
    
    2,463
    
    
    
    (1,710
    )Net (loss) income
    
    $
    (408
    )
    
    $
    (484
    )
    
    $
    4,012
    
    
    $
    (2,712
    )(Loss) earnings per share of common stock:Basic
    
    $
    (0.02
    )
    
    $
    (0.02
    )
    
    $
    0.15
    
    
    $
    (0.10
    )Diluted
    
    $
    (0.02
    )
    
    $
    (0.02
    )
    
    $
    0.15
    
    
    $
    (0.10
    )Weighted average number of common and common equivalent
shares outstanding:Basic
    
    
    26,725
    
    
    
    26,292
    
    
    
    26,663
    
    
    
    26,058Diluted
    
    
    26,725
    
    
    
    26,292
    
    
    
    26,884
    
    
    
    26,058
   4




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REWARDS NETWORK INC. AND SUBSIDIARIES
 
 Condensed Consolidated Statements of Cash Flows
(Unaudited)
(in thousands)
 Nine Months EndedSeptember 30,2006
    
    
    2005Cash flows from operating activities:Net income (loss)
    
    $
    4,012
    
    
    $
    (2,712
    )Adjustments to reconcile net income (loss) to net cash provided by (used in)
operating activities:Depreciation and amortization
    
    
    3,177
    
    
    
    3,108Tax benefit from the exercise of stock options
    
    
    
    
    
    
    301Amortization of deferred financing cost
    
    
    481
    
    
    
    794Goodwill impairment
    
    
    
    
    
    
    1,554Provision for losses on dining credits
    
    
    2,379
    
    
    
    19,782Stock-based compensation
    
    
    2,369
    
    
    
    443Deferred income taxes
    
    
    649
    
    
    
    (687
    )Changes in assets and liabilities:Accounts receivable
    
    
    541
    
    
    
    1,000Dining credits including accounts payabledining credits
    
    
    38,930
    
    
    
    (16,703
    )Prepaid expenses
    
    
    (766
    )
    
    
    19Income taxes receivable
    
    
    233
    
    
    
    (2,710
    )Other assets
    
    
    (441
    )
    
    
    (887
    )Accounts payabletrade
    
    
    (1,349
    )
    
    
    452Accounts payablemember benefits
    
    
    2,197
    
    
    
    (5,043
    )Accrued compensation
    
    
    1,855
    
    
    
    (376
    )Other liabilities
    
    
    1,023
    
    
    
    955Deferred membership fee income
    
    
    (226
    )
    
    
    (355
    )Net cash provided by (used in) operating activities
    
    
    55,064
    
    
    
    (1,065
    )Cash flows from investing activities:Additions to property and equipment
    
    
    (3,311
    )
    
    
    (1,334
    )(Purchases) sales of available for sale securities
    
    
    (20,000
    )
    
    
    6,772Net cash (used in) provided by investing activities
    
    
    (23,311
    )
    
    
    5,438Cash flows from financing activities:Tax benefit from the exercise of stock options
    
    
    250
    
    
    
    Proceeds from the exercise of stock options
    
    
    851
    
    
    
    1,050Net cash provided by financing activities
    
    
    1,101
    
    
    
    1,050Effect of exchange rate on cash
    
    
    121
    
    
    
    104Net increase in cash
    
    
    32,975
    
    
    
    5,527Cash and cash equivalents:Beginning of the period
    
    
    31,585
    
    
    
    8,728End of the period
    
    $
    64,560
    
    
    $
    14,255Supplemental disclosures of cash flow information:Cash paid during the period for:Interest
    
    $
    1,138
    
    
    $
    1,147Income taxes
    
    $
    2,839
    
    
    $
    1,411
   5




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REWARDS NETWORK INC. AND SUBSIDIARIES
 
 Notes to Unaudited Condensed Consolidated Financial Statements
(amounts in thousands, except per share data and square footage)
 Note 1  Basis of Presentation
  Nature of operations: SM
   Principles of consolidation:
 Note 2  Goodwill Impairment
    6




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Note 3  Certain Relationships and Related Party Transactions (square footage not in
thousands)
 Active agreements
      Year Ending December 31,Fourth quarter 2006
    
    $
    1462007
    
    
    5912008
    
    
    5922009
    
    
    555Thereafter
    
    
    930Total minimum lease payments
    
    $
    2,814
 Terminated agreements
    7




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Note 4  Litigation
           8




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Note 5  (Loss) Income per Share
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Net (loss) income
    
    $
    (408
    )
    
    $
    (484
    )
    
    $
    4,012
    
    
    $
    (2,712
    )Weighted average number of shares of common stock and
common stock equivalents outstanding
Basic
    
    
    26,725
    
    
    
    26,292
    
    
    
    26,663
    
    
    
    26,058Stock options and restricted stock
    
    
    
    
    
    
    
    
    
    
    221
    
    
    
    Diluted
    
    
    26,725
    
    
    
    26,292
    
    
    
    26,884
    
    
    
    26,058(Loss) Earnings per share:Basic
    
    $
    (0.02
    )
    
    $
    (0.02
    )
    
    $
    0.15
    
    
    $
    (0.10
    )Diluted
    
    $
    (0.02
    )
    
    $
    (0.02
    )
    
    $
    0.15
    
    
    $
    (0.10
    )
 Note 6  Stock-based Compensation
   9




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Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,Components of Stock-based Compensation Expense
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005Stock options included in salaries and benefits
expense
    
    $
    135
    
    
    $
    
    
    
    $
    439
    
    
    $
    Restricted stock unit awards included in salaries and
benefits expense
    
    
    720
    
    
    
    
    
    
    
    1,571
    
    
    
    Restricted stock unit awards included in general and
administrative expense
    
    
    56
    
    
    
    8
    
    
    
    136
    
    
    
    96Total stock-based compensation costs
    
    
    911
    
    
    
    8
    
    
    
    2,146
    
    
    
    96Income tax benefit
    
    
    (430
    )
    
    
    (2
    )
    
    
    (816
    )
    
    
    (37
    )Total after-tax stock-based compensation expense
    
    $
    481
    
    
    $
    6
    
    
    $
    1,330
    
    
    $
    59
 Stock Options
   Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Weighted average grant-date
fair value of options
    
    None granted
    
    $
    3.82
    
    
    $
    4.59
    
    
    $
    3.58Stock volatility
    
    
    
    
    
    
    50.5
    %
    
    
    60.0
    %
    
    
    51.9
    %Risk-free interest rate
    
    
    
    
    
    
    4.3
    %
    
    
    4.0
    %
    
    
    4.3
    %Expected option life in years
    
    
    
    
    
    
    10.0
    
    
    
    6.2
    
    
    
    10.0Expected dividend yield
    
    
    
    
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %
   10




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WeightedWeighted
    
    
    AverageAverage
    
    
    Remaining
    
    
    AggregateExercise
    
    
    Contractual
    
    
    IntrinsicShares
    
    
    Price
    
    
    Term (Years)
    
    
    ValueBalance at December 31, 2005
    
    
    1,451
    
    
    $
    6.63Granted
    
    
    40
    
    
    $
    7.68Exercised
    
    
    (224
    )
    
    $
    3.79Forfeitures
    
    
    (298
    )
    
    $
    8.31Balance at September 30, 2006
    
    
    969
    
    
    $
    6.80
    
    
    
    6.61
    
    
    $
    1,897Exercisable at September 30, 2006
    
    
    586
    
    
    $
    6.39
    
    
    
    5.30
    
    
    $
    917
    WeightedAverageGrant-Date FairShares
    
    
    PriceNonvested at December 31, 2005
    
    
    478
    
    
    $
    4.00Granted
    
    
    40
    
    
    $
    4.59Vested
    
    
    (112
    )
    
    $
    4.79Forfeited
    
    
    (23
    )
    
    $
    5.52Nonvested at September 30, 2006
    
    
    383
    
    
    $
    4.25
  Restricted Stock Unit Awards
    11




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WeightedAverageGrant-Date FairShares
    
    
    PriceNonvested at December 31, 2005
    
    
    77
    
    
    $
    5.58Granted
    
    
    789
    
    
    $
    7.87Vested
    
    
    (19
    )
    
    $
    5.85Forfeited
    
    
    (19
    )
    
    $
    6.85Nonvested at September 30, 2006
    
    
    828
    
    
    $
    7.72
   12




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2005 Pro Forma Information
  Three Months
    
    
    Nine MonthsEnded
    
    
    EndedSeptember 30,
    
    
    September 30,2005
    
    
    2005Net lossas reported
    
    $
    (484
    )
    
    $
    (2,712
    )Employee stock option compensation (expense) income,
net of tax
    
    
    (182
    )
    
    
    1,290Net losspro forma
    
    $
    (666
    )
    
    $
    (1,422
    )Loss per shareBasicas reported
    
    $
    (0.02
    )
    
    $
    (0.10
    )Basicpro forma
    
    $
    (0.03
    )
    
    $
    (0.05
    )Dilutedas reported
    
    $
    (0.02
    )
    
    $
    (0.10
    )Dilutedpro forma
    
    $
    (0.03
    )
    
    $
    (0.05
    )
  Note 7  Business and Credit Concentrations
  Three Months Ended September 30,
    
    
    Nine Months Ended September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Airlines
    
    
    60
    %
    
    
    57
    %
    
    
    58
    %
    
    
    57
    %All partners that each represent 10% or more of sales
    
    
    52
    %
    
    
    46
    %
    
    
    49
    %
    
    
    46
    %
 Note 8  Minimum Partner and Vendor Obligations
  Note 9  Available for Sale Securities
  MarketValueShort-term available for sale securitiesAuction Rate Securities
    
    $
    20,000
  13




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Note 10  Recently Issued Accounting Pronouncements
       14




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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
(amounts in thousands, except per share data, restaurants in the program, average transaction
amount and estimated months to consume dining credits portfolio)
 You should read the following discussion together with our unaudited condensed
consolidated financial statements and notes to those financial statements, which are included in
this report. This report contains forward-looking statements made pursuant to the safe harbor
provisions of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. The words anticipates, intends, expects,
could, should, plans, believes, estimates or words or phrases of similar import generally
identify forward-looking statements. You are cautioned that forward-looking statements are subject
to risks, trends and uncertainties that could cause actual results, performance or achievements to
differ materially from those expressed in any forward-looking statements. Important factors that
could cause our actual results, performance or achievements to be materially different from any
future results, performance or achievements expressed or implied by those statements include, but
are not limited to, the following: (i) adverse determination of lawsuits in which we are a
defendant that may result in liability and/or adversely impact the way in which we conduct
business, (ii) a class action lawsuit that, based on the courts summary judgment opinion, may
result in substantial monetary damages as well as restrictions on and changes to how we conduct our
business, (iii) our dependence on our relationships with airlines and other reward program partners
for a significant number of members, (iv) the concentration of a significant amount of our rewards
currency in one industry group, the airline industry, (v) our minimum purchase obligations and
performance requirements, (vi) our inability to attract and retain merchants, (vii) our inability
to attract and retain active members, (viii) adverse consequences of changes in our programs that
affect the rate of rewards received by members, (ix) our inability to maintain an appropriate
balance between the number of members and the number of participating merchants in each market, (x)
changes to payment card association rules and practices, (xi) our dependence upon our relationships
with payment card issuers, transaction processors, presenters and aggregators, (xii) network
interruptions or processing errors, (xiii) our susceptibility to a changing regulatory environment,
(xiv) increased operating costs due to privacy concerns of our marketing partners, payment card
processors and the public, (xv) the failure of our security measures, (xvi) the risk that our
members will not be able to use the dining credits we purchase from a merchant, (xvii) economic
changes, (xviii) an adverse change in our loss experience related to dining credits, (xix) the loss
of key personnel, (xx) increasing competition, (xxi) our inability to obtain sufficient cash, and
(xxii) the failure of our expansion into Canada. We undertake no obligation to, and expressly
disclaim any such obligation to, update or revise any forward-looking statements to reflect changed
assumptions, the occurrence of anticipated or unanticipated events or changes to future results
over time or otherwise, except as required by law. See the risk factors included as Part 1, Item 1A
Risk Factors in the Quarterly Report on Form 10-Q for the quarter ended June 30, 2006 and our
Annual Report on Form 10-K for the year ended December 31, 2005 for a more detailed discussion of
the foregoing and other factors that could cause actual results to differ materially from those
included in the forward-looking statements and that, among others, should be considered in
evaluating our outlook.
 OVERVIEW
 SM
    15




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CRITICAL ACCOUNTING POLICIES AND ESTIMATES
 Our discussion and analysis of our financial condition and results of operations are
based upon our condensed consolidated financial statements, which have been prepared in accordance
with accounting principles generally accepted in the United States. The preparation of these
financial statements requires that we make estimates and judgments that affect the reported amounts
of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and
liabilities. On an on-going basis, we evaluate our estimates, including those related to the
allowance for dining credits losses, the valuation allowance, if any, for net deferred tax assets,
investments and intangible assets. We base our estimates on historical experience and on various
other assumptions that we believe to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these estimates under
different assumptions or conditions. We believe the following critical accounting policies affect
our more significant judgments and estimates used in the preparation of our consolidated financial
statements.
 Allowance for Dining Credits Losses
 We provide allowances for dining credits losses based on our estimate of losses that would
result from the inability of participating merchants to remain in business or our merchants
unwillingness to honor their obligations relating to dining credits. If the financial condition of
our merchant base were to deteriorate beyond our expectations, resulting in participating
merchants inability to provide food, beverage, goods and services to members thereby reducing the
members use of dining credits, or if merchants are unwilling or otherwise unable to honor their
obligations relating to dining credits in greater numbers than we expect, additional allowances may
be required.
 We review members ability to use dining credits on a regular basis and provide for
anticipated losses on dining credits. Losses are reduced by recoveries of dining credits
previously written off. Account balances are charged off against the allowance after we believe
that our merchants are unwilling or unable to honor their obligations relating to dining credits.
Subsequent to the account being written-off, we continue to pursue recovery efforts.
 Deferred Tax Assets Valuation Allowance
 We record a valuation allowance to reduce our deferred tax assets when it is not likely to be
recognized due to cumulative losses and the uncertainty as to future recoverability. We consider
future taxable income and available tax planning strategies in assessing the need for the valuation
allowance. In the event we determine that we would not be able to realize all or part of our net
deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to
income in the period in which such determination is made.
 Impairment Loss of Unamortized Goodwill
 On at least an annual basis, we evaluate whether events and changes in
circumstances warrant the recognition of an impairment loss of unamortized goodwill. The conditions
that would trigger an impairment assessment of unamortized goodwill include a significant,
sustained negative trend in our operating results or cash flows, a decrease in demand for our
programs, a change in the competitive environment and other industry and economic factors.
Recoverability of an asset is
measured by comparison of its carrying amount to the expected future cash flows. Any
impairment to be recognized is measured by the amount by which the carrying amount of the asset
exceeds its fair market value. Significant management judgment is required in the forecasting of
future operating results that are used in the preparation of projected cash flows, and, if
different conditions prevail or judgments are made, a material write-down of goodwill could occur.
  17




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We comply with Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill
and Other Intangible Assets, the current standard for periodic assessment of the carrying value of
intangible assets, including goodwill. We assess the impact of SFAS No. 142 using a two-step
approach to assess goodwill based on applicable reporting units and any intangible assets,
including goodwill, recorded in connection with our previous acquisitions. During the three months
ended March 31, 2005, certain territories related to reacquired franchises experienced a
significant decline in sales related to unanticipated competition and the loss of key salespersons
in these territories which contributed to an operating loss for the quarter. These financial
results, coupled with several changes in senior sales management in the three months ended March
31, 2005, gave rise to our need to reassess the goodwill related to the reacquired franchises.
 In accordance with the provisions of SFAS No. 142, we prepared a discounted cash flow
analysis which indicated that the book value of certain reporting units exceeded their estimated
fair value and that goodwill had been impaired. Accordingly, we recognized a non-cash impairment
loss of $1,554 during the three months ended March 31, 2005. As of September 30, 2006, we had
unamortized goodwill of $8,117.
 Revenue Recognition
 We recognize revenue when members patronize our participating merchants and pay
using a payment card they have registered with us. Revenue is recognized only if the members
transaction qualifies for a benefit in accordance with the rules of the members particular
program. The amount of revenue recognized is that portion of the members total transaction amount
that we are entitled to receive in cash, in accordance with the terms of our agreement with the
participating merchant. For example, if a members total qualified transaction amount is $100 at a
participating merchant, as evidenced by the full amount of the payment card transaction, and our
contract provides for us to receive 80%, the amount of revenue we recognize is $80, representing
what we will actually realize in cash. Similarly, under the typical Marketing Services Program
contract, we recognize revenue only to the extent that we are contractually entitled to receive
cash for a portion of the members total qualified transaction amount. The same $100 transaction
referred to above at a Marketing Services Program merchant may yield $17 in revenue to be
recognized.
 Legal Contingencies
 We review the status of significant legal matters and assess our potential financial
exposure with respect to such legal matters on at least a quarterly basis. If the potential loss
from any claim or legal proceeding is considered probable and the amount can be reasonably
estimated, we accrue a liability for the estimated loss. Significant judgment is required in both
the determination of probability and the determination as to whether an exposure is reasonably
estimable. Because of uncertainties related to these matters, accruals are based only on the best
information available at the time. As additional information becomes available, we reassess the
potential liability related to pending claims and legal proceedings and may revise our estimates.
Such revisions in the estimates of the potential liabilities could have a material impact on our
results of operations and financial position.
  18




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RESULTS OF OPERATIONS  COMPARISON OF THE THREE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
  Percentage of SalesFor the Three Months EndedSeptember 30,2006
    
    
    2005Sales
    
    
    100.0
    
    
    
    100.0Cost of sales
    
    
    51.0
    
    
    
    52.2Provision for losses
    
    
    2.8
    
    
    
    10.0Member benefits
    
    
    14.6
    
    
    
    12.6Net revenue
    
    
    31.6
    
    
    
    25.2Membership fees and other income
    
    
    0.8
    
    
    
    1.0Total operating revenue
    
    
    32.4
    
    
    
    26.2Salaries and benefits
    
    
    9.3
    
    
    
    6.6Sales commission and expenses
    
    
    7.4
    
    
    
    8.5Professional fees
    
    
    6.7
    
    
    
    2.7Member and merchant marketing expenses
    
    
    2.4
    
    
    
    2.4General and administrative expenses
    
    
    8.1
    
    
    
    5.7Total operating expenses
    
    
    33.9
    
    
    
    25.9Operating (loss) income
    
    
    (1.4
    )
    
    
    0.3Other (income) expense, net
    
    
    (0.1
    )
    
    
    1.3Income before income tax benefit
    
    
    (1.3
    )
    
    
    (1.0
    )Income tax benefit
    
    
    (0.6
    )
    
    
    (0.3
    )Net loss
    
    
    (0.7
    )
    
    
    (0.7
    )
  19




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Operating Revenues
  For the Three Months Ended September 30,2006
    
    
    2005Marketing
    
    
    Marketing
    
    
    
    
    
    
    Marketing
    
    
    MarketingCredits
    
    
    Services
    
    
    
    
    
    
    Credits
    
    
    ServicesProgram
    
    
    Program
    
    
    Total
    
    
    Program
    
    
    Program
    
    
    TotalMerchant count as of
September 30, 2006 and 2005,
respectively
    
    
    6,285
    
    
    
    2,341
    
    
    
    8,626
    
    
    
    8,464
    
    
    
    1,795
    
    
    
    10,259Number of qualified transactions
    
    
    1,659
    
    
    
    697
    
    
    
    2,356
    
    
    
    2,079
    
    
    
    505
    
    
    
    2,584Average transaction amount
    
    $
    47.08
    
    
    $
    47.90
    
    
    $
    47.32
    
    
    $
    45.16
    
    
    $
    50.51
    
    
    $
    46.21Qualified transaction amount
    
    $
    78,105
    
    
    $
    33,384
    
    
    $
    111,489
    
    
    $
    93,887
    
    
    $
    25,508
    
    
    $
    119,395Sales yield
    
    
    70.1
    %
    
    
    16.9
    %
    
    
    54.2
    %
    
    
    69.8
    %
    
    
    18.8
    %
    
    
    58.9
    %Sales
    
    $
    54,733
    
    
    $
    5,656
    
    
    $
    60,389
    
    
    $
    65,533
    
    
    $
    4,784
    
    
    $
    70,317Cost of dining credits
    
    $
    30,347
    
    
    
    
    
    
    $
    30,347
    
    
    $
    36,297
    
    
    
    
    
    
    $
    36,297Processing fee
    
    
    319
    
    
    
    136
    
    
    
    455
    
    
    
    324
    
    
    
    88
    
    
    
    412Total cost of sales
    
    $
    30,666
    
    
    $
    136
    
    
    $
    30,802
    
    
    $
    36,621
    
    
    $
    88
    
    
    $
    36,709Provision for dining credits
losses
    
    
    1,682
    
    
    
    
    
    
    
    1,682
    
    
    
    7,024
    
    
    
    
    
    
    
    7,024Member benefits
    
    
    4,759
    
    
    
    1,913
    
    
    
    6,672
    
    
    
    5,583
    
    
    
    1,298
    
    
    
    6,881Bonus rewards
    
    
    585
    
    
    
    250
    
    
    
    835
    
    
    
    605
    
    
    
    164
    
    
    
    769Partner Commissions
    
    
    937
    
    
    
    368
    
    
    
    1,305
    
    
    
    973
    
    
    
    208
    
    
    
    1,181Total member benefits
    
    
    6,281
    
    
    
    2,531
    
    
    
    8,812
    
    
    
    7,161
    
    
    
    1,670
    
    
    
    8,831Net revenue
    
    $
    16,104
    
    
    $
    2,989
    
    
    $
    19,093
    
    
    $
    14,727
    
    
    $
    3,026
    
    
    $
    17,753
      20




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21




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Operating Expenses
       22




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Other Income and Expense
  Income tax provision
  Net Loss
   RESULTS OF OPERATIONS  COMPARISON OF THE NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
  Percentage of SalesFor the Nine Months EndedSeptember 30,2006
    
    
    2005Sales
    
    
    100.0
    
    
    
    100.0Cost of sales
    
    
    51.8
    
    
    
    51.2Provision for losses
    
    
    1.2
    
    
    
    9.1Member benefits
    
    
    14.0
    
    
    
    15.8Net revenue
    
    
    33.0
    
    
    
    24.0Membership fees and other income
    
    
    0.9
    
    
    
    1.0Total operating revenue
    
    
    33.9
    
    
    
    25.0Salaries and benefits
    
    
    9.0
    
    
    
    6.5Sales commission and expenses
    
    
    7.1
    
    
    
    7.4Professional fees
    
    
    4.2
    
    
    
    2.6Member and merchant marketing expenses
    
    
    2.0
    
    
    
    2.1Goodwill impairment
    
    
    
    
    
    
    0.7General and administrative expenses
    
    
    7.6
    
    
    
    6.8Patent litigation settlement
    
    
    0.1
    
    
    
    Total operating expenses
    
    
    30.5
    
    
    
    26.1Operating income (loss)
    
    
    3.5
    
    
    
    (1.0
    )Other expense, net
    
    
    0.1
    
    
    
    1.0Income before income tax provision (benefit)
    
    
    3.3
    
    
    
    (2.0
    )Income tax provision (benefit)
    
    
    1.3
    
    
    
    (0.8
    )Net income (loss)
    
    
    2.1
    
    
    
    (1.2
    )
  23




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Operating Revenues
  For the Nine Months Ended September 30,2006
    
    
    2005Marketing
    
    
    Marketing
    
    
    
    
    
    
    Marketing
    
    
    MarketingCredits
    
    
    Services
    
    
    
    
    
    
    Credits
    
    
    ServicesProgram
    
    
    Program
    
    
    Total
    
    
    Program
    
    
    Program
    
    
    TotalMerchant count as of
September 30, 2006 and 2005,
respectively
    
    
    6,285
    
    
    
    2,341
    
    
    
    8,626
    
    
    
    8,464
    
    
    
    1,795
    
    
    
    10,259Number of qualified transactions
    
    
    5,376
    
    
    
    1,991
    
    
    
    7,367
    
    
    
    6,243
    
    
    
    1,407
    
    
    
    7,650Average transaction amount
    
    $
    47.59
    
    
    $
    48.48
    
    
    $
    47.83
    
    
    $
    45.95
    
    
    $
    53.80
    
    
    $
    47.40Qualified transaction amount
    
    $
    255,828
    
    
    $
    96,527
    
    
    $
    352,355
    
    
    $
    286,876
    
    
    $
    75,698
    
    
    $
    362,574Sales yield
    
    
    69.7
    %
    
    
    16.6
    %
    
    
    55.2
    %
    
    
    70.6
    %
    
    
    20.7
    %
    
    
    60.2
    %Sales
    
    $
    178,298
    
    
    $
    16,049
    
    
    $
    194,347
    
    
    $
    202,477
    
    
    $
    15,645
    
    
    $
    218,122Cost of dining credits
    
    
    99,301
    
    
    
    
    
    
    
    99,301
    
    
    
    110,398
    
    
    
    
    
    
    
    110,398Processing fee
    
    
    862
    
    
    
    325
    
    
    
    1,187
    
    
    
    929
    
    
    
    245
    
    
    
    1,174Total cost of sales
    
    $
    100,163
    
    
    $
    325
    
    
    $
    100,488
    
    
    $
    111,327
    
    
    $
    245
    
    
    $
    111,572Provision for dining credits
losses
    
    
    2,379
    
    
    
    
    
    
    
    2,379
    
    
    
    19,782
    
    
    
    
    
    
    
    19,782Member benefits
    
    
    15,424
    
    
    
    5,448
    
    
    
    20,872
    
    
    
    24,182
    
    
    
    5,842
    
    
    
    30,024Bonus rewards
    
    
    1,805
    
    
    
    682
    
    
    
    2,487
    
    
    
    905
    
    
    
    239
    
    
    
    1,144Partner Commissions
    
    
    2,875
    
    
    
    977
    
    
    
    3,852
    
    
    
    2,659
    
    
    
    555
    
    
    
    3,214Total member benefits
    
    
    20,104
    
    
    
    7,107
    
    
    
    27,211
    
    
    
    27,746
    
    
    
    6,636
    
    
    
    34,382Net revenue
    
    $
    55,652
    
    
    $
    8,617
    
    
    $
    64,269
    
    
    $
    43,622
    
    
    $
    8,764
    
    
    $
    52,386
     24




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25




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Operating Expenses
        Other Income and Expense
  Income tax provision (benefit)
   26




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##### Table of Contents



Net income (loss)
   LIQUIDITY AND CAPITAL RESOURCES
 General
     Contractual Obligations and Commitments
  Payments by Due Periods (in thousands)FourthContractual Obligations and Commitments
    
    Total
    
    
    Qtr 2006
    
    
    2007-2008
    
    
    2009 and afterRevolving credit facility
    
    $
    48
    
    
    $
    16
    
    
    $
    32
    
    
    $
    Convertible subordinated debentures (including interest)
    
    
    75,239
    
    
    
    1,138
    
    
    
    74,101
    
    
    
    Vendor contracts
    
    
    23,686
    
    
    
    2,996
    
    
    
    20,690
    
    
    
    Patent litigation settlement
    
    
    200
    
    
    
    
    
    
    
    200
    
    
    
    Operating leases
    
    
    4,842
    
    
    
    487
    
    
    
    2,543
    
    
    
    1,812Total
    
    $
    104,015
    
    
    $
    4,637
    
    
    $
    97,566
    
    
    $
    1,812
 Revolving Credit Facility
   27




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##### Table of Contents



Convertible Subordinated Debentures
 1
 Dining Credits
  Off Balance Sheet Arrangements
  Litigation
   28




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##### Table of Contents



Item 3.
    
    Quantitative and Qualitative Disclosures about Market Risk
  
 Item 4.
    
    Controls and Procedures
 Evaluation of Disclosure Controls and Procedures.
 Changes in Internal Control over Financial Reporting.
  29




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##### Table of Contents



PART IIOTHER INFORMATION
(in thousands, except square footage)
 
 Item 1.
    
    Legal Proceedings
  
 Item 1A.
    
    Risk Factors
   30




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##### Table of Contents



Item 6.
    
    Exhibits
 Exhibit No.
    
    Description3.1
    
    
    Restated Certificate of Incorporation of Rewards Network Inc. is
incorporated herein by reference to Exhibit 4.1 to Rewards Network
Inc.s Registration Statement on Form S-3 (File No. 333-111390),
filed on December 19, 2003.3.2
    
    
    By-Laws of Rewards Network Inc., as amended, are incorporated herein
by reference to Exhibit 3.2 to Rewards Network Inc.s Annual Report
on Form 10-K (File No. 001-13806), filed on March 12, 2004.4.1
    
    
    Letter Agreement, dated as of June 12, 2002, between iDine Rewards
Network Inc. and Samstock, L.L.C. is incorporated herein by
reference to Exhibit 4.11 to Amendment No. 1 to iDine Rewards
Network Inc.s Annual Report on Form 10-K (File No. 001-13806),
filed on October 7, 2003.4.2
    
    
    Second Amended and Restated Investment Agreement, dated as of June
30, 1999, among Transmedia Network Inc., Samstock, L.L.C.,
EGI-Transmedia Investors, L.L.C. and Robert M. Steiner, as trustee,
is incorporated herein by reference to Exhibit 4.3 to Amendment No.
1 to Transmedia Network Inc.s Registration Statement on Form S-2
(File No. 333-84947), filed on October 5, 1999.4.3
    
    
    Amendment, dated February 5, 2003, to the Second Amended and
Restated Investment Agreement, dated as of June 30, 1999, among
iDine Rewards Network Inc., Samstock, L.L.C., and the former members
and distributees of EGI-Transmedia Investors, L.L.C., is
incorporated herein by reference to Exhibit 4.13 to Amendment No. 1
to iDine Rewards Network Inc.s Annual Report on Form 10-K (File No.
001-13806), filed on October 7, 2003.4.4
    
    
    Indenture, dated as of October 15, 2003, as amended and restated as
of February 4, 2004, between Rewards Network Inc. and LaSalle Bank
National Association is incorporated herein by reference to Exhibit
4.15 to Rewards Network Incs Annual Report on Form 10-K (File No.
001-13806), filed on March 12, 2004.4.5
    
    
    Registration Rights Agreement, dated October 8, 2003, between iDine
Rewards Network Inc. and Credit Suisse First Boston LLC is
incorporated herein by reference to Exhibit 4.18 to iDine Rewards
Network Inc.s Quarterly Report on Form 10-Q (File No. 001-13806),
filed on November 14, 2003.10.1
    
    
    Second Amendment, dated August 24, 2006, between Rewards Network
Inc. and Equity Office Properties Management Corp., as agent for Two
North Riverside Plaza Joint Venture Limited Partnership, an Illinois
limited partnership, sole beneficiary of LaSalle National Trust,
N.A., successor trustee under Trust Agreement dated June 26, 1969
and known as Trust No. 39712 is incorporated herein by reference to
Exhibit 10.1 to Rewards Network Inc.s Current Report on Form 8-K
(File No. 001-13806), filed on August 25, 2006.10.2
    
    
    Severance and Release Agreement, dated September 26, 2006, between
Bryan R. Adel and Rewards Network Inc. is incorporated herein by
reference to Exhibit 10.1 to Rewards Network Inc.s Current Report
on Form 8-K (File No. 001-13806), filed on September 26, 2006.31.1*
    
    
    Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer31.2*
    
    
    Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer32.1*
    
    
    Section 1350 Certification of Chief Executive Officer32.2*
    
    
    Section 1350 Certification of Chief Financial Officer
 
 *
    
    Filed herewith  31




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##### Table of Contents



SIGNATURES
  REWARDS NETWORK INC.November 7, 2006
    /s/    Christopher J. LockeChristopher J. LockeSenior Vice Presidentand Chief Financial Officer
(Principal Financial Officer and on behalf of the registrant)  32




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##### Table of Contents



Exhibit Index
 Exhibit No.
    
    Description3.1
    
    
    Restated Certificate of Incorporation of Rewards Network Inc. is
incorporated herein by reference to Exhibit 4.1 to Rewards Network
Inc.s Registration Statement on Form S-3 (File No. 333-111390),
filed on December 19, 2003.3.2
    
    
    By-Laws of Rewards Network Inc., as amended, are incorporated herein
by reference to Exhibit 3.2 to Rewards Network Inc.s Annual Report
on Form 10-K (File No. 001-13806), filed on March 12, 2004.4.1
    
    
    Letter Agreement, dated as of June 12, 2002, between iDine Rewards
Network Inc. and Samstock, L.L.C. is incorporated herein by
reference to Exhibit 4.11 to Amendment No. 1 to iDine Rewards
Network Inc.s Annual Report on Form 10-K (File No. 001-13806),
filed on October 7, 2003.4.2
    
    
    Second Amended and Restated Investment Agreement, dated as of June
30, 1999, among Transmedia Network Inc., Samstock, L.L.C.,
EGI-Transmedia Investors, L.L.C. and Robert M. Steiner, as trustee,
is incorporated herein by reference to Exhibit 4.3 to Amendment No.
1 to Transmedia Network Inc.s Registration Statement on Form S-2
(File No. 333-84947), filed on October 5, 1999.4.3
    
    
    Amendment, dated February 5, 2003, to the Second Amended and
Restated Investment Agreement, dated as of June 30, 1999, among
iDine Rewards Network Inc., Samstock, L.L.C., and the former members
and distributees of EGI-Transmedia Investors, L.L.C., is
incorporated herein by reference to Exhibit 4.13 to Amendment No. 1
to iDine Rewards Network Inc.s Annual Report on Form 10-K (File No.
001-13806), filed on October 7, 2003.4.4
    
    
    Indenture, dated as of October 15, 2003, as amended and restated as
of February 4, 2004, between Rewards Network Inc. and LaSalle Bank
National Association is incorporated herein by reference to Exhibit
4.15 to Rewards Network Incs Annual Report on Form 10-K (File No.
001-13806), filed on March 12, 2004.4.5
    
    
    Registration Rights Agreement, dated October 8, 2003, between iDine
Rewards Network Inc. and Credit Suisse First Boston LLC is
incorporated herein by reference to Exhibit 4.18 to iDine Rewards
Network Inc.s Quarterly Report on Form 10-Q (File No. 001-13806),
filed on November 14, 2003.10.1
    
    
    Second Amendment, dated August 24, 2006, between Rewards Network
Inc. and Equity Office Properties Management Corp., as agent for Two
North Riverside Plaza Joint Venture Limited Partnership, an Illinois
limited partnership, sole beneficiary of LaSalle National Trust,
N.A., successor trustee under Trust Agreement dated June 26, 1969
and known as Trust No. 39712 is incorporated herein by reference to
Exhibit 10.1 to Rewards Network Inc.s Current Report on Form 8-K
(File No. 001-13806), filed on August 25, 2006.10.2
    
    
    Severance and Release Agreement, dated September 26, 2006, between
Bryan R. Adel and Rewards Network Inc. is incorporated herein by
reference to Exhibit 10.1 to Rewards Network Inc.s Current Report
on Form 8-K (File No. 001-13806), filed on September 26, 2006.31.1*
    
    
    Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer31.2*
    
    
    Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer32.1*
    
    
    Section 1350 Certification of Chief Executive Officer32.2*
    
    
    Section 1350 Certification of Chief Financial Officer
 
 *
    
    Filed herewith  33