##### Table of Contents

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(Mark One)

|x | Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
|- | ---------------------------------------------------------------------------------------



For the quarterly period ended March 31, 2005



or



| ̈ | 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



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REWARDS NETWORK INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|DELAWARE                                                       |  | 84-6028875                          
|(State or other jurisdiction of incorporation or organization) |  | (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)



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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90
days.    x  Yes ̈No



Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).    x  Yes ̈No



As of May 2, 2005, there were
25,812,815 shares of the registrants common stock, par value $.02 per share, outstanding.



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##### Table of Contents

INDEX



REWARDS NETWORK INC. AND
SUBSIDIARIES



|           |  |                                                                                              |  |         
|---------- |  | -------------------------------------------------------------------------------------------- |  | --------
|           |  |                                                                                              |  | Page No.
|PART I.    |  | FINANCIAL INFORMATION                                                                        |  |         
|           |  |                                                                                             
|Item 1.    |  | Financial Statements:                                                                        |  |         
|           |  |                                                                                             
|           |  | Consolidated Balance SheetsMarch 31, 2005 (unaudited) and December 31, 2004                 |  | 3       
|           |  |                                                                                             
|           |  | Consolidated Statements of OperationsThree months ended March 31, 2005 and 2004 (unaudited) |  | 4       
|           |  |                                                                                             
|           |  | Consolidated Statements of Cash FlowsThree months ended March 31, 2005 and 2004 (unaudited) |  | 5       
|           |  |                                                                                             
|           |  | Notes to Unaudited Condensed Consolidated Financial Statements                               |  | 6-11    
|           |  |                                                                                             
|Item 2.    |  | Managements Discussion and Analysis of Financial Condition and Results of Operations        |  | 12-23   
|           |  |                                                                                             
|Item 3.    |  | Quantitative and Qualitative Disclosure About Market Risk                                    |  | 23      
|           |  |                                                                                             
|Item 4.    |  | Controls and Procedures                                                                      |  | 23      
|           |  |                                                                                             
|PART II.   |  | OTHER INFORMATION                                                                            |  |         
|           |  |                                                                                             
|Item 6.    |  | Exhibits                                                                                     |  | 24-25   
|           | 
|SIGNATURES |  | 26                                                                                          



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##### Table of Contents

REWARDS NETWORK INC. AND SUBSIDIARIES



PART I  FINANCIAL INFORMATION

Consolidated Balance Sheets

(in thousands, except per share data)



|                                                                                                                                                                         |  |                |         |   |                    |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | -------------- | ------- | - | ------------------ | - | ------- | -
|                                                                                                                                                                         |  | March 31, 2005 |         |   | December 31, 2004* |  
|                                                                                                                                                                         |  | Unaudited      |         |   |                    |  
|Assets                                                                                                                                                                   |  |                |         |   |                    |   |         |  
|Current assets:                                                                                                                                                          |  |                |         |   |                    |   |         |  
|Cash and cash equivalents                                                                                                                                                |  | $              | 4,056   |   |                    | $ | 8,728   |  
|Short-term available for sale securities                                                                                                                                 |  |                | 6,697   |   |                    |   | 6,718   |  
|Accounts receivable, net of allowance for doubtful accounts of $3,300 and $2,793, respectively                                                                           |  |                | 6,297   |   |                    |   | 7,642   |  
|Marketing Credits, net of allowance for doubtful accounts of $25,829 and $26,943, respectively                                                                           |  |                | 141,593 |   |                    |   | 143,947 |  
|Deferred income taxes                                                                                                                                                    |  |                | 9,255   |   |                    |   | 8,640   |  
|Prepaid expenses and other current assets                                                                                                                                |  |                | 1,389   |   |                    |   | 1,588   |  
|Income taxes receivable                                                                                                                                                  |  |                | 2,925   |   |                    |   | 1,194   |  
|                                                                                                                                                                         |  |                |         |   |                    |   |         |  
|Total current assets                                                                                                                                                     |  |                | 172,212 |   |                    |   | 178,457 |  
|                                                                                                                                                                         |  |               
|Property and equipment, net of accumulated depreciation and amortization of $14,234 and $13,194, respectively                                                            |  |                | 9,716   |   |                    |   | 10,450  |  
|Other assets                                                                                                                                                             |  |                | 2,260   |   |                    |   | 1,762   |  
|Long-term available for sale securities                                                                                                                                  |  |                | 331     |   |                    |   | 331     |  
|Excess of cost over net assets acquired (goodwill)                                                                                                                       |  |                | 8,117   |   |                    |   | 9,671   |  
|                                                                                                                                                                         |  |                |         |   |                    |   |         |  
|Total assets                                                                                                                                                             |  | $              | 192,636 |   |                    | $ | 200,671 |  
|                                                                                                                                                                         |  |                |         |   |                    |   |         |  
|Liabilities and Stockholders Equity                                                                                                                                     |  |                |         |   |                    |   |         |  
|Current liabilities:                                                                                                                                                     |  |                |         |   |                    |   |         |  
|                                                                                                                                                                         |  |               
|Accounts payableMarketing Credits                                                                                                                                       |  | $              | 8,358   |   |                    | $ | 13,031  |  
|Accounts payabletrade                                                                                                                                                   |  |                | 15,579  |   |                    |   | 15,685  |  
|Accrued compensation                                                                                                                                                     |  |                | 2,515   |   |                    |   | 2,641   |  
|Other current liabilities                                                                                                                                                |  |                | 4,053   |   |                    |   | 2,978   |  
|Deferred membership fee income                                                                                                                                           |  |                | 1,514   |   |                    |   | 1,616   |  
|                                                                                                                                                                         |  |                |         |   |                    |   |         |  
|Total current liabilities                                                                                                                                                |  |                | 32,019  |   |                    |   | 35,951  |  
|                                                                                                                                                                         |  |               
|Convertible subordinated debentures                                                                                                                                      |  |                | 70,000  |   |                    |   | 70,000  |  
|Deferred income taxes                                                                                                                                                    |  |                | 1,326   |   |                    |   | 1,904   |  
|Other long-term liabilities                                                                                                                                              |  |                | 399     |   |                    |   | 448     |  
|                                                                                                                                                                         |  |                |         |   |                    |   |         |  
|Total liabilities                                                                                                                                                        |  |                | 103,744 |   |                    |   | 108,303 |  
|                                                                                                                                                                         |  |                |         |   |                    |   |         |  
|Stockholders equity:                                                                                                                                                    |  |                |         |   |                    |   |         |  
|Common stock, par value $0.02 per share; authorized 70,000 shares; issued 26,079 and 26,041 shares, respectively; and outstanding 25,797 and
25,759 shares, respectively |  |                | 522     |   |                    |   | 521     |  
|Additional paid-in capital                                                                                                                                               |  |                | 59,664  |   |                    |   | 59,450  |  
|Cumulative other comprehensive income (loss):                                                                                                                            |  |                |         |   |                    |   |         |  
|Unrealized loss on marketable securities, net of tax                                                                                                                     |  |                | (60     | ) |                    |   | (54     | )
|Foreign currency translation, net of tax                                                                                                                                 |  |                | 241     |   |                    |   | 259     |  
|Retained earnings                                                                                                                                                        |  |                | 30,735  |   |                    |   | 34,402  |  
|Treasury stock, at cost (282 shares)                                                                                                                                     |  |                | (2,210  | ) |                    |   | (2,210  | )
|                                                                                                                                                                         |  |                |         |   |                    |   |         |  
|Total stockholders equity                                                                                                                                               |  |                | 88,892  |   |                    |   | 92,368  |  
|                                                                                                                                                                         |  |                |         |   |                    |   |         |  
|Total liabilities and stockholders equity                                                                                                                               |  | $              | 192,636 |   |                    | $ | 200,671 |  
|                                                                                                                                                                         |  |                |         |   |                    |   |         |  

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|* | The balance sheet at December 31, 2004 is derived from the registrants audited consolidated financial statements.
|- | ------------------------------------------------------------------------------------------------------------------



See accompanying notes to unaudited condensed consolidated financial
statements.



3



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##### Table of Contents

REWARDS NETWORK INC. AND SUBSIDIARIES



Consolidated Statements of Operations

(Unaudited)

(in thousands, except earnings per share)



|                                                                            |  |                              |        |   |      |   |        |  
|--------------------------------------------------------------------------- |  | ---------------------------- | ------ | - | ---- | - | ------ | -
|                                                                            |  | Three Months Ended March 31, |       
|                                                                            |  | 2005                         |        |   | 2004 |  
|Operating revenues:                                                         |  |                              |        |   |      |   |        |  
|Sales                                                                       |  | $                            | 74,764 |   |      | $ | 88,649 |  
|                                                                            |  |                              |        |   |      |   |        |  
|Cost of sales                                                               |  |                              | 37,561 |   |      |   | 42,395 |  
|Provision for losses                                                        |  |                              | 8,496  |   |      |   | 3,243  |  
|Member rewards and savings                                                  |  |                              | 13,153 |   |      |   | 19,475 |  
|                                                                            |  |                              |        |   |      |   |        |  
|Total direct expenses                                                       |  |                              | 59,210 |   |      |   | 65,113 |  
|                                                                            |  |                              |        |   |      |   |        |  
|Net revenue                                                                 |  |                              | 15,554 |   |      |   | 23,536 |  
|Membership fees and other income                                            |  |                              | 783    |   |      |   | 948    |  
|                                                                            |  |                              |        |   |      |   |        |  
|Total operating revenues                                                    |  |                              | 16,337 |   |      |   | 24,484 |  
|                                                                            |  |                              |        |   |      |   |        |  
|Operating expenses:                                                         |  |                              |        |   |      |   |        |  
|Salaries and benefits                                                       |  |                              | 5,235  |   |      |   | 5,565  |  
|Sales commissions and expenses                                              |  |                              | 5,189  |   |      |   | 5,437  |  
|Professional fees                                                           |  |                              | 1,980  |   |      |   | 851    |  
|Member and merchant marketing                                               |  |                              | 1,473  |   |      |   | 1,987  |  
|Goodwill impairment                                                         |  |                              | 1,554  |   |      |   |       |  
|General and administrative                                                  |  |                              | 6,352  |   |      |   | 4,242  |  
|                                                                            |  |                              |        |   |      |   |        |  
|Total operating expenses                                                    |  |                              | 21,783 |   |      |   | 18,082 |  
|                                                                            |  |                              |        |   |      |   |        |  
|Operating income (loss)                                                     |  |                              | (5,446 | ) |      |   | 6,402  |  
|                                                                            |  |                             
|Other income (expense):                                                     |  |                              |        |   |      |   |        |  
|Interest and other income                                                   |  |                              | 73     |   |      |   | 139    |  
|Interest expense and financing costs                                        |  |                              | (769   | ) |      |   | (932   | )
|                                                                            |  |                              |        |   |      |   |        |  
|Income (loss) before income tax provision (benefit)                         |  |                              | (6,142 | ) |      |   | 5,609  |  
|Income tax provision (benefit)                                              |  |                              | (2,475 | ) |      |   | 2,272  |  
|                                                                            |  |                              |        |   |      |   |        |  
|Net income (loss)                                                           |  | $                            | (3,667 | ) |      | $ | 3,337  |  
|                                                                            |  |                              |        |   |      |   |        |  
|Net income (loss) available for common stockholders                         |  |                              | (3,667 | ) |      |   | 3,749  |  
|                                                                            |  |                              |        |   |      |   |        |  
|Earnings (loss) per share of common stock:                                  |  |                              |        |   |      |   |        |  
|Basic                                                                       |  | $                            | (0.14  | ) |      | $ | 0.14   |  
|                                                                            |  |                              |        |   |      |   |        |  
|Diluted                                                                     |  | $                            | (0.14  | ) |      | $ | 0.13   |  
|                                                                            |  |                              |        |   |      |   |        |  
|Weighted average number of common and common equivalent shares outstanding: |  |                              |        |   |      |   |        |  
|Basic                                                                       |  |                              | 25,926 |   |      |   | 24,322 |  
|                                                                            |  |                              |        |   |      |   |        |  
|Diluted                                                                     |  |                              | 25,926 |   |      |   | 29,915 |  
|                                                                            |  |                              |        |   |      |   |        |  



See accompanying notes
to unaudited condensed consolidated financial statements.



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REWARDS NETWORK INC. AND SUBSIDIARIES



Consolidated Statements of Cash Flows

(Unaudited)

(in thousands)



|                                                                                                   |  |                              |         |   |      |   |        |  
|-------------------------------------------------------------------------------------------------- |  | ---------------------------- | ------- | - | ---- | - | ------ | -
|                                                                                                   |  | Three Months Ended March 31, |        
|                                                                                                   |  | 2005                         |         |   | 2004 |  
|Cash flows from operating activities:                                                              |  |                              |         |   |      |   |        |  
|Net income (loss)                                                                                  |  | $                            | (3,667  | ) |      | $ | 3,337  |  
|                                                                                                   |  |                             
|Adjustments to reconcile net income (loss) to net cash (used in) provided by operating activities: |  |                              |         |   |      |   |        |  
|Depreciation and amortization                                                                      |  |                              | 1,095   |   |      |   | 1,108  |  
|Amortization of deferred financing cost                                                            |  |                              | 205     |   |      |   | 254    |  
|Impairment of goodwill                                                                             |  |                              | 1,554   |   |      |   |       |  
|Provision for losses on Marketing Credits                                                          |  |                              | 8,496   |   |      |   | 3,243  |  
|Loss on disposal of fixed assets                                                                   |  |                              | 28      |   |      |   |       |  
|Deferred income taxes                                                                              |  |                              | (1,193  | ) |      |   |       |  
|                                                                                                   |  |                             
|Changes in assets and liabilities:                                                                 |  |                              |         |   |      |   |        |  
|Accounts receivable                                                                                |  |                              | 1,345   |   |      |   | 238    |  
|Marketing Credits (including accounts payable - Marketing Credits)                                 |  |                              | (10,815 | ) |      |   | (5,707 | )
|Prepaid expenses and other current assets                                                          |  |                              | 199     |   |      |   | 573    |  
|Other assets                                                                                       |  |                              | (752    | ) |      |   | 432    |  
|Accounts payable                                                                                   |  |                              | (106    | ) |      |   | (394   | )
|Income taxes                                                                                       |  |                              | (1,731  | ) |      |   | 1,546  |  
|Accrued compensation                                                                               |  |                              | (126    | ) |      |   | (1,958 | )
|Other current liabilities                                                                          |  |                              | 1,075   |   |      |   | 393    |  
|Deferred membership fee income                                                                     |  |                              | (102    | ) |      |   | (272   | )
|                                                                                                   |  |                              |         |   |      |   |        |  
|Net cash (used in) provided by operating activities                                                |  |                              | (4,495  | ) |      |   | 2,793  |  
|                                                                                                   |  |                              |         |   |      |   |        |  
|Cash flows from investing activities:                                                              |  |                              |         |   |      |   |        |  
|                                                                                                   |  |                             
|Additions to property and equipment                                                                |  |                              | (389    | ) |      |   | (900   | )
|Decrease in short-term available for sale securities                                               |  |                              | 15      |   |      |   | 7,598  |  
|Increase in long-term available for sale securities                                                |  |                              |        |   |      |   | (4,168 | )
|                                                                                                   |  |                              |         |   |      |   |        |  
|Net cash provided by (used in) investing activities                                                |  |                              | (374    | ) |      |   | 2,530  |  
|                                                                                                   |  |                              |         |   |      |   |        |  
|Cash flows from financing activities:                                                              |  |                              |         |   |      |   |        |  
|                                                                                                   |  |                             
|Exercise of warrants and options for common stock                                                  |  |                              | 215     |   |      |   | 634    |  
|                                                                                                   |  |                              |         |   |      |   |        |  
|Net cash provided by financing activities                                                          |  |                              | 215     |   |      |   | 634    |  
|                                                                                                   |  |                              |         |   |      |   |        |  
|Effect of exchange rate on cash                                                                    |  |                              | (18     | ) |      |   |       |  
|                                                                                                   |  |                             
|Net (decrease) increase in cash                                                                    |  |                              | (4,672  | ) |      |   | 5,957  |  
|                                                                                                   |  |                             
|Cash and cash equivalents:                                                                         |  |                              |         |   |      |   |        |  
|Beginning of the period                                                                            |  |                              | 8,728   |   |      |   | 9,709  |  
|                                                                                                   |  |                              |         |   |      |   |        |  
|End of the period                                                                                  |  | $                            | 4,056   |   |      | $ | 15,666 |  
|                                                                                                   |  |                              |         |   |      |   |        |  
|Supplemental disclosures of cash flow information:                                                 |  |                              |         |   |      |   |        |  
|Cash paid during the period for:                                                                   |  |                              |         |   |      |   |        |  
|Interest                                                                                           |  | $                            | 4       |   |      | $ | 109    |  
|                                                                                                   |  |                              |         |   |      |   |        |  
|Income taxes                                                                                       |  | $                            | 470     |   |      | $ | 587    |  
|                                                                                                   |  |                              |         |   |      |   |        |  



See accompanying notes
to unaudited condensed consolidated financial statements.



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REWARDS NETWORK INC. AND SUBSIDIARIES



Unaudited Notes to Condensed Consolidated Financial Statements



(1) Basis of Presentation



These
unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Rule 10-01 of Regulation S-X. Accordingly, they do
not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and
liabilities and the disclosure of contingent assets and liabilities to prepare these interim financial statements in conformity with accounting principles generally accepted in the United States of America. In the opinion of management, all
adjustments that are of a normal recurring nature necessary to present fairly the consolidated financial position of Rewards Network Inc. and its subsidiaries (collectively, the Company) at March 31, 2005, consolidated results of
operations for the three months ended March 31, 2005 and 2004 and the consolidated statements of cash flows for the three months ended March 31, 2005 and 2004 have been made. Operating results for the three months ended March 31, 2005 are not
necessarily indicative of the results to be expected for the full year. For further information, refer to the consolidated financial statements and footnotes thereto included in the Companys annual report on Form 10-K for the year ended
December 31, 2004 filed with the Securities and Exchange Commission (SEC) on March 14, 2005. The consolidated balance sheet as of December 31, 2004 is derived from the Companys audited consolidated financial statements.



Nature of operations: The Company markets and administers loyalty rewards
programs that bring its participating merchants and members together. The Company does this by marketing its participating merchants to members and offering benefits in the form of Cashback Rewardssmsavings, airline frequent flyer miles and other currencies to members who patronize its participating merchants and pay their bills using a payment card that
they have registered with the Company.



The Companys
participating merchants are principally restaurants and hotels. The Company attracts participating restaurants by purchasing Marketing Credits for food and beverages, which it then uses when members dine at the participating restaurant, and by
providing Marketing Services that market to members the participating restaurants and offer benefits to members for dining at the participating restaurants. Both the Companys Marketing Credits Program and Marketing Services Program are
designed to generate incremental business from new and existing customers. The Company attracts participating hotels by providing Marketing Services that market the participating hotels to members, offer benefits to members and are designed to fill
empty hotel rooms and generate business from members.



The
Company obtains members through its relationships with airlines and other loyalty program providers, directly through its website, through corporate clients who participate in its corporate program, and through its relationships with payment card
issuers. The Company is able to provide frequent flier miles and other currencies as benefits to its members through its relationships with these airlines, payment card issuers and other loyalty program providers.



Principles of consolidation: The Companys unaudited condensed
consolidated financial statements include the accounts of Rewards Network Inc. and its subsidiaries after the elimination of all material intercompany balances and transactions.



Reclassification: Certain prior period amounts have been reclassified to conform to the current periods presentation.



(2) Credit Agreement Covenant Waiver



On April 25, 2005, the Company, Bank of America, N.A., and the lenders party
thereto entered into a Waiver (Waiver) to the Credit Agreement among the Company, Bank of America, N.A., as Administrative



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REWARDS NETWORK INC. AND SUBSIDIARIES



Unaudited Notes to Condensed Consolidated Financial
Statements(Continued)



Agent and Letter of Credit Issuer, and the other lenders party thereto. Pursuant to the Waiver, the lenders agreed to waive any default having occurred or to
occur as a result of a breach of certain sections of the Credit Agreement, which require the Company to maintain positive net income and a ratio of indebtedness to earnings before interest, taxes, depreciation and amortization that does not exceed a
stated amount, for the quarterly accounting period ended March 31, 2005. The Waiver does not waive any defaults for purposes of requesting an extension of credit under the Credit Agreement. The Company does not currently have any borrowings
outstanding under the Credit Agreement. The Company is discussing with Bank of America, N.A. modifications to the Credit Agreement that would cure the defaults for purposes of requesting an extension of credit under the Credit Agreement.



(3) Goodwill Impairment



In 1997, the Company started the systematic reacquisition of its
franchised territories which it completed by mid-2000. At the time of the reacquisition, the Company treated the excess of cost over fair value of assets acquired as goodwill. During the first quarter of 2005, certain of these reacquired territories
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 executive management in the first quarter, gave rise to the Companys need to reassess the goodwill related to the reacquired franchises.



In accordance with the provisions of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 142
Goodwill and Other Intangible Assets SFAS 142, the Company prepared a discounted cash flow analysis which indicated that the book value of the certain reporting units exceeded their estimated fair value and that all of the
goodwill associated with these reporting units had been impaired. Accordingly, the Company has recognized a non-cash impairment loss of $1,553,637 ($0.04 per share) for the three months ended March 31, 2005.



(4) CEO Compensation Agreements



On March 29, 2005, the Board of Directors appointed Ronald L. Blake as
President and Chief Executive Officer. Mr. Blakes compensation consists of an annual salary of $600,000 and benefits consistent with the Companys standard employee benefit plans.



Also, on March 29, 2005, Mr. George S. Wiedemann, the former President and
Chief Executive Officer, resigned. As part of his severance agreement, Mr. Wiedemann will receive severance payments of $806,750 over a period of twelve months following his resignation and COBRA reimbursement for a period of twelve months. Mr.
Wiedemann also resigned from the Board of Directors. The entire amount relating to the severance was recorded during the three months ended March 31, 2005.



(5) Available for sale securities



Investments and marketable securities, all classified as available-for-sale, consisted of the following at March 31, 2005.



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REWARDS NETWORK INC. AND SUBSIDIARIES



Unaudited Notes to Condensed Consolidated Financial
Statements(Continued)



|                                         |  |                |       |                        |   |                         |  |              |    |  |   |      
|---------------------------------------- |  | -------------- | ----- | ---------------------- | - | ----------------------- |  | ------------ | -- |  | - | -----
|                                         |  | Amortized Cost |       | Gross Unrealized Gains |   | Gross Unrealized Losses |  | Market Value
|                                         |  | (in thousands)
|Short-term available for sale securities |  |                |       |                        |   |                         |  |              |    |  |   |      
|U.S. government obligations              |  | $              | 6,759 |                        | $ |                        |  | $            | 62 |  | $ | 6,697
|                                         |  |                |       |                        |   |                         |  |              |    |  |   |      
|Long-term available for sale securities  |  |                |       |                        |   |                         |  |              |    |  |   |      
|Other                                    |  |                | 331   |                        |   |                        |  |              |   |  |   | 331  
|                                         |  |                |       |                        |   |                         |  |              |    |  |   |      



(6) Certain Relationships and
Related Party Transactions



On August 30, 1999, the
Company entered into an office lease agreement with EOP  Northwest Properties, L.L.C., an affiliate of Equity Office Properties Trust. Samuel Zell, the Companys Chairman of the Board of Directors, is Chairman of the Board of Trustees and
a stockholder of Equity Office Properties Trust. The lease is for office space at 999 Third Avenue, Suite 3800, Seattle, Washington. The term of the lease commenced on September 1, 1999 and the Company has delivered notice of termination effective
August 31, 2005. The Company paid rent of $10,347 and $8,008 for the three months ended March 31, 2005 and 2004, respectively.



On May 5, 2003, the Company entered into an office lease agreement with Equity Office Properties Management Corp., the agent for Two North Riverside Plaza
Joint Venture Limited Partnership, a limited partnership comprised in part of trusts established for the benefit of Samuel Zell and members of his family. The lease initially provided for 10,000 square feet of office space at Two North Riverside
Plaza, Chicago, Illinois and, effective July 1, 2004, the Company exercised its option to increase this space to 14,324 square feet. The term of the lease is from September 1, 2003 through August 31, 2008. The Company paid rent of $71,218 and
$47,429 for the three months ended March 31, 2005 and 2004, respectively.



On June 25, 2004, the Company entered into an office lease agreement with Equity Office Management, L.L.C., as indirect manager of San Felipe Plaza, Ltd., a limited partnership. Equity Office Management, L.L.C. is an
affiliate of Equity Office Properties Trust. The lease provides for 827 square feet of office space at 5847 San Felipe, Suite 1675, Houston, Texas. The term of the lease is from July 1, 2004 through June 30, 2009. The Company paid rent of $4,342 for
the three months ended March 31, 2005.



The future minimum
lease obligation for these three leases is as follows:



|                                   |  |                |      
|---------------------------------- |  | -------------- | -----
|Year ending December 31,           |  | (in thousands)
|2005                               |  |                | 227  
|2006                               |  |                | 298  
|2007                               |  |                | 305  
|2008                               |  |                | 213  
|Thereafter (through June 30, 2009) |  |                | 8    
|                                   |  |                |      
|Total minimum lease payments       |  | $              | 1,051
|                                   |  |                |      



Equity Group
Investments, L.L.C. (EGI), an affiliate of Samstock, L.L.C., the Companys largest stockholder, provided investment and other financial advisory services to the Company in 2004. The Company paid $62,500 to EGI for these services for
the three-month period ended March 31, 2004. Samuel Zell serves as Chairman of EGI. This arrangement was terminated as of September 30, 2004.



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REWARDS NETWORK INC. AND SUBSIDIARIES



Unaudited Notes to Condensed Consolidated Financial
Statements(Continued)



On October 11, 2004, the Company entered into an agreement with EGI for administrative services
beginning October 18, 2004 and continuing on a month to month basis, with a 30 day written notice required for cancellation. The administrative services consist of rent for 1,251 square feet of additional office space at Two North Riverside Plaza,
Chicago, Illinois, utilities and maintenance service. For the three months ended March 31, 2005, the Company paid $6,724 to EGI for these services. This agreement was terminated as of April 30, 2005.



(7) Litigation



On May 25, 2004, a complaint was filed in the Los Angeles County Superior Court against the Company and certain of its
subsidiaries by Bistro Executive, Inc., Westward Beach Restaurant Holdings, LLC and MiniBar Lounge, all of which were participants in the Companys Dining Credits Purchase Plan (the Dining Plan), and their respective owners.



The complaint purports to be a class action brought by the
named plaintiffs on behalf of a class consisting of all restaurants located in California who participated in the Dining Plan and all persons in California who provided personal guaranties of obligations under the Dining Plan. The complaint claims
that amounts paid by the Company under the Dining Plan constituted loans, and asserts claims for damages and equitable and injunctive relief for violations of California usury laws and the California Unfair Business Practices Act and declaratory
relief. The complaint seeks, among other relief, disgorgement of all purported interest and profits earned by the Company from the Dining Plan in California, which plaintiffs allege to be a significant portion of an amount in excess of
$300 million, and treble damages for all purported interest paid within one year prior to the filing of the complaint.



On June 25, 2004, the action was removed from the Los Angeles County Superior Court to the United States District Court for the Central District of
California. The Company believes that the complaint is without merit and intends to vigorously defend against it. The ultimate cost to the Company from this action is not possible to predict and may not be determined for a number of years.



On October 1, 2004, a complaint was filed in the United States
District Court for the Eastern District of Texas against Rewards Network Inc. by Source Inc. The complaint claims that the Company is infringing four patents owned by Source Inc. The complaint seeks among other relief, treble damages due to willful
infringement and equitable relief. The Company is investigating the claims asserted by Source Inc. and believes that the complaint is without merit. The Company intends to vigorously defend against these claims. The ultimate cost to the Company from
this action is not possible to predict and may not be determined for a number of years.



(8) Earnings (loss) per Share



Basic
earnings (loss) per share were computed by dividing net income (loss) available to common stockholders by the weighted-average number of shares of the Companys common stock outstanding for each period presented. Diluted earnings per share were
computed by dividing net income (loss) available to common stockholders by the weighted-average number of shares of the Companys common stock and common stock equivalents outstanding for each period presented. Potentially dilutive securities
were considered for the three months ended March 31, 2005 and 2004 to the extent dilutive. There were 4,127,882 weighted average shares of common stock equivalents which were excluded for the three months ended March 31, 2005 as their effect would
have been anti-dilutive. The Company has restated diluted net income per share for the three months ended March 31, 2004 to include the dilutive impact of the convertible debentures and reflect the adoption of EITF 04-08.



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REWARDS NETWORK INC. AND SUBSIDIARIES



Unaudited Notes to Condensed Consolidated Financial
Statements(Continued)



|                                                                                           |  |                              |        |   |      |   |       
|------------------------------------------------------------------------------------------ |  | ---------------------------- | ------ | - | ---- | - | ------
|                                                                                           |  | Three months ended March 31,
|                                                                                           |  | 2005                         |        |   | 2004
|Net income (loss) as reported                                                              |  | $                            | (3,667 | ) |      | $ | 3,337 
|Convertible debentures, net of tax benefit                                                 |  |                              |       |   |      |   | 412   
|                                                                                           |  |                              |        |   |      |   |       
|Net income (loss) available to common stockholders                                         |  | $                            | (3,667 | ) |      | $ | 3,749 
|                                                                                           |  |                              |        |   |      |   |       
|Weighted average number of shares of common stock and common stock equivalents outstanding |  |                              |        |   |      |   |       
|Basic                                                                                      |  |                              | 25,926 |   |      |   | 24,322
|Stock options                                                                              |  |                              |       |   |      |   | 977   
|Warrants                                                                                   |  |                              |       |   |      |   | 703   
|Convertible debentures                                                                     |  |                              |       |   |      |   | 3,913 
|                                                                                           |  |                              |        |   |      |   |       
|Diluted                                                                                    |  |                              | 25,926 |   |      |   | 29,915
|                                                                                           |  |                              |        |   |      |   |       
|Earnings (loss) per share:                                                                 |  |                              |        |   |      |   |       
|Basic                                                                                      |  | $                            | (0.14  | ) |      | $ | 0.14  
|                                                                                           |  |                              |        |   |      |   |       
|Diluted                                                                                    |  | $                            | (0.14  | ) |      | $ | 0.13  
|                                                                                           |  |                              |        |   |      |   |       



(9) Stock-based Compensation



In accordance with the FASB Statement of Financial
Accounting Standards No. 148, Accounting for Stock-Based CompensationTransition and Disclosure, the Company has elected to continue to comply with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees (APB 25) to account for stock options and, accordingly, no compensation expense has been recognized in the Companys financial statements because the exercise price of employee stock options equals the fair market
price of the underlying stock on the date of grant. Under Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS No. 123), compensation cost is measured at the grant date based on
the estimated fair value of the award and is recognized as compensation expense over the vesting or service period. Had the Company determined compensation expense based on the fair value at the grant date for its stock options under SFAS No. 123,
the Companys net income would have been reduced to the pro forma amounts indicated below:



|                                                                   |  |                             |        |   |      |   |       |  
|------------------------------------------------------------------ |  | --------------------------- | ------ | - | ---- | - | ----- | -
|                                                                   |  | Three monthsended March 31, |       
|                                                                   |  | 2005                        |        |   | 2004 |  
|Net income (loss)                                                  |  |                             |        |   |      |   |       |  
|As reported                                                        |  | $                           | (3,667 | ) |      | $ | 3,337 |  
|Employee stock option compensation expense, net of tax             |  |                             | 1,534  |   |      |   | (568  | )
|                                                                   |  |                             |        |   |      |   |       |  
|Pro forma                                                          |  | $                           | (2,133 | ) |      | $ | 2,769 |  
|                                                                   |  |                             |        |   |      |   |       |  
|Net income (loss) per common share (basic)                         |  |                             |        |   |      |   |       |  
|As reported                                                        |  | $                           | (0.14  | ) |      | $ | 0.14  |  
|Employee stock option compensation expense, net of tax             |  |                             | 0.06   |   |      |   | (0.02 | )
|                                                                   |  |                             |        |   |      |   |       |  
|Pro forma                                                          |  | $                           | (0.08  | ) |      | $ | 0.12  |  
|                                                                   |  |                             |        |   |      |   |       |  
|Net income (loss) per common and common equivalent share (diluted) |  |                             |        |   |      |   |       |  
|As reported                                                        |  | $                           | (0.14  | ) |      | $ | 0.13  |  
|Employee stock option compensation expense, net of tax             |  |                             | 0.06   |   |      |   | (0.02 | )
|                                                                   |  |                             |        |   |      |   |       |  
|Pro forma                                                          |  | $                           | (0.08  | ) |      | $ | 0.11  |  
|                                                                   |  |                             |        |   |      |   |       |  



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REWARDS NETWORK INC. AND SUBSIDIARIES



Unaudited Notes to Condensed Consolidated Financial
Statements(Continued)



The Company uses the Black-Scholes valuation model for estimating the fair value of options granted.
During the three months ended March 31, 2005 and 2004, the Company granted options to purchase 90,000 and 140,000 shares of its common stock to certain executives, respectively. The following represents the estimated fair value of options granted
and the weighted-average assumptions used in calculating such estimate:



|                                                         |  |                              |      |   |      |   |      |  
|-------------------------------------------------------- |  | ---------------------------- | ---- | - | ---- | - | ---- | -
|                                                         |  | Three months ended March 31, |     
|                                                         |  | 2005                         |      |   | 2004 |  
|Weighted average estimated fair value per option granted |  | $                            | 2.91 |   |      | $ | 6.23 |  
|Stock volatility                                         |  |                              | 55.9 | % |      |   | 45.5 | %
|Risk-free interest rate                                  |  |                              | 4.3  | % |      |   | 3.8  | %
|Expected option life in years                            |  |                              | 10   |   |      |   | 10   |  
|Expected stock dividend yield                            |  |                              | 0    | % |      |   | 0    | %



(10) Recently Issued Accounting
Pronouncements



In September 2004, the Emerging Issues
Task Force of the FASB reached consensus on Issue No. 04-08, The Effect of Contingently Convertible Debt on Diluted Earnings per Share (EITF 04-08). The guidance requires companies to include shares issuable under convertible
debt in diluted earnings per share computations (if dilutive) regardless of whether the market price trigger (or other contingent feature) has been met. The Company adopted EITF 04-08 as of December 31, 2004 and prior periods diluted shares
outstanding and diluted earnings per share amounts were restated to present comparable information. The Company has $70 million of 3.25% debentures that are convertible into approximately 3.9 million shares of common stock if certain conditions are
met. Applying the if-converted method, as required by EITF 04-08, net income for the diluted earnings per share calculation is adjusted for interest expense associated with the convertible debt instrument and diluted weighted average shares
outstanding are increased for shares issuable upon conversion.



In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS 123R, Share-Based Payment, a revision of SFAS 123. In March 2005, the SEC issued Staff Bulletin No. 107 (SAB 107) regarding its
interpretation of SFAS 123R. The standard requires companies to expense the grant-date fair value of stock options and other equity-based compensation issued to employees. In accordance with the revised statement, the Company will be required to
recognize the expense attributable to stock options granted or vested subsequent to December 31, 2005. The Company is evaluating the requirements of SFAS 123R and SAB 107. The Company has not yet determined the method of adoption or the effect of
adopting SFAS 123R, and it has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123 in Note 8.



(11) Business and Credit Concentrations



As of March 31, 2005, the Company had contracts or relationships with nine major airlines that offer frequent flyer miles as
rewards. Also for the three months ended March 31, 2005, United Airlines, Delta Airlines and Upromise Inc. individually represented 10% or more of the Companys sales and for the three months ended March 31, 2004, United Airlines and Upromise
Inc. individually represented 10% or more of the Companys sales. The following table illustrates the Companys partner sales concentration as a percentage of total sales:



|                                             |  |                              |   |  |      |  
|-------------------------------------------- |  | ---------------------------- | - |  | ---- | -
|                                             |  | Three months ended March 31, |  
|                                             |  | 2005                         |   |  | 2004 |  
|Airlines                                     |  | 56.7                         | % |  | 55.6 | %
|Partners that represent 10% or more of sales |  | 46.0                         | % |  | 33.1 | %



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Unaudited Notes to Condensed Consolidated Financial
Statements(Continued)



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations



You should read the following discussion together with our 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) our dependence on our relationships with airlines and other reward program partners for a significant number of members, (ii) the concentration of a significant amount of our rewards currency in one industry group, the airline
industry, (iii) our inability to attract and retain merchants and members, (iv) our inability to maintain an appropriate balance between the number of members and the number of participating merchants in each market, (v) changes to card association
rules and practices, (vi) our dependence upon our relationships with transaction processors, presenters and aggregators, (vii) network interruptions or processing errors, (viii) our susceptibility to a changing regulatory environment, (ix) increased
operating costs due to privacy concerns of our marketing partners, payment card processors and the public, (x) the failure of our security measures, (xi) our susceptibility to restaurant credit risk, (xii) economic changes, (xiii) an adverse change
in our loss experience related to Marketing Credits, (xiv) adverse consequences of changes in our programs that affect the rate of rewards received by members, (xv) our inability to generate sufficient profit margin on expanded restaurant product
offerings, (xvi) the loss of key personnel, (xvii) adverse determination of lawsuits in which we are a defendant, (xviii) increasing competition, (xix) our inability to obtain sufficient cash, (xx) the failure of our program offering members rewards
for patronizing select hotels,(xxi) the failure of our retail rewards program, 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. See the cautionary statements included as Exhibit 99.1 to our annual report on Form 10-K for the
year ended December 31, 2004 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



We market and administer loyalty rewards programs that bring our
participating merchants and members together. We do this by marketing our participating merchants to members and offering benefits in the form of cash credits to the members payment card account, which we refer to as Cashback
Rewardssmsavings, airline frequent flier miles and other currencies to members who patronize our participating
merchants and pay their bills using a payment card that they have registered with us.



Our participating merchants are principally restaurants and hotels. We attract participating restaurants by purchasing Marketing Credits for food and beverages, which we then use when members dine at the participating
restaurant, and by providing Marketing Services that market to members the participating restaurants and offer benefits to members for dining at the participating restaurants. Until late 2004, the Marketing Credits Program was called the Dining
Credits Purchase Plan and Marketing Credits were referred to as Rights to Receive, RTR or Dining Credits. Also, our Marketing Services Program was previously referred to as the Revenue Management Plan. We have made these terminology changes to
better align the terms with the services provided. Both our Marketing Credits Program and Marketing Services Program are designed to generate incremental business from



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(dollar amounts in thousands except average transaction amounts and per
share data)



new and existing customers. We attract participating hotels by providing Marketing Services that market the participating hotels to members, offer benefits
to members and are designed to fill empty hotel rooms and generate business from members.



We obtain members through our relationships with airlines and other loyalty program providers, directly through our website, through corporate clients who participate in our corporate program, and through our
relationships with payment card issuers. We are able to provide frequent flier miles and other currencies as benefits to members through our relationships with these airlines, payment card issuers and other loyalty program providers.



Participating Merchants



Restaurants



As of March 31, 2005, we had 10,307 participating restaurants in more than 45 U.S. states and in Canada. We primarily offer
two programs for our participating restaurants  the Marketing Credits Program and the Marketing Services Program.



In June 2004, we launched our Marketing Credits Program and Marketing Services Program in Canada in the provinces of Ontario and British Columbia. As of
March 31, 2005, we had 103 participating restaurants in Canada.



Marketing Credits Program. Under this program, we purchase food and beverage credits, which we refer to as Marketing Credits, from a participating restaurant, typically for cash, at a discount from the retail price for which it sells
the food and beverages. We then market the participating restaurant to members and offer benefits to our members in the form of Cashback Rewards savings, frequent flier miles and other currencies for dining at the participating restaurant. The
amount of benefits offered to members may vary by the day of week. When a member dines at a restaurant that participates in the Marketing Credits Program and pays the bill with a payment card registered with us, we are entitled to receive from the
participating restaurant a percentage of the total transaction amount (including food, beverages, tax and tip), which we generally debit from the participating restaurants bank account. We then reduce the amount of Marketing Credits
outstanding with the participating restaurant by an amount equal to the amount that we receive from the participating restaurant.



Marketing Services Program. Under this program, we provide Marketing Services to a participating restaurant by marketing the participating
restaurant to members and offering to members Cashback Rewards savings, frequent flier miles and other benefits for dining at the participating restaurant. The amount of benefits offered to members may vary by the day of week. Under the Marketing
Services Program, we receive a marketing fee from the participating restaurant only when a member dines at the participating restaurant and pays the bill with a payment card registered with us. The marketing fee is equal to a percentage of the total
transaction amount. We generally debit the marketing fee from the participating restaurants bank account.



The percentage of the transaction amount that we receive under the Marketing Services Program is less than the percentage of the transaction amount that
we receive under the Marketing Credits Program, and as a result, our revenue per transaction in the Marketing Services Program is less than under the Marketing Credits Program. However, the Marketing Services Program does not require us to commit
capital through the purchase of any Marketing Credits from the participating restaurant.



Hotels



Since the
second quarter of 2003, we have offered a Marketing Services Program for hotels. We market participating hotels to members and offer members reduced rates and Cashback Rewards savings, frequent flier miles and other benefits if they make their
reservations at participating hotels through our website or call center.



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(dollar amounts in thousands except average transaction amounts and per
share data)



Our participating hotels include independent hotels, which typically do not have their own loyalty
programs, and major hotel chains. Participating hotels either enter into agreements directly with us or participate in the Marketing Services Program through our relationship with Travelweb LLC, a travel distribution company, which has enabled us to
expand our hotel Marketing Services Program by including additional independent hotels as well as certain major U.S. hotel chains. The number of participating hotels has grown to approximately 11,448 as of March 31, 2005, with participating hotels
located throughout the United States and in Canada.



Under our
Marketing Services Program for hotels, we receive a marketing fee from a participating hotel when a member pays for a hotel room with a payment card that they have registered with us after making a reservation through our website or call center. The
marketing fee is equal to a percentage of the hotel room rate.



Members



As of March 31, 2005, we had approximately 3.7
million active member accounts. We consider a member account to be active if the account has at least one transaction that qualified for a benefit at a participating merchant during the last 12 months. An active member account may consist of more
than one payment card and may have more than one person associated with the account, although we consider each member account to be held by one member.



We obtain members from a variety of sources and marketing efforts, including through advertising our programs and through
our relationships with major airlines, payment card issuers and other loyalty program providers. In our partner programs, members may be solicited for enrollment or may be directly enrolled by our partners. Generally, a member enrolled in one of our
programs through a partner remains a member so long as our relationship with the partner continues, and if our relationship with the partner terminates, in most cases our relationship with the member would terminate. Additionally, members enrolled
by our partners may also be unenrolled by the partner, and our partner generally has the right to approve all communications between us and the member.



We offer a choice of programs to members. Members who enroll directly in our Cashback Rewards Program generally pay an annual fee, and members who enroll
in our programs that provide benefits to members in other currencies, such as airline frequent flier miles, generally do not pay an annual fee. Our membership programs consist of the following:



Loyalty Partner Programs. We partner with various loyalty program
providers to offer their members the opportunity to earn awards, such as airline frequent flier miles or award points, through our programs when their members patronize our participating merchants. These programs are typically co-branded with our
loyalty partner (e.g., SkyMiles Dining by Rewards Network). The loyalty program provider benefits by expanding the earning opportunities for its members and increasing the volume of the loyalty currency it sells. In many cases, we work with the
loyalty program providers affinity payment card issuer by automatically including our benefit as a feature of the payment card.



Airline frequent flier programs represent the largest number of our member accounts that are part of our loyalty partner programs. As of March 31, 2005,
we provided dining benefits to nine major airlines, which we believe makes us the largest provider of dining programs for the airline industry. We are working to expand our loyalty partnerships beyond airlines. InterContinental Hotels Group,
Upromise, eBay and Electronic Script Incorporated (eScrip) are notable instances of non-airline loyalty program providers for which we provide dining benefits.



Cashback Rewards Program. This is a fee-based program that typically provides between 5% and 20% Cashback Rewards savings on charges for food,
beverage, tax and tip at participating restaurants and between 5%



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(dollar amounts in thousands except average transaction amounts and per
share data)



and 15% Cashback Rewards savings on charges for room rates at participating hotels. Cashback Rewards savings are a cash credit that we make directly to the
members payment card account. Some Cashback Rewards Program members may receive airline frequent flier miles instead of Cashback Rewards savings.



Members typically pay an upfront $49 annual fee. Alternatively, members may elect to earn their fee. In this case, we retain Cashback Rewards
savings until the member has received the amount of the fee in Cashback Rewards savings, after which point the member receives the Cashback Rewards savings and we (by not providing a benefit until the amount of the fee has accumulated) have
effectively received a fee.



Members of our Cashback Rewards
program tend to be our most engaged and profitable members due to the investment they make in the program by virtue of the fee paid and our direct relationship with the members.



Corporate Program. We offer the Corporate Program as a travel and entertainment expense reduction program to large
corporations. In this program, the corporate client enrolls in our program some or all of its corporate payment cards issued to its employees. We typically earn an annual fee by retaining a portion of the benefits for each member account enrolled in
the program, and we typically pay the benefits earned by the member accounts directly to the corporate client. In some cases, a portion of the benefit goes to employees in the form of airline frequent flier miles, providing further incentives for
employees to direct their spending to participating merchants.



Payment Card Issuer Programs. We work with various issuers of general purpose credit, debit and other charge cards to provide a Cashback Rewards program to certain payment card portfolios. Our program is a differentiating feature of
the card and provides cardholders with additional opportunities to earn benefits through the payment cards loyalty program. In some cases, the payment card issuer pays us a fee for their cardholders access to our program. As of March 31,
2005, our card issuer partners included Bank of America, Diners Club International, Royal Bank of Canada and JPMorgan Chase.



Registered Card Platform



A critical part of the administration of our programs is our registered card platform. Members enrolled in our programs have a major payment card
registered with us and then present that registered payment card while transacting at a participating merchant. Based on our agreements with various processors and presenters throughout the country, we receive data regarding all payment card
transactions at our participating merchants. We aggregate this transaction data and then match these data to a file containing members registered payment card information, enabling us to determine which transactions were made by members. The
transaction data that we receive is encrypted during transmission. We also receive files from some processors where the data is encrypted in a manner that allows us to read transactional data of registered members only. Members transactions
are qualified via business rules to determine whether they are eligible for a benefit.



We use the data regarding qualified transactions to provide Cashback Rewards savings, airline frequent flier miles and other benefits to members, depending on the program in which the member is enrolled. We also use
these data to invoice and collect our Marketing Services fees from participating merchants and reduce the amount of outstanding Marketing Credits at restaurants that participate in our Marketing Credits Program.



Member Benefits



We provide the vast majority of benefits to members in the form of Cashback Rewards savings, which are a direct cash credit
to their payment card account, a dollar-denominated award to their loyalty program account, or a mileage credit to their frequent flier account. Cashback Rewards savings typically represent between 5% and



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REWARDS NETWORK INC. AND SUBSIDIARIES



(dollar amounts in thousands except average transaction amounts and per
share data)



20% of the members total transaction amount with participating restaurants and typically between 5% and 15% of the members room rate with
participating hotels. Members of our partners loyalty programs and payment card issuer programs may receive benefits either as Cashback Rewards savings or in alternative currencies, such as airline frequent flier miles, depending on the
particular loyalty program. Members receiving airline frequent flier miles generally earn between five and ten miles for each dollar spent at participating restaurants and between five miles and ten miles for each room rate dollar spent at
participating hotels, provided that they make the hotel reservation through us.



We communicate benefit opportunities to members via a variety of communication tools, including email, our website, newsletters, directories, toll-free numbers, fax back services and personal digital assistants.



CRITICAL ACCOUNTING POLICIES AND ESTIMATES



Our discussion and analysis of our financial condition and results of
operations is based upon our unaudited 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 provision for Marketing 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 condensed consolidated financial statements.



Allowance for Marketing Credits Losses



We provide allowances for Marketing Credits losses based on our estimate
of losses that would result from the inability of participating merchants to remain in business and enable us to recover outstanding Marketing Credits. If the financial condition of our merchant base were to deteriorate beyond our expectations,
resulting in participating merchants inability to provide food and beverage to members thereby reducing the recoverability of Marketing Credits, additional allowances may be required.



We review our ability to realize Marketing Credits on a regular basis and
provide for anticipated losses on Marketing Credits from restaurants that have ceased operations, restaurants that interfere with our ability to recover unused Marketing Credits and restaurants whose Marketing Credits are not being utilized by
members. All other balances are segregated and evaluated based on the size of balance and the number of months required to recover the Marketing Credits outstanding. Account balances are charged off against the allowance when collection appears
unlikely. Losses are reduced by recoveries of Marketing Credits previously written off.



Deferred Tax Assets Valuation Allowance



We record a valuation allowance to reduce our deferred tax assets when future realization is in question. 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. Despite the current quarter loss, we believe that we will be able to fully utilize our net deferred tax asset in the future.



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(dollar amounts in thousands except average transaction amounts and per
share data)



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 that the asset is expected to generate. 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.



We comply with 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 reassessed any intangible assets, including goodwill, recorded in connection with
our previous acquisitions. During the first quarter of 2005, certain territories related to these 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 executive management in the first quarter, gave rise to the Companys need to reassess the goodwill related to
the reacquired franchises.



In accordance with the
provisions of SFAS 142, the Company 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, the Company has
recognized a non-cash impairment loss of $1,554 for the three months ended March 31, 2005.



Revenue Recognition



We recognize revenue when our 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 in accordance with the rules of
the particular marketing 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 contract with the participating merchant.



Membership Fee and Other Income



Membership fee and other income consists principally of renewal fees from
the Cashback Rewards Program members and is recognized over the membership period, which is usually twelve months beginning in the month the fee is received. Cardholder membership fees are cancelable and refunded to members, if requested, on a pro
rata basis based on the remaining portion of the membership. In those cases where we earn an annual fee by retaining a portion of the benefits for each member account enrolled in the program, the retained portion reduces the amount of rewards and
savings we record.



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(dollar amounts in thousands except average transaction amounts and per
share data)



(a) Results of operationsComparison of the quarters ended March 31, 2005 and 2004



The following table sets forth for the periods presented our sales,
components of our costs of sales and certain other information for each of our two revenue plans.



|                              |  |                              |        |   |                            |   |        |       |  |   |                           |   |  |                            |         |   |       |   |        |   |  |   |         |  
|----------------------------- |  | ---------------------------- | ------ | - | -------------------------- | - | ------ | ----- |  | - | ------------------------- | - |  | -------------------------- | ------- | - | ----- | - | ------ | - |  | - | ------- | -
|                              |  | Three Months ended March 31, |       
|                              |  | 2005                         |        |   | 2004                       |  
|                              |  | Marketing Credits Program    |        |   | Marketing Services Program |   |        | Total |  |   | Marketing Credits Program |   |  | Marketing Services Program |         |   | Total |  
|Qualified transaction amounts |  | $                            | 96,763 |   |                            | $ | 24,226 |       |  | $ | 120,989                   |   |  | $                          | 106,343 |   |       | $ | 30,521 |   |  | $ | 136,864 |  
|                              |  |                              |        |   |                            |  
|Sales yield                   |  |                              | 71.6   | % |                            |   | 22.7   | %     |  |   | 61.8                      | % |  |                            | 76.2    | % |       |   | 24.8   | % |  |   | 64.8    | %
|                              |  |                              |        |   |                            |  
|Sales                         |  |                              | 69,258 |   |                            |   | 5,506  |       |  |   | 74,764                    |   |  |                            | 81,065  |   |       |   | 7,584  |   |  |   | 88,649  |  
|                              |  |                              |        |   |                            |  
|Cost of Marketing Credits     |  |                              | 37,153 |   |                            |   |       |       |  |   | 37,153                    |   |  |                            | 42,088  |   |       |   |       |   |  |   | 42,088  |  
|Processing fee                |  |                              | 378    |   |                            |   | 30     |       |  |   | 408                       |   |  |                            | 281     |   |       |   | 26     |   |  |   | 307     |  
|                              |  |                              |        |   |                            |   |        |       |  |   |                           |   |  |                            |         |   |       |   |        |   |  |   |         |  
|Cost of sales                 |  | $                            | 37,531 |   |                            | $ | 30     |       |  | $ | 37,561                    |   |  | $                          | 42,369  |   |       | $ | 26     |   |  | $ | 42,395  |  
|                              |  |                              |        |   |                            |   |        |       |  |   |                           |   |  |                            |         |   |       |   |        |   |  |   |         |  
|Provision for losses          |  |                              | 8,328  |   |                            |   | 168    |       |  |   | 8,496                     |   |  |                            | 3,243   |   |       |   |       |   |  |   | 3,243   |  
|Member rewards and savings    |  |                              | 10,745 |   |                            |   | 2,408  |       |  |   | 13,153                    |   |  |                            | 15,827  |   |       |   | 3,648  |   |  |   | 19,475  |  
|                              |  |                              |        |   |                            |   |        |       |  |   |                           |   |  |                            |         |   |       |   |        |   |  |   |         |  
|Net revenue                   |  | $                            | 12,654 |   |                            | $ | 2,900  |       |  | $ | 15,554                    |   |  | $                          | 19,626  |   |       | $ | 3,910  |   |  | $ | 23,536  |  
|                              |  |                              |        |   |                            |   |        |       |  |   |                           |   |  |                            |         |   |       |   |        |   |  |   |         |  



As more fully
discussed below, net revenue for the three months ended March 31, 2005 decreased primarily due to an increase in the rate of provision for losses and a decrease in sales caused by a decrease in the number of transactions, a reduction in the average
transaction amount and a decrease in the sales yield recognized from qualified transactions.



Qualified transactions at our participating merchants (which are transactions where members are entitled to receive rewards or savings) decreased $15,875 or 11.6% to $120,989 for the three months ended March 31, 2005
as compared to $136,864 for the three months ended March 31, 2004. The number of transactions decreased 9.2% to approximately 2,515 for the three months ended March 31, 2005 as compared with 2,771 for the three months ended March 31, 2004 and the
average transaction amount decreased 2.6% to $48.11 for the three months ended March 31, 2005 from $49.40 for the three months ended March 31, 2004. The decrease in the number of qualified transactions is a result of our efforts to improve the
management of our members share of an individual restaurants business and fewer restaurants in the program. We believe that the lower average dining transaction amount in the three months ended March 31, 2005 compared with the three
months ended March 31, 2004 was due to a number of factors, including, but not limited to, (i) the replacement of some restaurant merchants in our programs with restaurant merchants with lower menu prices, (ii) decreased sales in some large primary
markets, (iii) increased weekday revenues where transaction amounts tend to be slightly lower, (iv) increased transactions among member groups with lower average dining transaction amounts and (v) decreased transactions among member groups with
higher average dining transaction amounts.



Sales yield, which
represents sales as a percentage of qualified transaction amounts, decreased to 61.8% for the three months ended March 31, 2005 compared with 64.8% for the three months ended March 31, 2004. The decline in the sales yield reflects the changing mix
in business propositions marketed to our merchants. We continue to work to improve restaurant merchant products to meet the needs of new merchants and reduce attrition of existing merchants. Many of these products have more favorable pricing for our
Marketing Credits and our Marketing Services and have resulted in lower sales yield from Marketing Credits Program and Marketing Services Program qualified transaction amounts.



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(dollar amounts in thousands except average transaction amounts and per
share data)



We have introduced new Marketing Services products and expanded our offering of Marketing Credits
products. Accordingly, we expect that in the future our sales yield percentage will further decline as qualified transactions from our Marketing Services Program represent a larger percentage of our total qualified transactions, and to the extent we
offer restaurant merchants participating in our Marketing Credits Program more favorable economics to address the increased rate of attrition we have been experiencing and to attract new restaurant merchants. To the extent that we are successful in
reducing restaurant merchant attrition and attracting new restaurant merchants, we believe that the increased sales that result from having more restaurant merchants should over time offset the lower sales yield.



Cost of sales, which is composed of the cost of Marketing Credits and related
processing fees, increased to 50.2% of sales for the three months ended March 31, 2005 compared with 47.8% of sales for the three months ended March 31, 2004. Many of the new products designed to meet the needs of merchants and reduce the rate of
attrition not only have lower sales yield, but they have more favorable pricing of Marketing Credits for our merchants and have resulted in a higher cost of sales for the three months ended March 31, 2005 compared with the three months ended March
31, 2004. Also contributing to the increase in the cost of sales percentage was the decrease in sales under our Marketing Services Program to 7.4% of total sales for the three months ended March 31, 2005 compared with 8.6% of total sales for
the three months ended March 31, 2004. There is effectively no direct cost of sales impact associated with sales under our Marketing Services Program and, therefore, the relative decrease in these sales as a percentage of total sales results in a
higher total cost of sales percentage.



The provision for
Marketing Credits losses increased to 11.4% of total sales and 12.3% of Marketing Credits Program sales for the three months ended March 31, 2005 compared with 3.7% of total sales and 4.0% of Marketing Credits Program sales for the three months
ended March 31, 2004. At the end of each reporting period we estimate the allowance for doubtful Marketing Credits accounts and, if necessary, adjust the provision for losses. The Marketing Credits portfolio is aged based on sales for the preceding
quarter and the allowance is computed primarily by applying estimated loss percentages to the aged portfolio. Allowances are also provided for specifically identified accounts and for Marketing Credits balances that are large or slow moving. The
increase in the provision for losses for the three months ended March 31, 2005 was primarily a result of the relatively large balance of Marketing Credits outstanding coupled with the decline in sales for the quarter. Accordingly, the sales for the
first quarter imply that recovery of the Marketing Credits portfolio will take longer and, therefore, that the allowance for uncollectible accounts should be larger.



Member rewards and savings which include partner commissions and incentive bonus rewards paid to members, decreased to 17.6%
of sales for the three months ended March 31, 2005 compared with 22.0% of sales for the three months ended March 31, 2004. There are two primary reasons for the decrease in the rate of rewards during 2005. First, in some cases, as part of the
changes in merchant deal economics, we have reduced member benefit levels. Secondly, in the second quarter of 2004, we introduced a program of variable benefits whereby some of our member rewards and savings are tied to their level of participation
in our programs. The reduced member benefit levels and the reduced rate of rewards paid to less engaged members has resulted in a lower overall effective rate of reward earned by our total membership base in the three months ended March 31, 2005
compared with the three months ended March 31, 2004.



Membership and other income decreased $165 or 17.4% for the three months ended March 31, 2005 compared with the three months ended March 31, 2004. The decrease can be primarily attributed to the decline in membership fee income and reflects
the continuing effects of a change in marketing strategy we adopted in late 1999 to reduce our marketing of fee-based memberships. Since that time our marketing strategy has been focused on marketing a no-fee dining program to key affinity and
loyalty partners where we can take advantage of the registered card platform and enroll large quantities of accounts at a reduced cost of acquisition and solicitation.



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REWARDS NETWORK INC. AND SUBSIDIARIES



(dollar amounts in thousands except average transaction amounts and per
share data)



Salaries and benefits decreased $330 or 5.9% to $5,235 for the three months ended March 31, 2005 from
$5,565 for the three months ended March 31, 2004 primarily as a result of a lower level of management incentive compensation in the three months ended March 31, 2005. This was partially offset by annual merit increases, higher employee benefit costs
and a planned increase in the number of employees.



Sales
commissions and expenses decreased $248 or 4.6% to $5,189 for the three months ended March 31, 2005 compared with $5,437 for the three months ended March 31, 2004 due to a 15.7% decrease in sales for the three months ended March 31, 2005. However,
sales commissions and expenses amounted to 6.9% of sales for the three months ended March 31, 2005 compared with 6.1% for the three months ended March 31, 2004. In January 2005, changes were made to the sales consultant compensation plan that
resulted in more guaranteed payments to salespersons as contrasted with commissions based solely on sales. The 15.7% decrease in sales for the first quarter of March 31, 2005 compared to the three months ended March 31, 2004, coupled with the
increase in guaranteed payments to salespersons, resulted in the increase in the sales commission percentage.



Professional fees increased $1,129 or 132.7% to $1,980 for the three months ended March 31, 2005 compared with $851 for the three months ended March 31,
2004. The increase is primarily due to increased accounting fees associated with the requirements under Sarbanes-Oxley for the review and evaluation of internal control, increased audit fees and legal costs for various litigation matters.



Member and merchant marketing expenses decreased $514 or 25.9%
for the three months ended March 31, 2005 compared with the three months ended March 31, 2004 due to a decrease in directory printing and mailing costs and a decrease in member promotional marketing, part of which relates to hotel marketing. The
decrease in directory printing and mailing is primarily due to the marketing initiative we began in the second half of 2003, replacing national directories with a customized, pocket-sized, eight-panel directory of restaurant listings in a
members frequent dining areas (which we call Fold-N-Go statements) for segments of our membership base. These Fold-N-Go statements are less expensive to produce and distribute than the directories. We continue to reduce the
distribution of directories as we concentrate on more electronic marketing such as emails. In addition, during the three months ended March 31, 2004, we had member promotions relating to the production of an airline video that was not repeated in
2005, and during the three months ended March 31, 2005, we scaled back our hotel marketing as we focus on our dining business.



During the three months ended March 31, 2005, certain territories we reacquired in 1998 and 1999 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 executive management in the first quarter, gave
rise to the Companys need to evaluate the goodwill related to the reacquired franchises. As a result of this evaluation, the Company recognized a non-cash impairment loss of $1,554 ($0.04 per share) for the three months ended March 31, 2005.



General and administrative expenses increased $2,110 or 49.7%
for the three months ended March 31, 2005 compared with the three months ended March 31, 2004. The increase is primarily the result of increases in severance costs of $1,577 related to the termination of certain executives during the three months
ended March 31, 2005 and a $127 increase in rent and other office expenses compared with the three months ended March 31, 2004 due primarily to rent increases and the opening of new sales offices.



Interest expense and financing costs related to our securitization facility,
revolving credit facility and convertible subordinated debentures decreased $163 or 17.5% for the three months ended March 31, 2005 compared with March 31, 2004. The decrease results from renewal costs associated with the securitization
that were fully amortized in May 2004, and therefore not included in the three months ended March 31, 2005. This



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REWARDS NETWORK INC. AND SUBSIDIARIES



(dollar amounts in thousands except average transaction amounts and per
share data)



decrease was partially offset by the amortization of fees and expenses relating to our revolving credit facility. On November 3, 2004, we entered into a
$50 million unsecured revolving credit facility with Bank of America, N.A. and LaSalle Bank, N.A. This facility expires on July 13, 2008. There were no borrowings outstanding at March 31, 2005.



Our effective tax benefit rate for the three months ended March 31, 2005 was
40.3% compared with an effective tax rate of 40.5% for the three months ended March 31, 2004.



Net loss for the three months ended March 31, 2005 was $3,667 compared with net income of $3,337 for the three months ended March 31, 2004. This change is primarily due to the decline in sales, higher provision for
marketing credits losses, severance costs and a goodwill impairment charge. Our weighted average shares and our diluted weighted average shares outstanding were 25,926 for the three months ended March 31, 2005 due to the fact that 4,128 weighted
average shares of common stock equivalents were excluded as their effect would have been anti-dilutive. Weighted average shares for the three months ended March 31, 2004 were 24,322 shares and our diluted weighted average shares were 29,915 shares.
We adopted the Emerging Issues Task Force of the FASB Issue No. 04-08, The Effect of Contingently Convertible Debt on Diluted Earnings per Share (EITF 04-08) as of September 31, 2004. We have $70 million of 3.25%
debentures that are convertible into approximately 3.9 million shares of common stock if certain conditions are met. Applying the if-converted method, as required by EITF 04-08, net income for the diluted earnings per share calculation is adjusted
for interest expense associated with the convertible debt instrument and diluted weighted average shares outstanding are increased for shares issuable upon conversion. Prior period diluted shares outstanding and diluted earnings per share amounts
have been revised to present comparable information.



(b) Liquidity and
Capital Resources



At March 31, 2005, our short-term
investments, cash and cash equivalents amounted to $10,753, and our long-term investments amounted to $331. Cash used in operating activities amounted to $4,495 in the quarter ended March 31, 2005 and was primarily due to the funding growth of our
Marketing Credits portfolio.



Cash used in investing activities
was $374 for the three months ended March 31, 2005 and included capital expenditures in the amount of $389. Capital expenditures for the quarter ended March 31, 2005 was primarily website development for our products and software development
relating to our sales consultants compensation plan and our geographic expansion into Canada.



During the three months ended March 31, 2005, our only source of financing cash flow was provided from the exercise of stock options.



On October 15, 2003, we completed a private placement of $70,000 principal amount of our 31/4% Convertible Subordinated Debentures with a final maturity date of October 15, 2023. The debentures bear interest
at 3.25% per annum, payable on April 15 and October 15 of each year, commencing on April 15, 2004. The net proceeds from the offering were $67,500, and the issuance costs of $2,500 are being amortized over five years. A holder of the debentures may
require us to repurchase for cash all or part of its debentures on October 15, 2008, October 15, 2013 and October 15, 2018 or upon a change of our control at a price equal to 100% of the principal amount of the debentures, together with accrued
and unpaid interest. We may redeem the debentures, in whole or in part, at any time after October 15, 2008 at a price equal to 100% of the principal amount of the debentures, together with accrued and unpaid interest. The debentures are convertible
prior to the maturity date into shares of our common stock at an initial conversion price of $17.89 per share, subject to adjustment for certain events, upon the occurrence of any of the following: (i) the closing price of our common



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(dollar amounts in thousands except average transaction amounts and per
share data)



stock on the trading day prior to the conversion date was 110% or more of the conversion price of the debentures on such trading day; (ii) we have called the
debentures for redemption; (iii) the average of the trading prices of the debentures for any five consecutive trading day period was less than the average conversion value for the debentures during that period, subject to certain limitations; or
(iv) we make certain distributions to holders of our common stock or enter into specified corporate transactions.



On November 3, 2004, we entered into a $50 million unsecured revolving credit facility with Bank of America, N.A. and LaSalle Bank, N.A. This facility
expires on July 13, 2008. For the quarterly accounting period ended March 31, 2005, we were in breach of certain sections of the Credit Agreement that require us to maintain positive net income and a ratio of indebtedness to earnings before
interest, taxes, depreciation and amortization that does not exceed a stated amount. On April 25, 2005, the Company, Bank of America, N.A. and LaSalle Bank, N.A. entered into a Waiver (Waiver) to the Credit Agreement. Pursuant to the
Waiver, the banks agreed to waive any default having occurred or to occur as a result of a breach of certain sections of the Credit Agreement. The Waiver does not waive any defaults for purposes of requesting an extension of credit under the Credit
Agreement. The Company is discussing with Bank of America, N.A. modifications to the Credit Agreement that would cure the defaults for purposes of requesting an extension of credit under the Credit Agreement. The Company does not currently have any
borrowings outstanding under the Credit Agreement.



Our working
capital was $140,193 at March 31, 2005. As of the date of this quarterly report on Form 10-Q, we expect to continue to maintain a positive working capital position. However, we cannot predict whether current trends and conditions will continue
or what the effect on our business might be from events beyond our control, such as airline bankruptcies, consolidation or liquidation, U.S. military actions, acts of terrorism or adverse litigation. We believe that investments available for sale at
March 31, 2005, together with cash on hand and cash generated from operations will be sufficient to satisfy all of our funding requirements while we work with the bank group to modify the Credit Agreement.



(c) Business Expansion and Outlook



The following is a description of some of the initiatives that, as of the
date of this quarterly report on Form 10-Q, we are undertaking or we plan to undertake. There can be no assurance that any of the initiatives will be successful, and we undertake no obligation to, and expressly disclaim any such obligation to,
update or revise any of the statements set forth below.



The
competitive environment in which we operate and an increase in the rate of restaurant merchant attrition suggest that we need to expand our array of product offerings to improve retention of existing restaurant merchants and attract new merchants to
our program. Although the failure rate in the restaurant industry is quite high and we experience merchant attrition due to the closing of restaurants, we also lose merchants as a result of their dissatisfaction with our programs impact on
their business.



In November 2004, in an effort to improve the
retention of existing restaurant merchants and attract new merchants to our programs, we began selling an expanded array of product offerings, some of which result in more favorable economics for participating restaurant merchants and, therefore,
will continue to reduce our sales yield rate and increase our cost of sales percentage.



In 2004, we significantly increased the size of the sales force and invested in their training. We will maintain the sales force at the current level while we focus on expanding the level of training with a view
toward improving the teams overall productivity. We believe that such productivity increases combined with new products and services should result in an increase in the number of new participating restaurant merchants in



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(dollar amounts in thousands except average transaction amounts and per
share data)



2005. Many of these restaurant merchants will be participants in the Marketing Credits Program and, therefore, we expect to use our capital to fund this
growth.



In 2005, we plan to review the processes and document
flow associated with our product offerings with the expectation of adding efficiencies to the process. These efficiencies should reduce the time currently experienced between contract execution with the merchant and the time the merchant is
available for member transactions. If successful, the changes should reduce cost, enhance revenue recognition and improve merchant relationships.



Beginning in the second quarter of 2004, we started to implement changes to our member rewards and savings propositions. Currently, these changes consist
of reduced member benefit levels at certain merchants. Additional changes that will become effective during July 2005 are designed to better align member benefits with member activity by introducing a tiered member benefit schedule to many of our
programs. Under the current benefit schedule, a member is entitled to earn a benefit per dollar spent at a participating merchant regardless of the members level of activity in our program. Under the new tiered member benefit schedule, a
members benefits and tier level will be based on the members level of participation in our program, with more active members receiving greater benefits per dollar spent at participating merchants, access to more participating merchants
and greater bonus opportunities than less active members. The tiered member benefit schedule could continue to reduce the percentage of sales represented by member rewards and savings.



As of the date of this quarterly report on Form 10-Q, we do not anticipate investing in any future product lines and expect
that during 2005 we will focus our efforts on improving our dining business, including expanding our marketing efforts to facilitate growth of the dining product offerings in Canada. We launched our retail initiative in December 2004 with an online
mall of a group of national retailers. We later decided to delay further expansion of our retail initiative and do not anticipate any significant further spending on this initiative. We have also decided to modify our hotel offering. Effective July
1, 2005, we will no longer have direct relationships with any hotels and will continue to offer hotels to members only through third parties.



Item 3. Quantitative and Qualitative Disclosures about Market Risk



Since December 31, 2004, there have been no changes with regard to market risk that would require further quantitative or qualitative disclosure. For our
quantitative and qualitative disclosures about market risk for the fiscal year ending December 31, 2004, refer to our annual report on Form 10-K, filed on March 14, 2005.



Item 4. Controls and Procedures



Evaluation of Disclosure Controls and Procedures. We maintain disclosure controls and procedures designed to ensure that information required to be disclosed in our filings under the Securities Exchange Act of 1934, as amended (the
Exchange Act), is recorded, processed, summarized and reported accurately within the time periods specified in the Securities and Exchange Commissions (SEC) rules and forms. As of the end of the period covered by this
report, an evaluation was performed under the supervision and with the participation of management, including the Chief Executive Officer (CEO) and Chief Financial Officer (CFO), of the effectiveness of the design and
operation of our disclosure controls and procedures (pursuant to Exchange Act Rule 13a-15). Based upon this evaluation, the CEO and CFO concluded that our disclosure controls and procedures were effective as of such date. The conclusions of the CEO
and CFO from this evaluation were communicated to the Audit Committee.



Changes in Internal Control over Financial Reporting. There were no changes in our internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to
materially affect, our internal control over financial reporting.



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PART IIOTHER INFORMATION



Item 6. Exhibits



|            |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|3.1         |  | 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         |  | Investment Agreement, dated as of April 28, 2000, among Transmedia Network Inc., Gene M. Henderson, Herbert M. Gardner, James M. Callaghan, Gregory J. Robitaille, John A. Ward III,
George S. Wiedemann, Christine M. Donohoo, Frank F. Schmeyer, Elliot Merberg, Gerald Fleischman and Thomas J. Litle is incorporated herein by reference to Exhibit 4.7 to Transmedia Network Inc.s Annual Report on Form 10-K (File No.
001-13806), filed on December 29, 2000.
|            | 
|4.2         |  | Investment Agreement, dated as of April 28, 2000, among Transmedia Network Inc., Minotaur Partners II, L.P., ValueVision International Inc., Dominic Mangone and Raymond Bank is
incorporated herein by reference to Exhibit 4.5 to Transmedia Network Inc.s Annual Report on Form 10-K (File No. 001-13806), filed on December 29, 2000.                                                                                                                           
|            | 
|4.3         |  | First Amendment, dated February     , 2003, to that certain Investment Agreement, dated April 28, 2000, among iDine Rewards Network Inc., Minotaur Partners II, L.P.,
ValueVision International Inc., Dominic Mangone and Raymond Bank is incorporated herein by reference to Exhibit 4.8 to iDine Rewards Network Inc.s Annual Report on Form 10-K (File No. 001-13806), filed on March 31, 2003.                                                                  
|            | 
|4.4         |  | 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.                                                                                                                                                                               
|            | 
|4.5         |  | 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.                                                                              
|            | 
|4.6         |  | 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.                            
|            | 
|4.7         |  | 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.                                                                                                                                                   
|            | 
|4.8         |  | 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        |  | Severance and Release Agreement, dated as of February 10, 2005, between Anthony Priore and Rewards Network Services Inc. is incorporated herein by reference to Exhibit 10.21 to Rewards
Network Inc.s Annual Report on Form 10-K (File No. 001-13806), filed on March 14, 2005.                                                                                                                                                                                    



24



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##### Table of Contents

|            |  |                                                                                                                                                                                                                                                                                                                                                                                                                           
|----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                                                                                                                                                                                                                               
|            | 
|10.2        |  | Severance and Release Agreement, dated April 11, 2005, between Domenic A. Rinaldi and Rewards Network Establishment Services 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 April 14, 2005.                                                                                                                                 
|            | 
|10.3        |  | Waiver to Credit Agreement, dated as of April 25, 2005, by and among Rewards Network Inc., Bank of America, N.A., as Administrative Agent and Letter of Credit Issuer, the other lenders party
thereto, and the subsidiaries of Rewards Network Inc. party thereto 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 April 26, 2005.
|            | 
|10.4        |  | Severance and Release Agreement, dated April 26, 2005, between George S. Wiedemann 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 April 27, 2005.                                                                                                                                                       
|            | 
|31.1*       |  | Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer                                                                                                                                                                                                                                                                                                                                                     
|            | 
|31.2*       |  | Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer                                                                                                                                                                                                                                                                                                                                                     
|            | 
|32.1*       |  | Section 1350 Certification of Chief Executive Officer                                                                                                                                                                                                                                                                                                                                                                     
|            | 
|32.2*       |  | Section 1350 Certification of Chief Financial Officer                                                                                                                                                                                                                                                                                                                                                                     

---

|* | Filed herewith
|- | --------------



25



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##### Table of Contents

SIGNATURES



Pursuant to the
requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



|             |  |                                                                                                                                                               
|------------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------
|             |  | REWARDS NETWORK INC.                                                                                                                                          
|             | 
|May 10, 2005 |  | /S/ KENNETH R. POSNER                                                                                                                                         
|             |  | Kenneth R. Posner Senior Vice President, Finance and Administration, and Chief Financial Officer (Principal Financial Officer and on behalf of the registrant)







26



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##### Table of Contents

REWARDS NETWORK INC. AND SUBSIDIARIES



EXHIBIT LIST



|            |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|3.1         |  | 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         |  | Investment Agreement, dated as of April 28, 2000, among Transmedia Network Inc., Gene M. Henderson, Herbert M. Gardner, James M. Callaghan, Gregory J. Robitaille, John A. Ward III, George S.
Wiedemann, Christine M. Donohoo, Frank F. Schmeyer, Elliot Merberg, Gerald Fleischman and Thomas J. Litle is incorporated herein by reference to Exhibit 4.7 to Transmedia Network Inc.s Annual Report on Form 10-K (File No. 001-13806), filed on
December 29, 2000.
|            | 
|4.2         |  | Investment Agreement, dated as of April 28, 2000, among Transmedia Network Inc., Minotaur Partners II, L.P., ValueVision International Inc., Dominic Mangone and Raymond Bank is incorporated
herein by reference to Exhibit 4.5 to Transmedia Network Inc.s Annual Report on Form 10-K (File No. 001-13806), filed on December 29, 2000.                                                                                                                           
|            | 
|4.3         |  | First Amendment, dated February     , 2003, to that certain Investment Agreement, dated April 28, 2000, among iDine Rewards Network Inc., Minotaur Partners II, L.P.,
ValueVision International Inc., Dominic Mangone and Raymond Bank is incorporated herein by reference to Exhibit 4.8 to iDine Rewards Network Inc.s Annual Report on Form 10-K (File No. 001-13806), filed on March 31, 2003.                                                                  
|            | 
|4.4         |  | 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.                                                                                                                                                                               
|            | 
|4.5         |  | 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.                                                                              
|            | 
|4.6         |  | 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.                            
|            | 
|4.7         |  | 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.                                                                                                                                                   
|            | 
|4.8         |  | 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.                                                                                                                                                                      



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##### Table of Contents

|            |   |  |                                                                                                                                                                                                                                                                                                                                                                                                                           
|----------- | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |   |  | Description                                                                                                                                                                                                                                                                                                                                                                                                               
|            |  
|10.1        |   |  | Severance and Release Agreement, dated as of February 10, 2005, between Anthony Priore and Rewards Network Services Inc. is incorporated herein by reference to Exhibit 10.21 to Rewards
Network Inc.s Annual Report on Form 10-K (File No. 001-13806), filed on March 14, 2005.                                                                                                                                         
|            |  
|10.2        |   |  | Severance and Release Agreement, dated April 11, 2005, between Domenic A. Rinaldi and Rewards Network Establishment Services 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 April 14, 2005.                                                                                                                                 
|            |  
|10.3        |   |  | Waiver to Credit Agreement, dated as of April 25, 2005, by and among Rewards Network Inc., Bank of America, N.A., as Administrative Agent and Letter of Credit Issuer, the other lenders party
thereto, and the subsidiaries of Rewards Network Inc. party thereto 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 April 26, 2005.
|            |  
|10.4        |   |  | Severance and Release Agreement, dated April 26, 2005, between George S. Wiedemann 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 April 27, 2005.                                                                                                                                                       
|            |  
|31.1        | * |  | Rule 13a-14(a)/15d-14(a) Certification of Principal Executive Officer                                                                                                                                                                                                                                                                                                                                                     
|            |  
|31.2        | * |  | Rule 13a-14(a)/15d-14(a) Certification of Principal Financial Officer                                                                                                                                                                                                                                                                                                                                                     
|            |  
|32.1*       |   |  | Section 1350 Certification of Chief Executive Officer                                                                                                                                                                                                                                                                                                                                                                     
|            |  
|32.2*       |   |  | Section 1350 Certification of Chief Financial Officer                                                                                                                                                                                                                                                                                                                                                                     

---

|* | Filed herewith
|- | --------------