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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-K

(Mark One)

For the Fiscal Year Ended December 31, 2002
or

Commission File Number: 0-22334

LodgeNet Entertainment Corporation

3900 West Innovation Street, Sioux Falls, South Dakota      57107

(605) 988-1000

Securities registered pursuant to Section 12(b) of the Act: None.

Securities registered pursuant to Section 12(g) of the Act: Common Stock, $.01 par value.

	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. Yes x No o.
	Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment to this Form 10-K. x
	Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No o
	State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $127,366,000.

The number of shares of common stock of the Registrant outstanding as of March 10, 2003, was 12,431,149 shares.

DOCUMENTS INCORPORATED BY REFERENCE — Portions of the Registrant’s definitive proxy statement for the 2003 Annual Meeting of Stockholders, which will be filed within 120 days of the fiscal year ended December 31, 2002, are incorporated by reference in Part III of this Form 10-K.

This Report contains a total of 66 pages, excluding exhibits. The exhibit index appears on page 33.

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     As used herein (unless the context otherwise requires) “LodgeNet”, the “Company” and/or the “Registrant” mean LodgeNet Entertainment Corporation and its consolidated subsidiaries.

     “LodgeNet”, the LodgeNet logo, and “TechConnection” are service marks or registered trademarks of LodgeNet Entertainment Corporation; all other trademarks or servicemarks used herein are the property of their respective owners.

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PART I

Item 1 — Business

Overview

     LodgeNet Entertainment Corporation is the world’s largest and leading provider of broadband, interactive TV systems and services to hotels, resorts and casinos throughout the United States and Canada as well as select international markets. More than 260 million guests a year can use a wide range of LodgeNet interactive services including digital movies, music and television on-demand programming as well as video games, high-speed Internet access and other services designed to make their stay more enjoyable, productive and convenient. As of December 31, 2002, the Company provided interactive television services to approximately 5,700 hotel properties serving more than 950,000 rooms, more properties and rooms than any other provider in the world.

     The Company’s services are purchased by guests on a per-view, hourly, or daily basis and include digital movies, video games, music and music videos, television on-demand programming, Internet on television which does not require a laptop for access, and high-speed laptop Internet access services (all of which are referred to by the Company as Guest Pay interactive services). Service packages may also include satellite-delivered basic and premium cable television programming, and other interactive entertainment and information services that are paid for by the hotel and provided to guests at no charge (referred to by the Company as free-to-guest services). The Company provides its services to various corporate-managed hotel chains such as Hilton, Doubletree, Embassy Suites, Sheraton, Ritz-Carlton, Harrah’s, Omni Hotels, Delta Hotels, Outrigger, La Quinta Inns, Wingate Inns, Homewood Suites, Grand Casinos, Hampton Inns & Suites, Baymont Inns & Suites, and Red Roof Inns, plus various major REITs and management companies such as MeriStar, Felcor, Flagstone, Prime, WestCoast Hospitality, as well as many independent properties using the Marriott, Holiday Inn, Inter-Continental, Courtyard by Marriott, Prince, Radisson, W Hotel, Westin and other trade names.

     As shown in the table below, the Company has experienced substantial revenue growth over the past five years, primarily as the result from the rapid expansion of the number of rooms installed with the Company’s interactive services. Since 1998, the Company’s interactive room base has increased by more than 279,000 rooms while its revenue has also increased by 41%. During the same period, the Company’s EBITDA (defined by the Company as earnings before interest, income taxes, depreciation, amortization and other non-operating income or expenses) has increased by 69% to $81.9 million in 2002, while its EBITDA margin improved to 34.8% from 29.2%. Management believes that EBITDA provides an important additional perspective on the Company’s operating results, the Company’s ability to service its long-term obligations, the Company’s ability to fund continuing growth, and the Company’s ability to continue as a going concern. Despite the heavy investment associated with the Company’s strong room growth, driven by the addition of 265,000 rooms served by the Company’s next-generation digital television platform during 2001 and 2002, the Company’s leverage ratio and interest coverage show marked improvement during the five-year period. Dollar amounts are in thousands.

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	(1)		End of year statistics.
	(2)		Digital services rooms are equipped with the interactive digital systems where on-demand movies, television on-demand programming, and music content are updated and delivered via satellite to the Company’s systems within respective hotels. Digital rooms are included with the total Guest Pay interactive rooms and represent more than 30% of the Guest Pay interactive rooms served in 2002.
	(3)		Total rooms served include those rooms receiving one or more of the Company’s services, including rooms served by international licensees.
	(4)		EBITDA is defined as earnings before interest, income taxes, depreciation, amortization and other non-operating income or expenses. EBITDA is not intended to represent an alternative to net income or cash flows from operating, financing or investing activities (as determined in accordance with generally accepted accounting principles) as a measure of performance, and is not representative of funds available for discretionary use due to the Company’s financing obligations. EBITDA, as defined by the Company, may not be calculated consistently among other companies applying similar reporting measures. EBITDA is included herein because it is a widely accepted financial indicator used by certain investors and financial analysts to assess and compare companies on the basis of operating performance. Management believes that EBITDA provides an important additional perspective on the Company’s operating results, the Company’s ability to service its long-term obligations, the Company’s ability to fund continuing growth, and the Company’s ability to continue as a going concern.

     The Company provides its services directly to customers throughout the United States and Canada, and through licensing arrangements with established companies in other select countries. The Company’s contracts with hotels, resorts and casinos are exclusive and typically have initial, non-cancelable terms of five to seven years. As of December 31, 2002, the Company’s average remaining contract term was approximately four years. The exclusive nature of these contracts allows the Company to estimate (based on certain operating assumptions) future revenues, cash flows and rates of return related to the contracts prior to making a capital investment decision.

     The Company designs, develops, owns and operates the broadband, interactive television systems installed at each property. The interactive system connects each individual hotel room to a server, referred to as the “headend” located in the hotel. Because of the flexible and modular design of the system architecture, the Company can periodically upgrade its software and hardware to support the introduction of new interactive services and integrate new technologies as they become commercially available and economically viable.

     In 2001, the Company introduced its interactive digital system that enhances and expands the delivery of content and services through its interactive television network, providing travelers with enhanced levels of choice, convenience and control in the guest room. In addition to the on-demand movies, video games, and other services already provided by the Company’s installed tape-based systems, the interactive digital system offers (i) increased variety and availability of video selections; (ii) television on-demand programming; (iii) digital music and music videos; (iv) Internet on television; (v) access to Internet-sourced content; (vi) on-screen controls that allow the guest more viewing control and flexibility; (vii) improved guest marketing and merchandising capabilities; and (viii) a system architecture that transmits video and music content via satellite, resulting in operating cost reductions for the Company. As of December 31, 2002, the Company had installed the interactive digital system in over 265,000 rooms or 30% of its interactive installed base. The Company plans to continue to install its next-generation digital system in newly installed hotel properties and in existing sites as current service contracts are successfully renewed and extended.

     The Company’s long-term business strategy is based on five key elements: (i) continue to expand the Company’s interactive digital room base; (ii) increase revenue per room by continuing to expand product offering to the guests; (iii) continue to increase operating margins; (iv) continue to integrate cost-effective system technologies; and (v) drive the Company toward free cash flow and profitability.

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     The Company’s principal executive offices are located at 3900 West Innovation Street, Sioux Falls, South Dakota 57107, (605) 988-1000.

Markets and Customers

     Domestic Market. The Company’s primary market for its services is predominantly in the mid-size and large hotel segments within the United States and Canada. Based on industry sources, the Company estimates that these segments account for approximately 78%, or 3.5 million, of the lodging industry’s estimated 4.5 million rooms. Furthermore, whereas the Company currently serves over 876,000 interactive rooms as of December 31, 2002, the Company believes that significant growth opportunities remain available through (i) economically-viable rooms not yet served by any provider; (ii) supply growth within the lodging industry; and (iii) rooms currently served by other service providers whose contracts expire over the next few years.

     Diversified Customer Base. The Company believes that its interactive hotel base is well diversified in terms of (i) location; (ii) demographics; and (iii) customer contracts. As of December 31, 2002, no single state or province accounted for more than 10% of the hotel properties served by the Company. In segmenting the Company’s hotel base according to six demographic classifications set by industry sources, no segment of the Company’s served hotels represented more than 30% of its interactive base. The Company provides its services to various corporate-managed hotel chains such as Hilton, Doubletree, Embassy Suites, Sheraton, Ritz-Carlton, Harrah’s, Omni Hotels, Delta Hotels, Outrigger, La Quinta Inns, Wingate Inns, Homewood Suites, Grand Casinos, Hampton Inns & Suites, Baymont Inns & Suites, and Red Roof Inns, as well as many individual properties using the Marriott, Holiday Inn, Inter-Continental, Courtyard by Marriott, Prince, Radisson, W Hotel, Westin and other trade names. No single contract represented greater than 10% of the Company’s revenue for the year ended December 31, 2002. In 2000, the Company signed a contract with Hilton Hotels Corporation (Hilton) to install, on an exclusive basis, its interactive television system in all Hilton owned properties and to be the exclusive recommended provider of choice for its Hilton managed and franchised properties. At December 31, 2002, the Company has installed its interactive system in approximately 73,000 Hilton rooms with the remaining installation base continuing into 2007.

     International Market. The Company also provides services in select international countries—primarily countries located in Central and South America—through licensing arrangements with established entities in these areas. Under the arrangements, the Company does not provide any capital investment. Instead, the Company sells equipment and licenses its interactive television system and technologies to the licensee and receives a royalty based on gross revenue. Financial information related to the Company’s international operations is included within the Company’s consolidated financial statements.

Services and Products

     Guest Pay Interactive Services. The Company’s primary source of revenue is providing in-room, interactive television services to the lodging industry, for which the hotel guest pays on a per-view, hourly or daily basis. The high-speed, two-way digital communications design of the Company’s broadband system architecture enables the Company to provide sophisticated interactive features such as on-demand movies, network-based video games, music services, Internet on television, and television on-demand programs. Guest Pay packages may also include satellite-delivered cable television programming which are paid for by the hotel and provided to guests free of charge, as well as other interactive services such as review of room charges and video checkout, guest surveying, merchandising, and other services that enable hotel owners to broadcast informational and promotional messages.

     In May 1993, the Company entered into a non-exclusive license agreement with Nintendo of America Inc. (Nintendo) to provide hotels with a network-based video game system. In May 1998, this agreement was revised and extended for ten years. Pursuant to this extended agreement, Nintendo provides the Company with access to its video game system and games. The Company uses its broadband system architecture to allow guests to play the video games over the hotel master antenna system. Hotel guests are charged a fee based on the amount of time they play the video games. The Company had over 854,000 rooms installed—90% of its room base—with the Nintendo video game systems as of December 31, 2002.

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     In 2001, the Company began wide-scale deployment of its new interactive digital system. In addition to the services already offered in its existing tape-based systems, the digital system allows guests to choose from an expanded menu of digital video as well as digital music selections. Rooms having the Company’s digital system generate an average of 37% more revenue than the traditional tape-based systems, due to the increased variety and availability of video content, the introduction of digital music services, access to Internet content through the television, improved guest marketing and merchandising capabilities, and on-screen controls that allow the guest more viewing control and flexibility. Additionally, the interactive digital systems are equipped so that content such as on-demand movies and music are updated and delivered via satellite to the Company’s system within the hotel. This not only eliminates videotapes and shipping costs and reduces the need for technician visits to update the content, but also ensures that all of the Company’s digital hotels can offer the content as of the first date available for exhibition. As of December 31, 2002, the Company had over 265,000 digital interactive television rooms.

     The revenues generated from Guest Pay interactive services at any given property are dependent upon a number of factors: (i) the occupancy rate at the property; (ii) the “buy rate” or percentage of occupied rooms that purchase a movie, video game, music service, Internet access or other interactive service offered at the property; and (iii) the price of the service purchased by the hotel guest. Occupancy rates vary by property based on the property’s competitive position within its marketplace, over time based on seasonal factors, and as a result of changes in general economic conditions. Typically, occupancy rates are higher during the second and third quarters due to seasonal travel patterns. Historically, the properties served by the Company have experienced higher occupancy rates versus the industry average. Buy rates generally reflect the hotel’s guest mix profile, the popularity of the available programming and the guests’ other entertainment alternatives. Buy rates also vary over time with general economic conditions. The price charged for each programming option is established by the Company and is set according to the guest mix profile at each property and overall economic conditions. Movie prices are set by the Company on a title-by-title basis and may be higher in some locations and for certain highly popular titles.

     Free-to-Guest and Other Services. In addition to Guest Pay interactive services, the Company provides cable television programming for which the hotel, rather than its guests, pays the charges. Programming is delivered via satellite and distributed to guest rooms over the network. The hotel pays the Company a fixed monthly charge per room for each programming channel selected. The hotel provides these channels to its guests free of charge. Premium channels, such as HBO, Showtime and The Disney Channel broadcast major motion pictures and specialty programming, while non-premium channels, such as CNN, ESPN and WTBS, broadcast news, sports and informational programs, among others. Premium programming suppliers typically contract only with cable companies and other large volume subscribers, such as the Company, and will not generally provide programming directly to individual hotel properties. The Company successfully competes with local cable television operators by tailoring different programming packages to provide specific channels desired by the hotel subscriber, which typically reduces the overall cost of the services provided.

     The Company also provides a variety of other services to its hotel customers including the sale of system equipment and service parts and labor. The Company believes that these services complement its goal of being a full-service provider of in-room entertainment and information services to the lodging industry.

Operations

     Contracts. The Company provides its Guest Pay interactive services under contracts with lodging properties that generally run for a term of five to seven years. Over the five year period ended December 31, 2002, the average initial term of new contracts was six and a half years. The Company’s contracts typically provide that the Company will be the exclusive provider of in-room, on-demand television entertainment services to the hotels, permit the Company to set prices for Guest Pay interactive services, and allow the Company to terminate the contract and remove its systems if the results of operation of the Company’s system installed at the hotel do not meet the Company’s return on investment criteria. The contracts also typically grant the Company a right of first refusal regarding the provision of additional video related services to the hotel. Under these contracts, the Company installs its system in the hotel free of charge and retains ownership of all equipment utilized in providing its services. The terms contained in the contract with corporate-managed hotels for any one chain generally are negotiated by that chain’s corporate management, and the hotels subscribe at the direction of corporate management. In the case of franchised hotels, the contracts are generally negotiated separately with each hotel. For Guest Pay interactive services which are paid for by the hotel guest, the hotel

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collects such charges, coincident with the collection of room and other charges made by the hotel guest, and the hotel remits monthly to the Company. The hotels retain a commission from such charges, which varies depending on the size and profitability of the system and other factors. The Company generally seeks to extend and renew hotel contracts in advance of their expiration on substantially similar terms. The average remaining life of the Company’s current Guest Pay interactive contracts is approximately four years with less than 12% of these contracts coming up for renewal before 2004.

     Technology, Product Development and Patents. The Company designs and develops its own broadband interactive television systems. Because such systems utilize an open architecture platform incorporating industry standard interfaces, the Company can upgrade system software to support the introduction of new services or integrate new technologies as they become economically viable. The Company’s interactive television system incorporates the Company’s scaleable broadband system architecture with commercially manufactured, readily available electronic and computer components and hardware.

     The Company’s broadband system architecture utilizes the Company’s proprietary, two-way digital communications design to process and respond rapidly to input commands from the viewer. This capability enables the Company to provide sophisticated interactive television services such as on-demand movies, network-based video games, music services, Internet on television, and a variety of other interactive services such as review of room charges and video checkout, guest surveying, and other guest services.

     The Company’s interactive systems consist of equipment located within the guest room connected via a local cable distribution network to a headend (associated equipment required for the reception, storage, amplification and modulation of signals) located elsewhere in the hotel. Typical in-room equipment includes a terminal unit, a hand-held television remote control and a video game controller. For those properties equipped with the digital systems, in-room equipment may also include an infrared computer keyboard. Those rooms equipped for high-speed Internet capabilities have a desktop device, which allows for the guest to link to a high-speed Internet connection. Video and music programming originates from the system headend and is transmitted to individual rooms over the network. Video game programs are downloaded into dedicated video game processors also located within the headend. Keystrokes and other system commands and communications are transmitted from the room using the Company’s proprietary communications infrastructure and the video and other signals are transmitted to the guest room over the network. The system computer controls the delivery of the Guest Pay interactive services to the guest room and also automatically records purchase transactions and billing data to the hotel’s accounting system, which automatically posts the charge to the guest’s bill.

     It is the Company’s policy to apply for patents on those product designs which management believes may be of significance to the Company. The Company currently owns twelve United States patents, and has other applications for patents pending in the U.S. Patent and Trademark Office dealing with various aspects of the Company’s interactive systems. The Company also licenses industry-related technology from third parties.

     The Company uses a number of registered and unregistered trademarks for its products and services. The Company has applications for registration pending for certain unregistered trademarks, and those trademarks for which the Company has not sought registration are governed by common law and state unfair competition laws. Because the Company believes that these trademarks are significant to the Company’s business, the Company has taken legal steps to protect its trademarks in the past and intends to actively protect these trademarks in the future. The Company believes that its trademarks are generally well recognized by consumers of its products and are associated with a high level of quality and value.

     Sales and Marketing. The Company focuses its sales and marketing strategies on acquiring new contracts from hotels, extending and retaining existing contracts, and marketing the Company’s Guest Pay interactive services to the hotel guest. The Company’s sales and marketing organization includes national account representatives who develop relationships with national hotel franchise organizations and management groups, and regional sales representatives who maintain relationships primarily with regional hotel management and ownership organizations. The Company markets its services and products to hotels by advertising in industry trade publications, attending industry trade shows, direct marketing and telemarketing. Sales activities are coordinated from the Company’s headquarters.

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     The Company markets its services to hotel guests by means of an interactive, image-based menu and purchasing protocol using on-screen graphics, promotions and programming information. The system also generates a “Welcome Channel”, which appears on-screen when the television is turned on and describes the programming and interactive services available through the Company’s system.

     Installation Operations. The Company’s installation personnel prepare engineering surveys at each hotel, install the Company’s systems, train the hotel staff to operate the systems and perform quality control tests. Due to the Company’s diversified customer base, it is more cost effective for the Company to utilize subcontract installation teams. In 2002, approximately 82% of the installation was completed by subcontractors where an employee of the Company managed the installation project from inception through completion.

     Service Operations. The Company believes that high quality and consistent systems support and maintenance are essential to competitive success in its industry. The Company emphasizes the use of Company-employed service personnel residing in 26 locations throughout the United States and Canada, but also uses Company-trained subcontractors in areas where there is not a sufficient concentration of Company-served hotels to warrant a Company-employed service representative. Currently, the Company’s service organization has responsibility for approximately 89% of the Guest Pay interactive hotel rooms served by the Company. Service personnel are responsible for all preventive and corrective systems maintenance.

     The Company also maintains a toll-free customer support hot line, TechConnection SM, which is staffed 24 hours a day, 365 days a year by Company-employed and trained support technicians. The on-line diagnostic capability of the Company’s systems enables the Company to identify and resolve a majority of reported system malfunctions from the Company’s service control center without visiting the hotel property. When a service visit is required, the modular design of the Company’s systems permits service personnel to replace only those components that are defective at the hotel site.

     Programming. The Company obtains non-exclusive rights to show recently released major motion pictures from motion picture studios pursuant to a long-term master agreement with each studio. The license period is typically 2 to 3 years in length and royalty rate for each movie are pre-determined, with the studio receiving a percentage of the Company’s gross revenue from the movie. For recently released motion pictures, the Company typically obtains rights to exhibit the picture while it is still in theatrical release, but prior to its release to the home video market or for exhibition on cable television. Generally, studios make a master of their movies available for distribution sufficiently in advance of the release dates for the lodging industry so that all of the Company’s hotels can offer the movies as of the first date they are available for exhibition. For its television on-demand programming, the Company obtains rights to release television on-demand hits where the Company pays a predetermined percentage of gross revenue or a flat fee. The Company obtains independent films, most of which are non-rated and intended for mature audiences, for a one-time flat fee that is nominal in relation to the licensing fees paid for major motion pictures and which permits the Company to distribute the films as necessary to its hotel sites. During 2002, the Company also entered into agreements with Broadcast Music Inc. and the American Society of Composers, Authors and Publishers, where the Company pays music license fees for certain music performances used within major motion pictures. The Company also obtains non-exclusive rights to market its digital music services through an agreement with a third party vendor whereby the Company pays a predetermined percentage of the gross revenue from the music service. The Company obtains its selection of Nintendo video games pursuant to a ten-year non-exclusive license agreement with Nintendo entered into in 1998. Under the terms of the agreement, the Company pays Nintendo a monthly fee based on the number of rooms offering Nintendo video game services. The Company continuously monitors guests’ entertainment selections and adjusts its programming to respond to viewing patterns.

     The Company obtains its basic and premium cable television programming pursuant to multiyear license agreements and pays its programming suppliers a fixed, monthly fee for each room or subscriber receiving the service. Management believes that relations with the programming suppliers are good and expects to renew these contracts as necessary on competitive terms. In January 2000, the Company entered into a seven year agreement with DIRECTV, Inc. to make DIRECTV® programming available to the properties it serves.

     Suppliers. The Company contracts directly with various electronics firms for the manufacture and assembly of certain of its systems hardware, the design of which is controlled by the Company. The Company has found these

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suppliers to be dependable and generally able to meet delivery schedules on time. The Company believes that, in the event of a termination of any of its sources, with proper notification from the supplier, alternate suppliers could be located without incurring significant costs or delays. Certain electronic component parts used within the Company’s products are available from a limited number of suppliers and can be subject to temporary shortages because of general economic conditions and the demand and supply for such component parts. If the Company were to experience a shortage of any given electronic part, the Company believes that alternative parts could be obtained or system design changes implemented. In such event, the Company could experience a temporary reduction in the rate of new room installations and/or an increase in the cost of such installations. All other components of the Company’s systems are standard commercial products, such as computers, hard drives, modulators and amplifiers that are available from multiple sources. The Company believes its anticipated growth can be accommodated through existing suppliers.

Competition

     Based on the number of hotels and rooms served, LodgeNet Entertainment Corporation is the world’s largest and leading provider of broadband, interactive TV systems and services to hotels, resorts and casinos throughout the United States and Canada as well as select international markets, serving over 5,700 hotels and 950,000 rooms. Competition in this industry is very active and includes virtually all aspects of the entertainment industry. Market participants include, but are not limited to (i) other interactive television service providers (such as On Command Corporation, Hospitality Networks, SeaChange, InRoomVideo, and other international providers); (ii) cable television companies (such as AT&T, AOL Time Warner, Cox Cable, and Comcast); (iii) direct broadcast satellite companies (such as DirecTV and EchoStar Communications); (iv) television networks and programmers (such as ABC, NBC, CBS, FOX, HBO, and Showtime); (v) Internet service providers and portals (such as AOL Time Warner and Yahoo); (vi) companies offering web sites that provide on-demand movies; and (vii) rental companies that provide videocassettes and DVDs that can be viewed in properly equipped hotel rooms. Lodging industry guests also obtain entertainment and information from print media (such as newspapers, magazines, and books), concerts, sporting events, and movie theatres. Given the dynamism of communications technology, the Company expects to continue to confront new sources of competition—many of which have access to cheaper and more available financing.

     A number of potential competitors could use their existing infrastructure to provide in-room entertainment services to the lodging industry, including some of the aforementioned franchised and wireless cable operators, telecommunications companies, Internet service and digital broadcast service providers. Some of these potential competitors are already providing free-to-guest or Internet-related services to the lodging industry and have announced plans to offer guest pay services. Some of these companies have substantially greater financial and other resources than the Company, and it is possible that such competitors may develop a technology that is more cost effective than the Company’s. To respond to competition, the Company will need to continue to enhance its interactive systems, expand its operations and meet the increasing demands for competitive pricing, service quality and availability of value-added product offerings.

     Competition with respect to new hotel contracts centers on a variety of factors, depending upon the features important to a particular hotel. Among the more important factors are: (i) the features and benefits of the entertainment systems; (ii) the quality of the vendor’s technical support and maintenance services; (iii) the financial terms and conditions of the proposed contract (including commissions to the hotel); and (iv) the ability to complete system installation in a timely and efficient manner. In addition, with respect to hotel properties already receiving in-room entertainment services, the incumbent provider may have certain informational and installation cost advantages as compared to outside competitors.

     The Company believes that its competitive advantages include: (i) its broadband, interactive television system architecture that enables the Company to deliver a broad range of interactive features and services such as on-demand movies, television on-demand programming, network-based video games, music services, Internet on television, and high speed Internet connectivity; (ii) the flexible design of the Company’s system which enables it to add enhancements or integrate new technologies and services as they become commercially available and economically viable; (iii) high quality customer support and field service operations; and (iv) an experienced management team and well-trained professional sales organization. The Company believes that its success in securing contracts reflects the strong competitive position of the Company’s products and services.

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     While the Company believes that its system architecture is comparable or superior to the systems currently being used by its competitors in the lodging industry, there can be no assurance that such competitors will not develop a cost-effective system that is comparable or superior to the Company’s system. There can be no assurance that the Company will continue its current level of success in obtaining new contracts from hotels currently served by other vendors or previously unserved, or that the Company will be able to retain contracts with hotels it serves when those contracts expire.

     Although in the free-to-guest market, the local franchised cable operator in a hotel’s market may have a substantial market presence, such operators typically offer the hotel owner only standard packages of programming typically developed for the residential market rather than the lodging market, and at a fixed price per room based on all the channels provided. The Company competes with the franchised cable operator for free-to-guest contracts by customizing packages of programming to provide only those channels desired by the hotel, typically reducing the overall cost per room to the hotel operator.

     Competitive pressures in the guest pay and free-to-guest segments could result in reduced market share for the Company, higher hotel commissions, lower margins and increased expenditures for marketing, product development and systems installation, each of which could adversely affect the Company’s financial condition and operating results.

Business Strategy

     Continue to Expand Interactive Room Base. Within the Company’s target market of hotels with 75 or more rooms (which is estimated, based on industry resources, to contain 3.5 million hotel rooms), the Company believes substantial opportunity exists for continued, selective growth in its Guest Pay interactive room base. The Company estimates that 335,000 rooms are presently not served by any interactive services provider and fit its target economic profile. The Company also estimates that 130,000 newly constructed lodging rooms will open within the next two years that meet or exceed target criteria. In addition, the Company estimates that another 290,000 rooms, which are under contract with the Company’s competitors, will be approaching expiration over the next two years. Historically, LodgeNet has had significant success in capturing such rooms. Over the last seven years, 30% of the Company’s growth has come from other providers while, during the same time, the Company has lost an average of less than 2% of its installed base. Of those hotels that the Company did not renew, the majority was at the discretion of the Company, as the expected return on required renewal upgrade capital did not meet the Company’s return criteria. The Company believes that the cost-effective and flexible design of its scaleable interactive digital system which offers enhanced revenue opportunities, combined with its expertise in installation, programming, technical support and customer service, will allow the Company to continue to expand and retain its interactive room base pursuant to long-term contracts. Internationally, the Company intends to continue to expand into selected countries in Asia, Latin America, South America and other regions through licensing agreements with established entities in those areas.

     Increase Revenue per Room from Expanded Installation of the Next-Generation Digital System. The Company plans to increase the revenue it realizes from each Guest Pay interactive room by expanding and enhancing the scope of its interactive television programming. The Company intends to continue installing its interactive digital system in new rooms and in selected existing properties currently served by the Company in exchange for long-term contract extensions of its services. The Company’s interactive digital system, which is currently installed in approximately 30% of the Company’s Guest Pay interactive room base, generates 37.5% more revenue than the traditional tape-based rooms due to the increased variety and availability of video content, television on-demand programming, digital music services, Internet on television, improved marketing and merchandising capabilities, and on-screen controls that allow the guest more viewing control and flexibility.

     Continue to Increase Operating Margins. Complementing the Company’s room and revenue growth objectives is its ongoing goal of increasing operating margins by reducing direct and overhead expenses, as measured on a percentage of revenue and on a per-installed unit basis. Since 1998, the Company has increased its EBITDA margin to 34.8% from 29.2% as it spread its expenses related to corporate overhead and operating infrastructure over a larger base of installed rooms, as well as a broader range of revenue generating sources. Further, the Company’s digital system continues to lower operating costs as the platform distributes video, television on-demand programming, and music content via satellite, eliminating videotape and shipping costs as well as a technician’s visit to the hotel to load the content. The on-line diagnostic capabilities of the Company’s systems also

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enable the Company to identify and resolve a majority of reported system malfunctions from the Company’s service control center without visiting the hotel property. The Company believes that further efficiencies will be achieved as it continues to expand the number of installed rooms and the scope of its interactive television and interactive product offerings.

     Continue to Integrate Cost-effective System Technologies. The Company intends to continue to use its product design and development expertise to make system improvements as well as lower the installation cost of new and upgraded systems. Lower installation costs allow the Company to economically install its system into more diverse hotel properties as the Company makes its investment decisions based upon estimates of future revenues, cash flows and rates of return related to the contracts. In addition, lower installation and upgrade costs increase the return on invested capital for any given revenue stream. Lastly, system enhancements typically increase the market demand for the Company’s interactive systems based on new system features and benefits and many times also increase the revenue generating capability of the system.

     Drive the Company toward Free Cash Flow and Profitability. During 2002, the Company generated $43.8 million in cash flow from operations and $6.0 million of operating income. The expansion of the Company’s interactive digital room base coupled with the renewal of its current room base pursuant to long term contracts at capital reinvestment levels substantially below the cost of a new interactive room will tend to drive increased revenue, EBITDA and operating income. Given the Company’s current business plan for projected capital investment over the next several years, the Company anticipates that it will begin reducing its level of outstanding long-term debt and associated interest costs, all of which will create more cash flow from operations and ultimately net income.

Regulation

     Cable Television Regulation. The Communications Act of 1934, as amended by the Cable Communications Policy Act of 1984, the Cable Television Consumer Protection and Competition Act of 1992, and the Telecommunications Act of 1996, (collectively, the “Communications Act”) governs the regulation of cable systems. The law defines a “cable system” as a facility, consisting of a set of closed transmission paths and associated signal generation, reception, and control equipment that is designed to provide cable service which includes video programming and which is provided to multiple subscribers within a community, but the law exempts from that definition, among other facilities, a facility that serves subscribers without using any public rights-of-way. The Company constructs and operates separate headend systems at each hotel and those systems do not use public rights-of-way. Consequently, the Company is not required to comply with many of the Federal Communication Commission’s (“FCC”) rules relating to cable systems, including, among other things, rate regulation and the requirement to obtain a franchise from local government authorities in order to provide video services.

     As a multichannel video programming distributor, however, the Company is subject to various provisions of the Communications Act. These include laws and regulations that benefit the Company, such as provisions that ensure the Company access to programming on fair, reasonable and nondiscriminatory terms, as well as provisions that subject the Company to additional requirements, such as the requirement to obtain consent from broadcasters in order to retransmit their signals over the Company’s systems.

     Internet Regulation. The Internet-based services offered by the Company potentially may be affected by various laws and government regulations. There are currently few laws or regulations directly applicable to access to or commerce on commercial online services or the Internet. However, because of the increasing popularity and use of commercial online services and the Internet, new laws and regulations may be adopted. The adoption of such laws or regulations in the future may slow the growth of commercial online services and the Internet, which could in turn cause a decline in the demand for the Company’s Internet-based services and products or otherwise have an adverse effect on the Company.

     On January 18, 2001, the FCC released a Notice of Inquiry regarding interactive television services (“ITV”) over cable television. The FCC sought comment on, among other things, an appropriate definition of ITV services, whether access to a high-speed connection is necessary to realize ITV capabilities, and whether a nondiscrimination

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rule is necessary and/or appropriate. The FCC has not yet taken any action in response to this proceeding. It is not possible at this time to predict the outcome of the proceedings or its effect on the Company.

     The foregoing does not purport to describe all present and proposed federal, state and local regulations and legislation relating to the video programming industry. Other existing federal, state and local laws and regulations currently are, or may be, the subject of a variety of judicial proceedings, legislative hearings, and administrative and legislative proposals that could change in varying degrees the manner in which private cable operators, other video programming distributors, and Internet service providers operate. The Company cannot predict the outcome of these proceedings or their impact upon its operations at this time.

Employees

     As of December 31, 2002, the Company had 807 employees in the United States and Canada, none of which are covered by a collective bargaining agreement. The Company has not experienced any significant labor problems and believes that its relationship with its employees is good.

Web Site Access to SEC Filings

     The Company’s Web site address is www.lodgenet.com. It makes its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K and all amendments to those reports available free of charge on its Web site as soon as reasonably practicable after such material is electronically filed with the SEC.

Item 2 — Properties

     The Company’s headquarters, including its distribution center and principal executive offices, are located in Sioux Falls, South Dakota. The Company owned facility occupies approximately 228,500 square feet including approximately 126,500 square feet for executive, administrative and support functions, approximately 60,000 square feet for assembly and distribution functions, and approximately 42,000 square feet for warehouse space. The opening of the facility in 1997 allowed the Company to consolidate its local operations into a single, multipurpose facility, which is designed to enhance operational efficiency and to facilitate any necessary future expansion needs of the Company. The Company believes that its facility is sufficient to accommodate its foreseeable local operational space requirements.

     The Company leases 25 facilities, in various locations, from unaffiliated third parties. These facilities are combination warehouse/office facilities for installation and service operations and are located throughout the United States and Canada. Twenty-four of these facilities occupy less than 3,500 square feet and one occupies over 7,700 square feet.

Item 3 — Legal Proceedings

     During 2002, the Company entered into settlement agreements with Broadcast Music Inc. (BMI) and the American Society of Composers, Authors and Publishers (ASCAP), which resolved claims for alleged nonpayment of royalties on copyrighted musical works performed in major motion pictures. BMI and ASCAP had asserted that the music, primarily background music, used within major motion pictures required licensing. BMI and ASCAP sought damages for public performances of such music from their respective catalogues. As a result of the settlements, the Company recorded a provision for the litigation settlements of $2.7 million that is related to pre-2002 reporting periods. This nonrecurring charge has been reported as a litigation expense in the accompanying statements of operations. The Company has paid approximately $1.2 million of the settlement amount with the balance to be paid ratably over the next five quarters, the first payment scheduled during the first quarter of 2003. In addition, the Company recorded approximately $420,000 as 2002 operating expense to accurately reflect music royalty costs directly related to current year operating activities.

     The Company is subject to litigation arising in the ordinary course of business. As of the date hereof, the Company believes it is unlikely that resolution of such litigation will have a material adverse effect upon the Company’s financial condition or results of operations.

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Item 4 — Submission of Matters to a Vote of Security Holders

     There were no matters submitted to a vote of security holders during the quarter ended December 31, 2002.

PART II

Item 5 — Market for Registrant’s Common Equity and Related Stockholder Matters

     The Company’s Common Stock currently trades on the NASDAQ National Market System (“NASDAQ NMS”) under the symbol “LNET”. The Company’s Common Stock began trading on the NASDAQ NMS on October 14, 1993 upon the effectiveness of its initial public offering. As of March 10, 2003 there were outstanding 12,431,149 shares of the Company’s Common Stock.

     The following table sets forth, for the fiscal quarters indicated, the range of high and low sales prices of the Company’s Common Stock as reported by NASDAQ NMS.

     On March 10, 2003, the closing price of the Company’s Common Stock, as reported by NASDAQ NMS was $7.14. Stockholders are urged to obtain current market quotations for the Company’s Common Stock. As of March 10, 2003, there were 122 stockholders of record of the Company with approximately 99% of the shares held in “street name”. The Company estimates that as of March 10, 2003, there were more than 2,500 stockholders of the Company.

Dividends

     No dividends have been paid to date on the Common Stock of the Company. Management of the Company does not intend to pay any cash dividends on Common Stock of the Company in the foreseeable future, rather, it is expected that the Company will retain earnings to finance its operations and growth. The terms and conditions of the Company’s 10.25% Senior Notes and of the Company’s bank credit facility both contain covenants which restrict and limit payments or distributions in respect of the Common Stock of the Company.

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Stockholder Rights Plan

     On February 28, 1997, the Company adopted a stockholder rights plan. The rights plan is intended to maximize stockholder value by providing flexibility to the Board of Directors in the event that an offer for the Company is received that is either inadequate or not in the best interest of all stockholders.

     Under the rights plan, the Board of Directors declared a dividend distribution of one right for each outstanding share of common stock to stockholders of record at the close of business on March 10, 1997. Each right, when exercisable, entitles the registered holder to purchase one one-thousandth of a share of a new series of Series A Participating Preferred Stock, at a price of $60.00.

     Initially, the rights are “attached” to the common stock and trade with the common stock. They separate from the common stock if a person or group acquires 15% or more of the outstanding shares of common stock or a public announcement of a tender offer or exchange offer is made which would result in someone becoming the owner of 15% or more of the outstanding common stock. Following a separation, the rights become exercisable, are separately tradable and the Company will mail separate rights certificates to stockholders.

     The rights expire on the earliest of February 28, 2007, the date of the consummation of a merger with a person who acquired common stock with the approval of the Board of Directors or the redemption of the rights by the Company.

     The number of rights is adjusted to prevent dilution in the event of a stock split or stock dividend. The purchase price, and the number of shares of preferred stock issuable upon exercise of the rights, are also adjusted for stock splits and dividends, as well as for other events, including the issuance of preferred stock at less than the market price or the distribution of Company assets to preferred stockholders.

     If the Company is acquired without the approval of the directors who are neither officers of the Company nor related to the acquirer, the rights become exercisable for shares of common stock of the acquiring company with a market value of two times the exercise price. If there is merely an acquisition of at least 15% of the common stock of the Company without such approval, the rights become exercisable for common stock with a market value of two times the exercise price

     Prior to a 15% acquisition or the expiration of the rights, the Company may redeem the rights at a price of $.01 per right. The rights are also redeemable in connection with a merger or other similar transaction not involving a 15% acquirer or if the acquirer has acquired less than 15% and there are no other acquirers.

     In addition, the Board of Directors may, after a 15% acquisition (but less than a 50% acquisition), exchange the rights for shares of common stock on a one for one basis or for cash or other assets or securities of the Company.

     If issued, the preferred stock will be nonredeemable and junior to any other series of preferred stock the Company may issue, but will have a preferential quarterly dividend equal to 1,000 times the dividend, if any, declared on each share of common stock, but not less than $25.00 and, in the event of liquidation of the Company, a preferred liquidation preference equal to the greater of $1,000 or 1,000 times the payment per share of common stock. Each share of preferred stock will have 1,000 votes and will vote together with the common stock.

     Until a right is exercised, the holder will have no rights as a stockholder of the Company. The Company and the rights agent have broad discretion to amend the Rights Agreement governing the rights; however, following a separation, no amendment may adversely affect the rights holders.

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Item 6 — Selected Financial Data

     The following is a summary of Selected Data, the Statement of Operations data and other data is derived from the audited financial statements. The data should be read in conjunction with the Company’s Consolidated Financial Statements, the notes thereto, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, all included elsewhere herein. Dollar amounts are in thousands, except share data and per room amounts.

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(1)		During 2002, the Company entered into settlement agreements with Broadcast Music Inc. (BMI) and the American Society of Composers, Authors and Publishers (ASCAP), which resolved claims for alleged nonpayment of royalties on copyrighted musical works performed in major motion pictures. BMI and ASCAP had asserted that the music, primarily background music, used within major motion pictures required licensing. BMI and ASCAP sought damages for public performances of such music from their respective catalogues. As a result of the settlements, the Company recorded a provision for the litigation settlements of $2.7 million that is related to pre-2002 reporting periods. This nonrecurring charge has been reported as a litigation expense in the accompanying statements of operations. The Company has paid approximately $1.2 million of the settlement amount with the balance to be paid ratably over the next five quarters, the first payment scheduled during the first quarter of 2003. In addition, the Company recorded approximately $420,000 as 2002 operating expense to accurately reflect music royalty costs directly related to current year operating activities.
(2)		In April 2002, the Financial Accounting Standards Board issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections”. Under SFAS No. 145, gains and losses on extinguishments of debt will no longer be classified as extraordinary items as previously required under SFAS No. 4. Extraordinary treatment will be required for certain extinguishments as provided in APB Opinion No. 30. Effective January 1, 2002, the Company adopted the provisions of SFAS No. 145. In connection with the adoption, the Company reclassified the $2.1 million loss on early retirement of its 1999 bank credit facility, which was recorded in the third quarter of 2001 as an extraordinary item, to other expense within the Company’s consolidated statement of operations.
(3)		EBITDA is defined as earnings before interest, income taxes, depreciation, amortization and other non-operating income or expenses. EBITDA is not intended to represent an alternative to net income or cash flows from operating, financing or investing activities (as determined in accordance with generally accepted accounting principles) as a measure of performance, and is not representative of funds available for discretionary use due to the Company’s financing obligations. EBITDA, as defined by the Company, may not be calculated consistently among other companies applying similar reporting measures. EBITDA is included herein because it is a widely accepted financial indicator used by certain investors and financial analysts to assess and compare companies on the basis of operating performance. Management believes that EBITDA provides an important additional perspective on the Company’s operating results, the Company’s ability to service its long-term obligations, the Company’s ability to fund continuing growth, and the Company’s ability to continue as a going concern.
(4)		Presented as cash used for property and equipment additions as reported in the Statement of Cash Flows.
(5)		End of year statistics.
(6)		Total rooms served include those rooms receiving one or more of the Company’s services, including rooms served by international licensees.

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Special Note Regarding Forward-Looking Statements

     Certain statements in this Annual Report on Form 10-K, including, without limitation, statements in Item 1, including certain statements under the headings “Overview”, “Markets and Customers”, “Services and Products”, “Operations”, “Competition”, “Business Strategy”, and “Regulation”, in Item 3 under the heading “Legal Proceedings”, and in Item 7 under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” constitute “forward-looking statements”. When used in this Annual Report, the words “expects,” “anticipates,” “estimates,” “believes,” “no assurance” and similar expressions and statements which are made in the future tense, are intended to identify such forward-looking statements. Such forward-looking statements” within the meaning of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, and are subject to risks, uncertainties, and other factors that could cause the Company’s actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. In addition to the risks and uncertainties discussed in the foregoing sections, such factors include, among others, the following: the effects of economic conditions, including in particular the economic condition of the lodging industry, competition, programming availability and quality, technological developments, developmental difficulties and delays, relationships with clients and property owners, the availability of capital to finance growth, the impact of government regulations, and other factors detailed, from time to time, in the Company’s filings with the Securities and Exchange Commission. These forward-looking statements speak only as of the date of this Annual Report. The Company expressly disclaims any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in the Company’s expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations

     The following discussion should be read in conjunction with the Consolidated Financial Statements of the Company, including the notes thereto, appearing elsewhere herein.

Overview

     LodgeNet Entertainment Corporation is the world’s largest and leading provider of broadband, interactive TV systems and services to hotels, resorts and casinos throughout the United States and Canada as well as select international markets. More than 260 million guests a year can use a wide range of LodgeNet interactive services including digital movies, music and television on-demand programming as well as video games, high-speed Internet access and other services designed to make their stay more enjoyable, productive and convenient. As of December 31, 2002, the Company provided interactive television services to approximately 5,700 hotel properties serving more than 950,000 rooms, more properties and rooms than any other provider in the world.

     Guest Pay Interactive Services. Guest Pay interactive services are purchased by guests on a per-view, hourly, or daily basis and include on-demand movies, television on-demand programming, music and music videos, network-based video games, Internet on television, and high-speed Internet access services. Guest Pay packages may also include additional satellite-delivered basic and premium cable television, video review of room charges, video checkout, guest surveying, and merchandising services that are paid for by the hotel and provided to guests at no charge.

     The Company’s Guest Pay interactive revenues depend on a number of factors, including the number of rooms equipped with the Company’s systems, hotel occupancy rates and guest demographics, and the popularity, pricing, and availability of programming. The primary direct costs of providing Guest Pay interactive services are (i) license fees paid to studios for non-exclusive distribution rights to recently-released major motion pictures; (ii) nominal one-time license fees paid for independent films, most of which are non-rated and intended for mature audiences; (iii) license fees for music rights associated with motion pictures (iv) license fees for other interactive services; (v) Internet connectivity costs; and (vi) the commission retained by the hotel. Guest Pay operating expenses include costs of system maintenance and support, programming delivery and distribution, data retrieval, insurance, and personal property taxes.

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During the years ended December 31, the Company installed its systems in the following number of rooms, net of de-installations:

De-installation activity is less than 2% of the total installed number of rooms.

The Company’s base of installed rooms was comprised as follows at December 31:

(1)		100% of Guest Pay interactive rooms are served by the Company’s on-demand interactive systems.
(2)		Digital services rooms are equipped with the interactive digital systems where on-demand movies, television on-demand programming, and music content are updated and delivered via satellite to the Company’s systems within respective hotels. Digital rooms are included with the total Guest Pay interactive rooms and represent more than 30% of the Guest Pay interactive rooms served in 2002.
(3)		Total rooms served, representing rooms receiving one or more of the Company’s services, including rooms served by international licensees.

     Free-to-Guest and Other Services. In addition to Guest Pay interactive services, the Company provides satellite-delivered basic and premium cable television programming for which the hotel, rather than its guests, pays the charges. The hotel pays the Company a fixed monthly charge per room for each programming channel provided. The Company obtains its free-to-guest programming pursuant to multi-year agreements and pays a monthly fee per room, which varies depending on incentive programs in effect from time to time.

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

     InnMedia LLC. During the fourth quarter of 2000, the Company entered into an arrangement with Hilton Hotels Corporation (“Hilton”) to form a new broadband, interactive media company, InnMedia LLC (InnMedia). InnMedia provided hotel guests new and innovative interactive television content through Internet on television as well as customized hotel and guest information. Under this arrangement, InnMedia supplied Internet portal and interactive television content to LodgeNet for distribution to subscribing hotels using LodgeNet’s broadband, interactive system for which it paid LodgeNet a fee for the use of LodgeNet’s system. The arrangement included $5 million in financing from LodgeNet and $5 million in financing from Hilton to fund start-up and near-term operating costs. The Company had a 47.5% equity interest in InnMedia and accounted for its investment using the equity method of accounting. For the years ended December 31, 2001 and 2000, the Company recorded equity losses of $2.6 million and $3.0 million, respectively.

     InnMedia began delivery of content and services in the third quarter of 2001 under the arrangement described above. In connection with the services provided, the Company charged InnMedia for system access fees of

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$866,000, connectivity costs of $1.2 million, and support and administrative expenses of $1.4 million for the year ended December 31, 2001.

     On April 12, 2002, the Company terminated the Distribution and Carriage Agreement, dated October 9, 2000, and Services Agreement, dated October 9, 2000, with InnMedia. The terminations followed the institution of legal proceedings by InnMedia against the Company. The agreements were terminated due to, among other things, InnMedia’s effective repudiation of the agreements and InnMedia’s failure to perform. As a result of the dispute with InnMedia, the Company charged off $471,000 in uncollectable receivables and continued to incur the costs associated with the provisioning of InnMedia’s services, totaling $914,000 through the end of July 2002. Prior to the terminations, the Company had charged InnMedia for system access fees of $633,000, connectivity costs of $793,000, and support and administrative expenses of $355,000 related to the first quarter of 2002.

     Effective July 31, 2002, the Company and InnMedia’s co-owner, Hilton, mutually agreed to dissolve InnMedia. InnMedia and the Company mutually released their claims against each other, and the lawsuit filed by InnMedia against the Company was dismissed with prejudice on August 7, 2002. During the third quarter of 2002, the Company contributed $252,000 for its share of pre-dissolution operating costs. For the year ended December 31, 2002, the Company recorded an equity loss of $419,000. The Company expects InnMedia to be fully dissolved in 2003 with no additional funding required to cover dissolution expenses.

Critical Accounting Policies

     Management’s discussion and analysis of financial condition and results of operations are based upon the Company’s financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company’s primary cost drivers are fact-based with predetermined rates, such as hotel commissions, license fees paid for major motion pictures, or one-time flat fee for independent films. However, the preparation of financial statements requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. The Company bases its estimates on historical experience and on various other assumptions that the Company believes to be reasonable based upon the available information. The following critical policies relate to the more significant judgments and estimates used in the preparation of the financial statements:

     Revenue Recognition. The Company recognizes revenue from the sale of interactive television services in the period the related services are provided to the hotel or guest. No future performance obligations exist on a service that has been provided. The price related to the Company’s products or services are fixed prior to delivery of the products or services. Revenue from the sale of system equipment and service parts and labor is recognized when the equipment is delivered or the service has been provided. The Company also has advance billings for certain free-to-guest programming services where the revenue is deferred and recognized in the periods that services are provided.

     Allowance for doubtful accounts. The Company determines the estimate of the allowance for doubtful accounts considering several factors, including: (1) historical experience, (2) aging of the accounts receivable, and (3) contract terms between the hotel and the Company. In accordance with the Company’s hotel contracts, monies collected by the hotel for interactive television services are held in trust on behalf of the Company. Collectibility is reasonably assured as supported by the Company’s nominal write-off history. For periods ended December 31, 2002, 2001, and 2000, charges to the allowance for doubtful account for related interactive television services were $283,000, $148,000, and $340,000 respectively. If the financial condition of a hotel chain or group of hotels were to deteriorate and reduce the ability to remit the Company’s monies, the Company may be required to increase its allowance by recording additional bad debt expense.

     Allowance for excess or obsolete system components. The Company regularly evaluates component levels to ascertain build requirements based on its backlog and service requirements based on its current installed base. When a certain system component becomes obsolete due to technological changes and it is determined that the component cannot be utilized within its current installed base, the Company records a provision for excess and obsolete component inventory based on estimated forecasts of product demand and service requirements. The Company makes every effort to ensure the accuracy of its forecasts of service requirements and future production,

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however any significant unanticipated changes in demand or technological advances could have an impact on the value of system components and reported operating results.

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Results of Operations — Years Ended December 31, 2002 and 2001

Revenue Analysis

     Total revenue for 2002 was $235.0 million, an increase of $18.1 million or 8.3% compared to 2001. The increase resulted from a 10.2% increase in average Guest Pay interactive rooms in operation, driven by the addition of nearly 150,000 rooms served by the Company’s next-generation interactive digital system, which represents a 129.8% increase over 2001.

     Guest Pay Interactive Services. Guest Pay interactive service revenue increased 9.8%, or $20.2 million, in 2002 as compared to 2001. The increase was primarily due to the additional 77,800 average Guest Pay rooms in operation and the growth of Guest Pay rooms installed with the interactive digital system. The following table sets forth the components of the Company’s revenue (in thousands) for the years ended December 31:

     Average movie revenue per room decreased 1.0% from 2001 due to a 110 basis point decline in occupancy rates of the properties served by the Company. This factor was partially offset by higher prices charged for movies. The following table sets forth information with respect to revenue per Guest Pay room for the years ended December 31:

     Average other interactive service revenue per room increased 2.0% from the prior year. This increase was primarily due to the increase in the number of rooms served by the interactive digital system, which provides a broader range of products available to the hotel guests.

     Other Revenue. Revenue from other sources is comprised of free-to-guest services provided to hotels not receiving Guest Pay services and sales of system equipment and service parts and labor. The $2.1 million decrease in other revenue was primarily driven by decreased equipment sales to international licensees due to the civil and economic uncertainties in the international market where the Company serves.

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Expense Analysis

     Direct Costs. The following table sets forth information regarding the Company’s direct costs (in thousands) and gross profit margin for the years ended December 31:

     Guest Pay interactive direct costs increased 12.6% to $96.0 million in 2002 from $85.3 million in the prior year. Guest Pay direct costs (movie license fees, music license fees within major motion pictures, license fees for other interactive services, Internet connectivity fees, and the commission retained by the hotel) are primarily based on related revenue, and such costs generally vary directly with revenue. The decrease of gross profit margin from 58.6% to 57.5% was primarily attributable to the costs that the Company absorbed upon termination of InnMedia and increases in hotel commissions, offset by reductions in video game royalties. InnMedia costs included Internet connectivity, hotel commissions, royalties, and technical support fees, and other direct expenses.

     Other direct costs associated with other revenue decreased $2.1 million, or 30.3%, in 2002 from the prior year and the gross profit margin increased from 37.6% in 2001 to 45.9% in 2002. The resulting increased gross profit margin was attributable to the reduction of lower margin sales of equipment to international licensees.

     The Company’s overall gross profit increased 7.5% in 2002 to $134.2 million on an 8.3% increase in revenue as compared to 2001. As a percentage of revenue, the overall gross profit margin was 57.1% in 2002 compared to 57.5% in the prior year. The change was primarily due to the costs that the Company absorbed upon termination of InnMedia and increases in hotel commissions, offset by reductions in video game license fees and a nominal shift in sales from higher margin Guest Pay interactive services, such as movies, to lower margin free to guest and Internet services.

     Operating Expenses. The following table sets forth information in regard to the Company’s operating expenses (in thousands) for the years ended December 31:

     Guest Pay operations expenses consist of costs directly related to the operation of systems at hotel sites. Guest Pay operations expenses increased by $1.5 million, or 5.3%, in 2002 from the prior year. This increase is primarily attributable to the 10.2% increase in average installed Guest Pay interactive rooms in operation during 2002 as compared to 2001. Offsetting the increased operating costs were greater operating efficiencies resulting from reduced truck rolls related to tape changes and related freight costs and improved economies of scale. Per average installed room, Guest Pay operations expenses decreased by 4.5% to $2.98 per month in 2002 as compared to $3.12 per month in 2001.

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     Selling, general and administrative expenses increased 5.4% to $22.1 million in 2002 from $21.0 million in 2001. The increase was substantially attributable to an InnMedia bad debt charge of $471,000 taken in the second quarter and approximately $640,000 of professional fees connected with the InnMedia-related litigation that was dismissed with prejudice pursuant to a settlement reached in August 2002. As a percentage of revenue, selling, general and administrative expenses were 9.4% in 2002 and 9.7% in 2001.

     Depreciation and amortization expenses increased 15.0% to $75.9 million in 2002 from $66.0 million in the prior year. The increase was primarily due to the additional 77,800 average Guest Pay interactive rooms in operation. During the fourth quarter, the Company also expensed approximately $1.4 million of unamortized costs related to browser software that the Company replaced with new browser software that provides greater functionality. Additionally, the Company also incurred depreciation expense of $860,000 for other capitalized costs including new service vans, equipment, and computers, and additional amortization expense of $1.3 million for software development and other intangibles, offset by the changes in fully depreciated assets remaining in service. As a percentage of revenue, depreciation and amortization expenses increased to 32.3% in 2002 from 30.4% in 2001.

     Operating Income. As a result of increased Guest Pay interactive revenue and decreased operating expenses as a percent of revenue driven by greater operating efficiencies, the Company generated operating income of $6.0 million in 2002 as compared to operating income of $9.1 million in 2001. As noted above, the change in operating income was primarily driven by hotel commissions, costs that the Company absorbed upon termination of InnMedia, bad debt and professional fees connected with the InnMedia-related litigation, depreciation and amortization, and service costs related to the 10.2% increase in average installed Guest Pay interactive rooms in operation.

Investment Losses

     InnMedia LLC. As previously described, InnMedia was formed by LodgeNet and Hilton during the fourth quarter of 2000. The Company has a 47.5% equity interest in InnMedia and recorded losses under the equity method of accounting for an investment of $2.6 million during 2001 and $3.0 million during 2000.

     On April 12, 2002, the Company terminated the Distribution and Carriage Agreement, dated October 9, 2000, and Services Agreement, dated October 9, 2000, with InnMedia. The terminations followed the institution of legal proceedings by InnMedia against the Company. The agreements were terminated due to, among other things, InnMedia’s effective repudiation of the agreements and InnMedia’s failure to perform. As a result of the dispute with InnMedia, the Company charged off $471,000 in uncollectable receivables and continued to incur the costs associated with the provisioning of InnMedia’s services, totaling $914,000 through the end of July 2002. Prior to the terminations, the Company had charged InnMedia for system access fees of $633,000, connectivity costs of $793,000, and support and administrative expenses of $355,000 related to the first quarter of 2002.

     Effective July 31, 2002, the Company and InnMedia’s co-owner, Hilton, mutually agreed to dissolve InnMedia. InnMedia and the Company mutually released their claims against each other, and the lawsuit filed by InnMedia against the Company was dismissed with prejudice on August 7, 2002. During the third quarter of 2002, the Company contributed $252,000 for its share of pre-dissolution operating costs. For the year ended December 31, 2002, the Company recorded an equity loss of $419,000. The Company expects InnMedia to be fully dissolved in 2003 with no additional funding required to cover dissolution expenses.

     ResNet Merger/GICC Investment. In November 1998, the operations of the Company’s majority-owned subsidiary, ResNet Communications, LLC (“ResNet”), were merged with two non-affiliated entities to form Global Interactive Communications Corporation (“GICC”). GICC’s business consisted of providing cable television programming and telecommunications services to the multi-family dwelling unit market. The Company contributed net assets totaling $31.3 million in exchange for a 30% equity interest in GICC and notes receivable totaling $10.8 million. The Company accounted for its investment in GICC using the equity method of accounting and recorded losses of $183,000 and $4.2 million for the years ended 2001 and 2000, respectively. In the second quarter of 2001, the Company transferred its equity interest back to GICC and had no further financing obligation to GICC. GICC filed for bankruptcy protection in the third quarter of 2001. In 2002, the Company recovered the full amount of its

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receivable, which was $316,000 as of December 31, 2001, and recorded an investment gain of $1.3 million from the $1.7 million in proceeds derived from the sale of GICC’s assets.

     Loss On Early Retirement of Debt. In April 2002, the Financial Accounting Standards Board issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections”. Under SFAS No. 145, gains and losses on extinguishments of debt will no longer be classified as extraordinary items as previously required under SFAS No. 4. Extraordinary treatment will be required for certain extinguishments as provided in APB Opinion No. 30. Effective January 1, 2002, the Company adopted the provisions of SFAS No. 145. In connection with the adoption, the Company reclassified the $2.1 million loss on early retirement of its 1999 bank credit facility, which was recorded in the third quarter of 2001 as an extraordinary item, to other expense within the Company’s consolidated statement of operations.

     Litigation Settlements. During 2002, the Company entered into settlement agreements with Broadcast Music Inc. (BMI) and the American Society of Composers, Authors and Publishers (ASCAP), which resolved claims for alleged nonpayment of royalties on copyrighted musical works performed in major motion pictures. BMI and ASCAP had asserted that the music, primarily background music, used within major motion pictures required licensing. BMI and ASCAP sought damages for public performances of such music from their respective catalogues. As a result of the settlements, the Company recorded a provision for the litigation settlements of $2.7 million that is related to pre-2002 reporting periods. This nonrecurring charge has been reported as a litigation expense in the accompanying statements of operations. The Company has paid approximately $1.2 million of the settlement amount with the balance to be paid ratably over the next five quarters, the first payment scheduled during the first quarter of 2003. In addition, the Company recorded approximately $420,000 as 2002 operating expense to accurately reflect music royalty costs directly related to current year operating activities.

     Interest Expense. Interest expense was $33.0 million in 2002 compared to $30.3 million in 2001 due to increases in long-term debt to fund the Company’s continuing expansion of its business. The average principal amount of long-term debt outstanding during 2002 was approximately $339 million (at a weighted average interest rate of approximately 9.8%) as compared to an average principal amount outstanding of approximately $307 million (at a weighted average interest rate of approximately 9.9%) during 2001.

     Net Loss. As a result of factors previously described, the Company incurred a net loss of $29.1 million as compared to a net loss of $26.4 million in 2001.

     EBITDA. EBITDA (defined by the Company as earnings before interest, income taxes, depreciation, amortization and other non-operating income or expenses) increased 9.0% to $81.9 million in 2002 as compared to $75.1 million in 2001. This increase was primarily due to a 10.2% increase in the average number of installed rooms receiving Guest Pay interactive services and the related increase in Guest Pay revenue, as well as increased gross profit earned on Guest Pay revenue and other revenue as described above. As a percentage of total revenue, EBITDA increased to 34.8% in 2002 as compared to 34.6% in 2001.

     EBITDA is not intended to represent an alternative to net income or cash flows from operating, financing or investing activities (as determined in accordance with generally accepted accounting principles) as a measure of performance, and is not representative of funds available for discretionary use due to the Company’s financing obligations. EBITDA, as defined by the Company, may not be calculated consistently among other companies applying similar reporting measures. EBITDA is included herein because it is a widely accepted financial indicator used by certain investors and financial analysts to assess and compare companies on the basis of operating performance. Management believes that EBITDA provides an important additional perspective on the Company’s operating results, the Company’s ability to service its long-term obligations, the Company’s ability to fund continuing growth, and the Company’s ability to continue as a going concern.

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Results of Operations — Years Ended December 31, 2001 and 2000

Revenue Analysis

The Company’s total revenue for 2001 increased 10.2%, or $20.1 million, in comparison to 2000. The following table sets forth the components of the Company’s revenue (in thousands) for the years ended December 31:

     Guest Pay Interactive Services. Guest Pay interactive service revenue increased 10.3%, or $19.3 million, in 2001 as compared to 2000. This increase was primarily due to a 10.6% increase in the average number of installed Guest Pay rooms. The following table sets forth information with respect to revenue per Guest Pay room for the years ended December 31:

     Average movie revenue per room decreased 1.4% from 2000 due to a lower occupancy rate throughout the hotel industry, which was attributable to the tragic events of September 11th and the impact on the general economy, and due to a relatively less popular selection of major motion pictures during the early part of 2001. These factors were partially offset by higher prices charged for movies.

     Average other interactive service revenue per room increased 4.9% from the prior year. This increase was primarily due to (i) increased per room revenue from Internet services resulting from increased penetration of Internet services into Guest Pay rooms, an expanded selection of revenue generating Internet services, and increasing interest in Internet services from hotel guests; and (ii) increased revenue from cable television programming services resulting from decreased incentive credits granted to hotels and increases in the number of cable television programming channels supplied by hotels to their guests.

     Other Revenue. Revenue from other sources is comprised of free-to-guest services provided to hotels not receiving Guest Pay services and sales of system equipment and service parts and labor. The 7.9%, or $795,000, increase in other revenue was due to increased equipment sales to international licensees.

Expense Analysis

     Direct Costs. The following table sets forth information regarding the Company’s direct costs (in thousands) and gross profit margin for the years ended December 31:

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     Guest Pay interactive direct costs increased 11.4% to $85.3 million in 2001 from $76.6 million in the prior year. Guest Pay direct costs (movie license fees, license fees for other interactive services, Internet connectivity fees, and the commission retained by the hotel) are primarily based on related revenue, and such costs generally vary directly with revenue. The nominal decrease to gross profit margin from 59.0% to 58.6% was primarily due to the shift from sales of higher margin Guest Pay interactive services to lower margin free-to-guest and Internet services.

     Other direct costs associated with other revenue increased $938,000 or 16.0% in 2001 from the prior year and the gross profit margin decreased from 41.9% in 2000 to 37.6% in 2001. The resulting decreased gross profit margin was due to lower profit margin sales of equipment to international licensees.

     The Company’s overall gross profit increased 9.1% in 2001 to $124.8 million on a 10.2% increase in revenue as compared to 2000. As a percentage of revenue, the overall gross profit margin decreased to 57.5% in 2001 from 58.1% in the prior year. The decrease was due to increased equipment sales to international licensees, which generally earns a lower profit margin and a nominal shift in sales from higher margin Guest Pay interactive services such as movies to lower margin free to guest and Internet services.

     Operating Expenses. The following table sets forth information in regard to the Company’s operating expenses (in thousands) for the years ended December 31: