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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended September 30, 2003

or

For the transition period from         to        

Commission File Number 0-22334

LodgeNet Entertainment Corporation

3900 West Innovation Street, Sioux Falls, South Dakota 57107

(605) 988-1000

          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 [  ].

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

          At October 27, 2003, there were 12,663,681 shares outstanding of the Registrant’s common stock, $0.01 par value.

This report contains a total of 28 pages not including exhibits.

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LodgeNet Entertainment Corporation and Subsidiaries

Index

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Part I — Financial Information

Item 1 — Financial Statements

LodgeNet Entertainment Corporation and Subsidiaries
Consolidated Balance Sheets (Unaudited)
(Dollar amounts in thousands, except share data)

The accompanying notes are an integral part of these consolidated financial statements.

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LodgeNet Entertainment Corporation and Subsidiaries
Consolidated Statements of Operations (Unaudited)
(Dollar amounts in thousands, except share data)

The accompanying notes are an integral part of these consolidated financial statements.

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LodgeNet Entertainment Corporation and Subsidiaries
Consolidated Statements of Cash Flows (Unaudited)
(Dollar amounts in thousands)

The accompanying notes are an integral part of these consolidated financial statements.

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LodgeNet Entertainment Corporation and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)

Note 1 — Basis of Presentation

The accompanying consolidated financial statements as of September 30, 2003, and for the three and nine month periods ended September 30, 2003 and 2002, have been prepared by LodgeNet Entertainment Corporation (the “Company”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (the “Commission”). The information furnished in the accompanying consolidated financial statements reflects all adjustments, consisting of normal recurring adjustments, which, in the opinion of management, are necessary for a fair presentation of such financial statements.

Certain information and footnote disclosures, normally included in annual financial statements prepared in accordance with generally accepted accounting principles, have been condensed or omitted pursuant to the rules and regulations of the Commission. Although the Company believes that the disclosures are adequate to make the information presented herein not misleading, it is recommended that these unaudited consolidated financial statements be read in conjunction with the more detailed information contained in the Company’s Annual Report on Form 10-K for 2002, as filed with the Commission. The results of operations for the three and nine month periods ended September 30, 2003 and 2002 are not necessarily indicative of the results of operations for the full year due to inherent seasonality within the business, among other factors.

The consolidated financial statements include the accounts of LodgeNet Entertainment Corporation and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

Note 2 — Property and Equipment, Net

Property and equipment was comprised as follows (in thousands):

Note 3 — Loss Per Share Computation

The Company follows SFAS No. 128, “Earnings Per Share”, which requires the computation and disclosure of two EPS amounts, basic and diluted. Basic EPS is computed based only on the weighted average number of common shares actually outstanding during the period. Diluted EPS is computed based on the weighted average number of common shares outstanding plus all potentially dilutive common shares outstanding during the period. Potential common shares that have an anti-dilutive effect are excluded from diluted earnings per share.

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The loss per common share for the three months ended September 30, 2003 and 2002, and the nine months ended September 30, 2003 and 2002, is based on 12,503,325, 12,406,919, 12,455,494 and 12,363,428 weighted average shares outstanding during the respective periods. Potential common shares were not included in the computation of diluted earnings per share because their inclusion would be anti-dilutive. As of September 30, 2003 and 2002, the number of potential common shares was approximately 4,946,000 and 4,729,000, respectively. Such potential dilutive common shares consist of stock options and warrants.

Note 4 — Stock-Based Compensation

The Company measures compensation costs associated with its stock option plans using the intrinsic value method. Accordingly, compensation costs for stock options are measured as the excess, if any, of the quoted market price of the Company’s stock at the date of grant over the amount an employee must pay to acquire the stock. Had compensation costs been determined based on the fair value at the date of grant for awards, net loss and loss per share would have changed to the pro forma amounts as follows for the periods ended September 30 (in thousands of dollars, except per share amounts):

Note 5 — Long-term Debt and Credit Facilities

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

Bank Credit Facility — On August 29, 2001, the Company entered into a $225 million bank credit facility, comprised of a $150 million term loan and a $75 million revolving credit facility that may be increased to $100 million, subject to certain limitations. The term loan matures in August 2008 and quarterly repayments began in December 2001. The term loan bears interest at the Company’s option of (1) the bank’s base rate plus a margin of 2.75% or (2) LIBOR plus a margin of 4.00%. The term loan interest rate as of September 30, 2003 was 5.14%. The revolving credit facility matures in August 2007 and borrowings under the credit facility bear interest at the Company’s option of (1) the bank’s base rate plus a margin of from 1.00% to 1.75%, or (2) LIBOR plus a margin of from 2.25% to 3.00%. As of September 30, 2003, there were no amounts outstanding under the revolving credit facility. Loans under the credit facility are collateralized by a first priority security interest in all of the Company’s assets.

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The facility provides for the issuance of letters of credit up to $10 million, subject to customary terms and conditions. As of September 30, 2003, the Company had outstanding letters of credit totaling $500,000.

The facility includes terms and conditions which require compliance in accordance with a material adverse effect covenant as well as the maintenance of certain financial ratios and place limitations on capital expenditures, additional indebtedness, liens, investments, guarantees, asset sales and certain payments or distributions in respect of the common stock. In June 2003, the Company received consent to offer the 9.50% senior subordinated notes described below, and amended its existing bank credit facility. The amendment modified the covenants for maximum consolidated total leverage ratio and minimum consolidated interest coverage ratio. The allowable maximum consolidated total leverage ratio increased from 4.5 to 5.0 until the end of the fourth quarter 2003 at which time, the ratio steps down to 4.75 times for the first two quarters of 2004 and to 4.5 times for the last two quarters of 2004. The minimum consolidated interest coverage ratio change from 2.25 to 2.50 was deferred from the third quarter 2004 until the first quarter 2005. The Company had previously amended its bank credit facility in August 2002. As of September 30, 2003, the Company’s leverage and interest coverage ratios were 4.41 and 2.45, respectively. Upon refinancing of the 10.25% Notes, the Company, at its sole discretion and without the payment of any additional costs, expenses or fees, extended the maturity dates of the term loan and the revolver loan from June 2006 to August 2008 and August 2007, respectively. In addition, the Company was in compliance with all covenants, terms and conditions of the bank credit facility.

9.50% Senior Notes — In June 2003, the Company issued $200 million of unsecured 9.50% Senior Subordinated Notes (the “9.50% Notes”), due June 15, 2013. The proceeds of the 9.50% Notes, which were issued at par, after underwriter fees and offering expenses, were approximately $192.5 million. Approximately $154.8 million of such proceeds were used to redeem the outstanding principal amount of the 10.25% Senior Notes, pay accrued interest, pay call premiums, and pay related fees. Approximately $35 million of the proceeds were used to pay all outstanding amounts under the Company’s revolving credit facility. The remaining proceeds of approximately $2.7 million were placed in cash for use in funding general corporate purposes.

The 9.50% Notes are unsecured, are subordinated in right of payment to all existing and future senior debt of the Company and rank pari passu in right of payment with any future senior subordinated indebtedness of the Company. The 9.50% Notes require semi-annual interest payments, commencing December 15, 2003, and contain covenants which restrict the ability of the Company to incur additional indebtedness, create liens, pay dividends or make certain distributions in respect to its common stock, redeem capital stock, issue or sell stock of subsidiaries in certain circumstances, effect certain business combinations and effect certain transactions with affiliates or stockholders. As of September 30, 2003, the Company was in compliance with all covenants, terms, and conditions of the 9.50% Notes.

The 9.50% Notes are redeemable at the option of the Company, in whole or in part, on or after June 15, 2008, initially at 104.75% of their principal amount (plus accrued and unpaid interest), declining ratably to 100% of their principal amount (plus accrued and unpaid interest) on or after June 15, 2011. At any time prior to June 15, 2006, the Company may redeem up to 35% of the aggregate principal amount at 109.50% of the principal amount (plus accrued and unpaid interest) with the cash proceeds of certain equity offerings.

10.25% Senior Notes — In December 1996, the Company issued $150 million of unsecured 10.25% senior notes (the “10.25% Notes”), due December 15, 2006. The 10.25% Notes were unsecured, ranked pari passu in right of payment with future unsubordinated unsecured indebtedness and ranked senior in right of payment to all subordinated indebtedness of the Company. The 10.25% Notes required semi-annual interest payments and contained certain covenants including limitations on indebtedness, liens, guarantees, asset sales and certain payments or distributions in respect to capital stock. On June 20, 2003, the Company redeemed approximately 79% of its outstanding 10.25% Notes at 102.688% of their principal amount, with the balance of the outstanding 10.25% Notes redeemed on July 1, 2003 at 102.563% of their principal amount, as part of its refinancing in which the 9.50% Notes were issued.

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11.50% Senior Notes — During 1995, the Company issued $30 million principal amount of unsecured 11.50% senior notes (the “11.50% Notes”). The 11.50% Notes are unsecured, rank pari passu in right of payment with future unsubordinated unsecured indebtedness and rank senior in right of payment to all subordinated indebtedness of the Company. Annual principal payments of $6 million commenced in July 2001 and continue through July 2005. The 11.50% Notes require semi-annual interest payments and contain certain covenants including limitations on indebtedness, liens, guarantees, asset sales and certain payments or distributions in respect to capital stock. As of September 30, 2003, the Company was in compliance with all covenants, terms, and conditions of the 11.50% Notes.

The Company issued a total of 480,000 warrants to purchase common stock of the Company in connection with the issuance of the 11.50% Notes. Each warrant entitles the holder to purchase one share of common stock at an exercise price of $7.00 per share. The value of the warrants, $1.68 million, was recorded as additional paid-in capital and shown as a discount on the 11.50% Notes.

Capital Leases — As of September 30, 2003, the Company has total capital lease obligations of $2,925,000. Equipment acquired under capital lease arrangements totaled $2,208,000 during the year ended December 31, 2002, and $722,000 during the nine months ended September 30, 2003.

Long-term debt has the following scheduled principal maturities for the twelve months ended September 30 (in thousands of dollars): 2004 — $8,645; 2005 — $8,322; 2006 — $2,150; 2007 — $1,705 and thereafter $340,999.

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

Note 6 — Accounting for Derivative Instruments and Hedging Activities

In August 2003, the Company entered into a $50 million interest rate swap agreement, which expires in June 2013, to effectively change the underlying debt from a fixed interest rate to a variable interest rate. In addition, the Company had existing interest rate swap agreements on $100 million of long-term debt, of which $50 million expire in December 2005 and $50 million expire in March 2006, to effectively change the underlying debt from a variable interest rate to a fixed interest rate for the term of the swap agreements. The Company is required by its bank credit facility to have a minimum of 50% of its term loan balance covered under interest rate swap arrangements and cannot exceed $150 million in swap agreements. The swap agreements have been designated as, and meet the criteria for, cash flow hedges and are not considered speculative in nature.

Note 7 — Loss on Early Retirement of Debt

In connection with the issuance of the 9.50% Notes in June 2003, the Company redeemed its 10.25% Notes due December 15, 2006. As a result of this early redemption, the Company incurred call and tender premiums, and related expenses, in the amount of $4.6 million and wrote off unamortized debt issuance costs of $2.5 million.

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Note 8 — Comprehensive Loss

Statement of Financial Accounting Standard No. 130, “Reporting Comprehensive Income,” provides standards for reporting and disclosure of comprehensive loss and its components. Comprehensive loss reflects the changes in equity during a period from transactions and other events and circumstances. For the Company, comprehensive loss was as follows for the periods ended September 30 (in thousands):

Components of accumulated other comprehensive loss as shown on the Company’s consolidated balance sheets were as follows (in thousands):

Note 9 — Effect of Recently Issued Accounting Standards

In November 2002, the FASB Emerging Issues Task Force reached a consensus on EITF 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” The EITF addresses how to account for multiple-deliverable revenue arrangements and focuses on when a revenue arrangement should be separated into different revenue-generating deliverables or “units of accounting” and if so, how the arrangement considerations should be allocated to the different deliverables or units of accounting. The provisions of EITF 00-21 are effective for fiscal years beginning after December 15, 2002. The adoption of the EITF had no impact on the Company’s consolidated financial statements.

In November 2002, FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” was released and had no impact on the Company’s consolidated financial statements.

In December 2002, the Financial Accounting Standards Board (FASB) issued SFAS No. 148, “Accounting for Stock Based Compensation—Transition and Disclosure—as Amendment to FAS 123.” SFAS 148 provides two additional transition methods for entities that adopt the preferable method of accounting for stock based compensation. In addition, the statement requires disclosure of comparable information for all companies regardless of whether, when, or how an entity adopts the preferable, fair value based method of accounting. These disclosures are now required for interim periods in addition to the traditional annual disclosure. The Company adopted the additional disclosure provisions of this statement in the first quarter of 2003. The amendments to SFAS No. 123, which provide for additional transition methods, are effective for periods beginning after December 15, 2002. The transition methods were not applicable to the Company as it continues to account for stock options using the intrinsic value method.

In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities”. This interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements, addresses consolidation by business enterprises of variable interest entities that possess certain characteristics. FIN 46 requires that if a business enterprise has a controlling financial interest in a variable interest entity, the assets, liabilities, and results of the activities of the variable interest entity must be included in the consolidated financial statements with those of the business enterprise. FIN 46 applies immediately to variable interest entities created after January 31, 2003 and to variable interest entities in which an enterprise obtains an interest after that date. For variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003, FIN 46 is effective for the first period ending after December 15, 2003. The adoption of FIN 46 will not impact the Company’s financial condition or results of operations. The Company does not have ownership in any variable interest entities.

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In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” This statement amends SFAS 133 to provide clarification on the financial accounting and reporting of derivative instruments and hedging activities and requires contracts with similar characteristics to be accounted for on a comparable basis. SFAS 149 is effective for contracts entered into or modified after June 30, 2003. The adoption of this statement, effective July 1, 2003, had no effect on the Company’s financial condition or results of operations.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity”. SFAS No. 150 requires that certain financial instruments issued in the form of shares that are mandatorily redeemable as well as certain other financial instruments be classified as liabilities in the financial statements. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003 and otherwise is generally effective at the beginning of the first interim period after June 15, 2003. The adoption of this statement, effective July 1, 2003, had no impact on the Company’s consolidated financial position or results of operations.

Note 10 — Gamet and PointOne

In the first quarter of 2003, the Company entered into an agreement with Gamet Technology, Inc (“Gamet”), a company engaged in the casino system technology industry, to form a limited liability company, PointOne Technologies, LLC (“PointOne”). The business purpose of PointOne was to engage in the development of server-based gaming systems for the casino industry by utilizing some of the Company’s intellectual property. The Company entered into a technology licensing agreement with PointOne, for which the Company received a 37.5% equity interest in PointOne, which could be diluted to less than 20% under certain circumstances. The Company’s contribution consisted of the license of certain technology rights to PointOne, and accordingly did not record an investment in PointOne as an asset. Gamet also contributed certain intellectual property related to server-based gaming to PointOne and entered into a technology licensing agreement with PointOne for other owned software, pursuant to which Gamet received a 62.5% equity interest in PointOne.

Other than the non-exclusive and non-transferable rights to utilize the Company’s licensed technology, the Company did not provide additional funding nor is the Company obligated or committed to providing any current and future funds to PointOne. The Company also reserved the right to terminate its technology licensing agreement if PointOne did not attain a specified level of funding by September of 2003. PointOne raised $850,000 in financing from private investors. However, PointOne was not able to obtain additional funds through permanent equity financing or other sources and in May its operations were suspended. The parties are currently in dispute regarding the ultimate disposition of PointOne and its technology. During the second quarter, the Company provided certain services to PointOne for which the Company invoiced approximately $100,000. This amount due from PointOne was fully reserved as a bad debt expense during the second quarter of 2003.

During the first quarter of 2003, the Company advanced $1.0 million to Gamet pursuant to a written promissory note. The note is personally guaranteed by the principal owners of Gamet and collateralized by the unconditional assignment of rights to receive quarterly payments due to the principal owner pursuant to a long-term note held by the principal owner in connection with the sale of a prior business. The note was due and payable on April 18, 2003. On July 2, 2003, the Company filed a lawsuit in U.S. District Court, Southern Division, in South Dakota, against Gamet and its principal owners demanding payment of the promissory note. Gamet filed an answer and counterclaim against the Company, alleging that its failure to repay the loan was caused by the Company’s failure to procure financing for PointOne and seeking unspecified damages. The Company believes the counterclaim is without merit and intends to vigorously contest it.

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Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis provides information concerning our results of operations and financial condition. This discussion should be read in conjunction with the accompanying consolidated financial statements and the notes thereto.

Special Note Regarding Forward-Looking Statements

Certain statements in this Quarterly Report on Form 10-Q constitute “forward-looking statements”. When used in this Quarterly Report, the words “expects,” “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, 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 elsewhere in this Report, 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, international crises, acts of terrorism, public health issues, 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 Quarterly 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.

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 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 September 30, 2003, the Company provided interactive television and other services to approximately 5,800 hotel properties serving more than 980,000 rooms.

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.

The room installations for the twelve months ended September 30, 2003 represent an increase of 5.7% for Guest Pay interactive rooms as compared to September 30, 2002. Additionally, digital services rooms increased 57.4% over the number of installed rooms at September 30, 2002. De-installation activity is less than 2% of the total installed room base.

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The Company’s base of installed rooms was comprised as follows at September 30:

	(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 39% of the Guest Pay interactive rooms served.
	(3)		Total rooms served represent 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 service fee, 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 related to such revenues are included in the statements of operations.

Gamet and PointOne. In the first quarter of 2003, the Company entered into an agreement with Gamet Technology, Inc (“Gamet”), a company engaged in the casino system technology industry, to form a limited liability company, PointOne Technologies, LLC (“PointOne”). The business purpose of PointOne was to engage in the development of server-based gaming systems for the casino industry by utilizing some of the Company’s intellectual property. The Company entered into a technology licensing agreement with PointOne, for which the Company received a 37.5% equity interest in PointOne, which could be diluted to less than 20% under certain circumstances. The Company’s contribution consisted of the license of certain technology rights to PointOne, and accordingly did not record an investment in PointOne as an asset. Gamet also contributed certain intellectual property related to server-based gaming to PointOne and entered into a technology licensing agreement with PointOne for other owned software, pursuant to which Gamet received a 62.5% equity interest in PointOne.

Other than the non-exclusive and non-transferable rights to utilize the Company’s licensed technology, the Company did not provide additional funding nor is the Company obligated or committed to providing any current and future funds to PointOne. The Company also reserved the right to terminate its technology licensing agreement if PointOne did not attain a specified level of funding by September of 2003. PointOne raised $850,000 in financing from private investors. However, PointOne was not able to obtain additional funds through permanent equity financing or other sources and in May its operations were suspended. The parties are currently in dispute regarding the ultimate disposition of PointOne and its technology. During the second quarter, the Company provided certain services to PointOne for which the Company invoiced approximately $100,000. This amount due from PointOne was fully reserved as a bad debt expense during the second quarter of 2003.

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During the first quarter of 2003, the Company advanced $1.0 million to Gamet pursuant to a written promissory note. The note is personally guaranteed by the principal owners of Gamet and collateralized by the unconditional assignment of rights to receive quarterly payments due to the principal owner pursuant to a long-term note held by the principal owner in connection with the sale of a prior business. The note was due and payable on April 18, 2003. On July 2, 2003, the Company filed a lawsuit in U.S. District Court, Southern Division, in South Dakota, against Gamet and its principal owners demanding payment of the promissory note. Gamet filed an answer and counterclaim against the Company, alleging that its failure to repay the loan was caused by the Company’s failure to procure financing for PointOne and seeking unspecified damages. The Company believes the counterclaim is without merit and intends to vigorously contest it.

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

Property and equipment. The Company’s property and equipment is stated at cost, net of accumulated depreciation and amortization. Installed Guest Pay and free-to-guest systems consist of equipment, related costs of installation, including certain payroll costs, and customer acquisition costs. Maintenance costs, which do not significantly extend the useful lives of the respective assets, and repair costs are charged to Guest Pay operations as incurred. The Company begins depreciating Guest Pay and free-to-guest systems when such systems are installed and activated. Depreciation of other equipment begins when such equipment is placed in service. The Company attributes no salvage value to equipment, and depreciation and amortization are computed using the straight-line method over the following useful lives:

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Discussion and Analysis of Results of Operations
Three Months Ended September 30, 2003 and 2002

Revenue Analysis. The Company’s total revenue for the third quarter of 2003 increased 6.5%, or $4.1 million, in comparison to the third quarter of 2002. The following table sets forth the components of revenue (in thousands) for the quarter ended September 30:

Guest Pay interactive revenue increased 8.0%, or $4.9 million, in the third quarter of 2003 in comparison to the same quarter of 2002. This increase was attributable to a 6.0% increase in the average number of installed Guest Pay interactive rooms, including an additional 130,000 digital services rooms deployed, compared to the third quarter of 2002. The following table sets forth information in regard to average monthly revenue per Guest Pay room for the quarter ended September 30:

Other interactive service revenue increased 8.8%, driven by expanding revenue from TV Internet, TV on demand, digital music and music videos, cable television programming services, and other interactive TV services available with the digital system.

Revenue from other sources includes revenue from free-to-guest services provided to hotels not receiving Guest Pay services and sales of system equipment and service parts and labor. Other revenue decreased $788,000, or 35.0%, resulting from decreased equipment sales to international licensees.

Gross Profit (exclusive of other operating expenses discussed separately below). Gross profit totaled $36.7 million for the third quarter ended September 30, 2003, an increase of 2.2% over the third quarter of 2002.

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Gross profit on Guest Pay interactive services increased 2.9%, or $1.0 million on an 8.0% increase in related revenue. Guest Pay direct costs include primarily 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, which generally fluctuate directly with revenue. Conversely, Internet connectivity fees are fixed costs independent of changes to revenue or occupancy. The addition of Internet connectivity costs to the Company’s direct cost base occurred with the transitioning of the TV Internet product from InnMedia to the Company in August of 2002. As a percentage of revenue, the decrease to gross profit margin from 56.8% to 54.1% was due to programming costs, Internet connectivity costs, and hotel commissions. The increase in programming costs was driven by a shift in the type of programming purchased by hotel guests. As noted above, the addition of Internet connectivity, fixed costs associated with the acquisition of the TV Internet product, was a contributor to the change in gross margin. These costs were only part of the direct cost base for the months of August and September during the third quarter 2002. Hotel commissions increased as a result of the Company’s utilization of its “pay for performance” commission structure whereby an increase in revenue per room could result in a higher commission paid to the hotel. The change in commissions paid had a negative affect of less than 1% on related margin.

Gross profit on other services decreased $227,000, or 22.9%, in the third quarter of 2003 from the prior year quarter and the gross profit margin increased from 44.0% to 52.1%. The resulting increased gross profit margin was attributable to the decrease in lower margin sales of equipment to international licensees.

As a percentage of revenue, the Company’s overall gross profit margin of 54.1% was lower than prior year quarter of 56.4%. In addition to the information provided above, the following table sets forth the primary change drivers of composite gross margin for the quarter ended September 30:

Operating Expenses. The following table sets forth information in regard to the Company’s operating expenses for the quarter ended September 30 (dollar amounts in thousands):