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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission file number 0-22935

Pegasus Solutions, Inc.

Campbell Centre I, 8350 North Central Expressway, Suite 1900 Dallas, Texas 75206

Registrant’s telephone number, including area code:

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

      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 þ          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 this Form 10-K or any amendment to this Form 10-K. o

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

      The aggregate market value of the registrant’s voting stock held by non-affiliates on June 30, 2004, based on the closing price of the registrant’s common stock on such date as reported on the NASDAQ national market, was $185,554,381.

      The number of shares of the registrant’s common stock, par value $0.01 per share, outstanding as of February 28, 2005 was 20,709,345.

      Portions of the Registrant’s definitive proxy statement for its 2005 annual meeting of stockholders to be held on May 10, 2005 are incorporated by reference into Part III of this Form 10-K.

TABLE OF CONTENTS

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PART I

      Except where expressly indicated or the context otherwise requires, the “Company,” “Pegasus,” “we,” “our” or “us” when used in this Annual Report refers to Pegasus Solutions, Inc., a Delaware corporation, and its predecessors and consolidated subsidiaries. This report contains forward-looking statements within the meaning of the federal securities laws, including statements using terminology such as “may,” “will,” “expects,” “plans,” “intends,” “anticipates,” “believes,” “estimates,” “potential,” or “continue,” or a similar negative phrase or other comparable terminology regarding beliefs, hopes, plans, expectations or intentions for the future. Forward-looking statements involve various risks and uncertainties. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain and the actual results and timing of certain events could differ materially from our current expectations. Factors that could cause or contribute to such a difference include, but are not limited to, changes in general economic conditions, variation in demand for our products and services and in the timing of our sales, changes in product and price competition for existing and new competitors, changes in our level of operating expenditures, delays in developing, marketing and deploying new products and services, terrorist activities, action by U.S. or other military forces, global health epidemics, changes in hotel room rates, capacity adjustments by airlines, negative trends in the overall demand for travel, other adverse changes in general market conditions for business and leisure travel, as well as other risks and uncertainties, including those appearing in this report under the caption “Risk Factors.”

Overview

      Pegasus is a global leader in providing technology and services to hotels and travel distributors. Founded in 1989, our customers include a majority of the world’s travel agencies and more than 60,000 hotel properties around the globe. Our services include central reservation systems, electronic distribution services, commission processing and payment services, property management systems, and marketing representation services. Our representation services, including Utell by Pegasus™ and Unirez by Pegasus™, are used by nearly 8,000 member hotels in approximately 140 countries, making Pegasus the hotel industry’s largest third-party marketing and reservations provider. We have 17 offices in 12 countries, including regional hubs in London, Scottsdale and Singapore.

      After several difficult years for the hotel industry, the year ended December 31, 2004 showed gradual but steady recovery in both reservation volumes and average daily room rates (ADR). Pegasus benefited from both the improved economic and industry environments as well as the December 2003 strategic acquisition of Unirez, Inc. Strength in foreign currencies, particularly the euro and the British pound, also favorably impacted Pegasus. Offsetting these benefits, increased competition resulted in reduced pricing on contract renewals and new business. In addition, an increase in the percentage of Internet reservations made at hotel chain Internet sites versus third-party Internet sites negatively impacted our distribution services revenues.

      Due to the improved operating environment, we increased discretionary spending in 2004 with a focus on customer satisfaction, sales, marketing, product development and employee retention activities intended to promote long-term growth. We also incurred additional expenses related to compliance with the Sarbanes-Oxley Act of 2002.

      Organizationally, we made leadership changes in key functions during 2004, particularly our information technology and product management groups. We also established or enhanced processes throughout the company with the goal of expediting the time to market on new products and improving customer satisfaction. During this transition period, we still met our earnings goals and made significant progress on product development priorities established at the beginning of the year.

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Strategy

      Our vision is to be the world leader in providing comprehensive and innovative solutions designed to transform critical business processes for hotels and travel distributors. Key elements of our strategy include the following:

	•	Provide Outstanding Customer Service. In 2004, we embarked on a company-wide campaign to embrace customer satisfaction as part of our corporate culture. To emphasize the importance of customer satisfaction, a portion of our employees’ compensation is tied to customer satisfaction benchmarks. While the results of our second customer satisfaction survey, completed in late 2004, showed notable progress, we will continually strive to provide outstanding customer service.
	•	Develop Leading Technologies and Expedite the Time to Market for New Products. We strive to develop new technologies, services and solutions to meet the changing needs of our current and prospective customers. During 2004, we created a product marketing organization to research customer needs, market trends and competitive offerings to sharpen our focus on new product strategies. We also realigned our information technology group and implemented new software development processes with a focus on expediting the time to market of new products and reducing development costs.
	•	Pursue Complete, Integrated Technology Solutions. We plan to bring together all of the technology needs of our customers instead of just a specific application. This includes providing services ranging from Web site integration to complete information technology outsourcing.
	•	Capitalize on Our Extensive and Diverse Portfolio of Independent Hotels and Small Hotel Groups. We believe consumers’ demand for a unique hotel experience, combined with lower cost distribution channels such as the Internet, will increase the presence of independent hotels and small hotel groups internationally and in the United States. With nearly 8,000 hotels using our representation services, we have an opportunity to grow revenues by cross-selling our other services and by launching consumer channels to market our member hotels directly to consumers.
	•	Pursue Emerging Hospitality Markets. We believe emerging markets such as Asia — in particular, China — and Latin America present a significant opportunity for revenue growth. We plan to utilize business partners, including sales agent partners, to expedite penetration in emerging markets in a cost effective manner.
	•	Build Strategic Alliances and Partnerships. We seek to build strategic alliances and partnerships, particularly related to sales distribution and product packaging. We believe that these relationships will broaden the brand recognition and market presence of our services and help to expand our customer base. We may also seek to acquire assets, technology and businesses that provide complementary services to our existing customers or access to other new travel-related markets and customers.

Services

      Through our comprehensive and integrated service offerings we can provide one or more of the following services to hotels and travel distributors worldwide:

      Reservation Services. Our award winning Central Reservation Services (CRS) utilize our RezView® application at its core. Hotel chains and hotel representation companies use a CRS to store information about all of their properties in a central database and then use that information to make and modify reservations and to generate various operational, management and marketing reports.

      Offered under the application service provider (ASP) model, our CRS service is a cost effective option for those hotel chains and hotel representation companies that neither have, nor want, the overhead associated with developing, implementing and maintaining the systems infrastructure inherent to CRS ownership.

      We provide CRS services on an ASP basis to approximately 8,000 hotel properties, representing approximately 1.3 million hotel rooms worldwide (including properties in our Utell by Pegasus representation portfolio). During 2004, we processed approximately 13.9 million hotel bookings through our CRS.

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      Distribution Services. Distribution services provides the connections and interfaces that enable hotels to distribute their rates and inventory to — and receive reservations from — the four global distribution systems (GDSs) used by travel agencies worldwide, a growing number of tour operators, wholesalers, and a wide variety of Powered by Pegasus® Internet sites. During 2004, distribution services processed approximately 27.6 million transactions. Distribution services include:

	•	GDS distribution — GDS distribution is offered to hotel customers. Our GDS distribution service offering automates hotel reservations through traditional GDS channels. The offering consists of connectivity to the four major GDSs (Sabre, Galileo, Amadeus and Worldspan) for reservation-related transactions, support of GDS maintenance activities, such as availability status and rate update functions, and standard reporting on transactional activity.
	•	Third-party Internet sites — We provide travel-related Internet sites access to our hotel information database containing content and images on more than 60,000 properties and on-line hotel reservation capability. We provide this service to several of the leading travel Internet sites such as Expedia.com, Orbitz.com, and our own HotelBook.com and Utell.com.
	•	Hotel Internet sites — A component of the online distribution environment, NetBooker® is a Pegasus developed and hosted online Internet booking engine available to hoteliers and travel portal companies who want a private label Internet site with integrated, seamless availability and booking engine but without the responsibilities and overhead of internal design, development and hosting. Hotel Internet sites that are “Powered by Pegasus” offer brand-loyal Internet shoppers real-time rates, availability and booking capabilities.
	•	PegsTour™ — In 2004, we introduced PegsTour, a new service which automates hotel bookings by wholesale travel companies and tour operators. This product has generated strong interest from wholesalers, tour operators and hotel companies and is expected to contribute to distribution services revenues in 2005.

      Representation Services. We offer a variety of hotel representation services to independent hotels and small hotel groups. Pegasus represents nearly 8,000 independent and small hotel group properties around the world.

      To market and sell their rooms, many independent hotels and small hotel groups associate themselves with our representation services and use our systems and infrastructure to offer and accept reservations for their rooms. Hotels typically utilize our representation services to obtain a presence in the primary electronic distribution channels (GDSs and the Internet) through our CRSs and global voice reservation capability.

      Our Unirez by Pegasus service provides a connection to all GDSs and thousands of linked third-party Internet sites through a leading Web-based CRS. Our advanced technology offers a user-friendly interface that allows hotel customers to upload or modify hotel data, including room rates, availability and descriptions, at any time.

      In addition to the distribution connectivity and CRS service, our Utell by Pegasus offering includes marketing programs, sales representation, a voice reservation call center network covering over 40 countries, and enhanced revenue management support. Hotels using our Utell® offering benefit from the enhanced market image created by affiliation with Utell by Pegasus, a well-known name in hotel distribution, as well as worldwide sales and marketing support.

      Utell representation customers also have the option to utilize our financial services capabilities under the names Paytell™ and TravelCom®. In some international markets, it is customary for travelers to prepay for hotel rooms and other travel arrangements. Paytell is a service that allows travelers to prepay for reservations, with Pegasus remitting amounts to hotels when the guest stay occurs. TravelCom is an Internet-based proprietary system that allows member hotels to expedite commission payments to travel agents.

      Property Services. Our PegasusCentral™ service is a full-featured Internet-based property management system (PMS). PegasusCentral benefits both hotel chains and independent properties by assisting in the management and operation of many hotel functions from a single location. Its intuitive user interface also

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      In addition to PegasusCentral, we obtained two proprietary software solutions as part of the acquisitions of REZ, Inc. (REZ) and Global Enterprise Technology Solutions, LLC (GETS). We are discontinuing the use of one of these systems, GuestView®, in 2005. This system is fully amortized, so there will not be a write-down related to its discontinuance.

      Financial Services. Financial services provides comprehensive commission processing and payment solutions to hotels, other travel suppliers and travel agencies in more than 200 countries. Key services include: commission processing; commission reconciliation and tracking for member agencies; and global commission solutions for participating hotels.

      Each month, Pegasus consolidates, distributes, reconciles, tracks and reports millions of dollars in commission payments to travel agency locations worldwide on behalf of more than 35,000 participating hotel properties. Traditionally, the process of reconciling and paying hotel commissions to travel agencies was based on transaction-specific hotel data and consisted of a number of relatively small payments to travel agencies, often including payments in multiple currencies. Our value-added commission consolidation and reporting service benefits both hotel and travel agency participants by providing a single, monthly commission payment to member travel agencies from participating hotels in their choice of currency. Our commission processing service processed approximately $504 million in hotel commissions in 2004.

      PegsPay® facilitates the exchange of funds and incentives between travel resellers (travel Internet sites, tour operators, travel wholesalers, etc.) and travel suppliers within a merchant-model-based distribution system, easing the administrative burdens associated with the reconciliation and distribution of payments. Under the merchant model, travel distributors receive hotel room inventory from suppliers at wholesale, or “net”, rates. Travel distributors then set the retail price for rooms and process transactions as the merchant of record, but are generally not obligated to pay suppliers for unsold inventory.

      Other Services. Pegasus regularly seeks to develop other new or enhanced technologies, services and solutions to meet the changing needs of our current and prospective customers. Pegasus has not received a material amount of revenue from these services, and there can be no assurance that any of these services will produce a material amount of revenue in the future.

Competition

      Our service offerings face competition from within their respective markets. Principal factors affecting our customers’ purchasing decisions for our services include pricing, product functionality, product performance and the breadth of service offerings. To compete successfully, we must meet our customers’ expectations and develop new technological solutions to meet the changing needs of the hospitality industry. We cannot assure you that any of our services will compete successfully. Please see the Risk Factors section below which further discusses competitive pressures.

      Reservation Services. Our reservation services compete with hotel companies that develop and host their own CRSs and third parties that provide CRS and related services under a license agreement or as an ASP. Our reservation service competitors include TRUST International (subsidiary of Cendant Corporation), SynXis Corporation (subsidiary of Sabre Holdings Corporation), Vantis Corporation and MICROS Systems, Inc.

      Distribution Services. Pegasus’ distribution services support a variety of distribution channels, each with its own competition. For example:

	•	GDS connectivity — Our GDS connectivity service competes primarily with WizCom International, Ltd. (subsidiary of Cendant Corporation). Customers may change their electronic reservation interface to WizCom or to another similar service. Also, some hotels have established a direct connection to one or more GDSs rather than through an intermediary, such as Pegasus or WizCom. Other hotels may choose to take the same action. If hotels establish this direct connection, they would bypass our

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		intermediary position and eliminate the need to pay our fees. However, the cost to maintain a separate connection to each GDS is typically more costly than maintaining a single connection to Pegasus.
	•	Third-party and hotel Internet sites — Our online distribution services face competition in the online hotel room reservation business from GDSs, middleware providers and Internet sites establishing direct connections to a hotel chain’s CRS. Several competitors have Internet-based reservation services offering a more comprehensive range of travel opportunities than we do, such as air, car rental and vacation packages. These competitors include priceline.com, Hotels.com (subsidiary of InterActive Corporation), Travelocity.com (subsidiary of Sabre Holdings Corporation), Orbitz.com (subsidiary of Cendant Corporation) and Expedia.com (a subsidiary of InterActive Corporation). Other potential competitors are Internet site development companies that could develop an interface directly between a hotel’s property system and a travel Internet site or an interface between a hotel company’s CRS and a travel Internet site. These companies are known as middleware providers. Hotels have been increasingly promoting the use of their own Internet sites. The cost of entry into the Internet hotel room reservation business is relatively low. However, the cost to maintain a separate connection to each Internet site is typically more costly than maintaining a single connection to Pegasus.

      Representation Services. Our hotel representation services compete with other providers of distribution, sales and marketing services, including hotel groups, franchisors, reservation companies and other travel or hotel representation companies. Our primary competitors offering hotel representation services are Vantis Corporation, SHS-WorldHotels, Supranational Hotels, SynXis Corporation and Sceptre Hospitality Resources.

      Property Services. Our property services compete with hotel companies that sell their own PMSs and third parties that provide PMSs. Our primary property service competitors include MICROS Systems, Inc., Hotel Information Systems, Northwind and Ramesys Hospitality.

      Financial Services. Our commission processing service faces competition principally from Perot Systems, Inc. In addition, current or prospective hotel customers can decide to process commission payments on their own. Our PegsPay service competes with credit card processors.

Seasonality

      Our business, particularly our representation services, is sensitive to seasonal changes in the demand for hotel rooms. The demand for business and leisure travel is typically lower in the first and fourth quarters of the year; therefore, these quarters have historically generated lower revenue than the second and third quarters. Because the majority of our operating expenses are fixed, fluctuations in revenue from quarter to quarter may have a material effect on operating income for the respective quarters.

International Operations

      We derive approximately 41 percent of our revenue from customers located outside the United States, primarily in the United Kingdom. Fluctuations in the value of foreign currencies relative to the U.S. dollar directly impact our revenues and expenses. More information regarding specific risks associated with our foreign operations and our exposure to movements in foreign currency exchange rates is available under the heading “Risk Factors” and “Item 7A. Quantitative and Qualitative Disclosures about Market Risk.” See enterprise-wide disclosures in Note 15 to the consolidated financial statements included in Item 8 of this Annual Report on Form 10-K.

Intellectual Property

      We are continually developing new technology and enhancing existing proprietary technology. We currently have one registered patent and are pursuing patent protection with respect to one other matter. We primarily rely on a combination of trademark, copyright, trade secrets, confidentiality procedures and contractual provisions to protect our technology and other intellectual property rights. Despite these protections, it may be possible for unauthorized parties to copy, obtain or use certain portions of our

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Research and Development

      Our research and development activities primarily consist of software development, development of enhanced communication protocols and custom user interfaces, and database design and enhancement. Our total research and development expense was $4.0 million, $5.2 million and $5.8 million for 2004, 2003 and 2002, respectively. The decrease in research and development expenses in 2004 is primarily due to the cost savings realized in conjunction with our 2003 restructuring.

Employees

      At January 31, 2005, we had 1,210 employees, 845 of whom are located in the United States. We had 234 people performing information technology functions, 812 people performing sales and marketing, customer relations and business development functions, and the remainder performing corporate functions, such as finance, legal, human resources and administrative. We have no unionized employees. We believe that our employee relations are satisfactory.

Available Information

      The public may read and copy any materials filed with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. As an electronic filer, Pegasus’ reports, proxy and information statements, and other information is available at the SEC’s Internet site, http://www.sec.gov.

      Our Internet address is www.pegs.com. Select company SEC reports, including reports on Form 10-K, Form 10-Q and Form 8-K (and amendments to those reports), are available free of charge on our Web site as soon as reasonably practicable after electronic filing or furnishing with the SEC. Our Code of Ethics for Senior Financial Officers, amendments thereto and waivers thereof are published and maintained on our Web site. Once published, any waiver will be posted for at least twelve months after it is granted. We disclaim incorporation by reference of information contained on any Internet site.

Risk Factors

      The following risk factors should be carefully considered in conjunction with the other information included or incorporated by reference in this report. If any of these risks occur, our business, financial condition, operating results, cash flows and securities’ market prices could be materially adversely affected. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business, financial condition or trading price of our securities.

Risks related to our industry

                  As nearly all of our revenues are derived from the hotel industry, a downturn in the hotel industry would likely adversely affect our business.

      Nearly all of our revenues are directly or indirectly dependent on the hotel industry, which is highly sensitive to any change in the general economic climate as well as economic conditions affecting business and leisure travel in particular. The hotel industry is susceptible to rapid and unexpected downturns, as experienced after the events of September 11, 2001, the war in Iraq, and the SARS health crisis. In the event of any future downturn in the hotel industry, we would likely experience significantly reduced revenues, as the use of our services and the demand for our future services and solutions would decline. A continued downturn in the hotel industry or any reduction in hotel reservation volume, average daily room rates, or the demand for travel generally, would negatively impact our business, operating results and financial condition.

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      Many factors affect the hotel industry, most of which are beyond our control. The hotel industry and demand for hotel rooms or travel may be affected by, among other things:

	•	General economic conditions including recession, inflation and currency fluctuations
	•	The existence or threat of military conflict, terrorism or political instability
	•	Increased government regulation and enforcement
	•	Natural disasters, such as hurricanes, earthquakes, and tsunamis, and any other unfavorable weather events or patterns
	•	Global or regional health issues
	•	Gasoline and aviation fuel price escalation
	•	Labor strikes
	•	Instability in the airline industry

      We may experience substantial period-to-period fluctuations in our results of operations as a consequence of these factors and others and the general economic conditions affecting the demand for hotel rooms and travel.

                  Reductions in room rates and hotel commission payments would reduce our revenues and net income.

      Pegasus financial services, which includes our commission processing service, derives revenues based on the dollar value of travel agency commissions paid by hotels. The dollar value of these commissions is based on the number of reservations, the length of stay and the room rate. Hotels typically are under no contractual obligation to pay room reservation commissions to travel agencies. Hotels could elect to reduce the current industry customary commission rate of 10 percent, limit the maximum commission generally paid for a hotel room reservation or eliminate commissions entirely. Hotels increasingly utilize other direct distribution channels, like the Internet, or offer negotiated rates to major corporate customers that are non-commissionable to travel agencies. If there is any decline in average daily room rates, change in the commission payment process, reduction in the amount of commissions paid for reservations or any increase in the direct distribution of rooms by hotels, our revenues and net income could substantially decrease.

              Consolidation in the travel industry, including hotels, travel agencies and electronic reservation providers, could result in reduced revenues.

      We offer volume-based discounted fees for some of our services. Recent consolidation in the hotel industry has resulted in a higher percentage of discounted fees and this trend could continue. In addition, the GDS industry has consolidated into four major GDSs. If further consolidation occurs, the value of our services and the benefits to hotel operators of utilizing our GDS distribution service would be reduced. Any potential decrease in our customer base or any potential increase in the percentage of discounted fees may adversely affect the profitability of our business.

Risks Related to the Company

      Our future success depends on our ability to successfully develop leading technologies, enhance our existing services and develop and introduce new services. In particular, our technologies and services must meet the demands of our current and prospective customers on a timely and cost-effective basis, staying abreast of technological advances and evolving industry standards and practices.

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      Although we strive to be a technological leader, future technology advances may not complement or be compatible with our services. In addition, we may be unable to economically and timely incorporate technology changes and advances into our business. We may be unsuccessful in effectively developing and implementing new technologies, adapting our services to emerging industry standards or developing, introducing and marketing service enhancements or new services in a timely manner and with acceptable performance levels.

      We also may experience difficulties that could delay or prevent the successful development or introduction of these services. It is also possible that a new service, while achieving a technological success, may fail to be accepted and utilized by prospective customers.

      If we are unable to successfully develop, introduce and implement new services or enhance existing services on a timely and cost-effective basis or if new services do not achieve market acceptance, it could adversely affect our ability to compete in the marketplace and negatively affect our business. Any such failures could have a material negative impact on our operating results and financial condition, including write-downs or write-offs related to impaired assets.

      Service failures, delays in the implementation of our service offerings or our failure to deliver services in a timely manner with acceptable service levels could result in reduced revenues, particularly since our transaction-based revenues are dependent upon services being available, reduced pricing for our services, a loss of customers, an inability to effectively compete and breach of contract claims. Certain service failures could also require us to credit customers pursuant to service level agreements, which we intend to use more frequently in the future.

      We compete in markets that are rapidly evolving, intensely competitive and involve continually changing technology and industry standards. We may experience increased competition from current and potential competitors, many of which have significantly greater financial, technical, marketing and other resources than we possess. Consolidation among our competitors may result in economies of scale, or broader or more comprehensive service offerings with which we may have difficulty competing. Competitive pressures have contributed to less profitable arrangements with some of our customers and could reduce our market share or require us to reduce the prices of our services. Consolidation among travel distribution companies, such as Cendant and Expedia, may increase competitive pressure with respect to our service offerings to travel distribution companies and the hotels that may utilize our distribution capabilities. Our inability to compete effectively with alternative service providers could adversely affect our business, operating results and financial condition.

      Our business is dependent upon our customer arrangements with hotel chains, independent hotels, hotel representation firms, travel management companies, travel agencies, travel agency consortia, global distribution systems, travel-related Internet sites and Internet-based information and reservation systems. In the future, our customers may elect to perform certain functions themselves, may circumvent our services, may select the services of competing companies, or we may otherwise be unable to continue or renew these arrangements on favorable terms or initiate new arrangements. In addition, customers may elect to utilize our lower cost service offerings over our higher-priced offerings that provide us with greater revenue. For example, our representation customers may switch from our Utell by Pegasus offering to our Unirez by Pegasus offering, resulting in less revenue to us. If we are unable to renew, continue or initiate customer arrangements on a favorable basis, it could result in a significant reduction in our customer base and revenue sources.

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      We rely on certain third party arrangements for the provision of our services and increasingly for the development and enhancement of our services. Such “outsourcing” presents a number of risks primarily relating to our reduced control of the functions that are outsourced. Further, because much outsourcing occurs outside of the U.S., these activities are subject to the risks of international operations, including the risk of increased governmental regulation of these activities.

      We rely on third parties for many services, including remittance and worldwide currency exchange services for our commission processing service and for facility maintenance and enterprise resource planning system hosting. If we are unable to renew or extend our contracts with existing third-party service providers or enter into contracts with alternate service providers on favorable terms, it could adversely affect our business, operating results and financial condition.

      Our operations depend on our ability to protect our computer systems and databases against damage or system interruptions from fire, earthquake, power loss, telecommunications failure, unauthorized entry, human error or other events beyond our control. A significant amount of our computer equipment is located in Scottsdale, Arizona. Any unanticipated problems may cause a significant system outage or data loss. Despite the implementation of security measures, our infrastructure may also be vulnerable to break-ins, computer viruses or other disruptions caused by our customers or others. Our infrastructure may also fail to provide consistent dependable service as a result of circumstances both in and out of our control. Any damage to our databases, failure of communication links, security breach or other factors that cause interruptions in our operations could adversely affect our business, operating results and financial condition.

      Our potential future growth may place significant demands on management as well as on our administrative, operational and financial resources. Expanding our business to take advantage of new market opportunities will require significant management attention and Company resources, possibly adversely impacting our existing operations. In order to obtain certain distribution, supply or operations capabilities, our attempts to expand may involve an increased use of revenue sharing arrangements, which may affect our profitability or result in additional liabilities.

      We plan to expand our presence in international markets, particularly including the Asia-Pacific region in general and specifically China. In addition to being subject to the risks of international operations described below, it is costly to establish new international operations and our net sales from international market segments may not offset the expense of establishing and maintaining the operations. We have relatively little experience in marketing and distributing our services in many of these international markets, and we may not succeed in these efforts.

      We also regularly evaluate acquisition and joint venture opportunities and in the future may make additional acquisitions of other companies or technologies or enter into joint ventures. Acquisition and joint ventures involve many risks including:

	•	Difficulty in integrating or otherwise assimilating technologies, products, personnel and operations
	•	Diversion of management’s attention from other business concerns
	•	Issuance of dilutive equity securities and the incurrence of debt or contingent liabilities
	•	Large write-offs and amortization expense related to identifiable intangible assets

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	•	Loss of key employees of acquired organizations
	•	Risks of entering markets in which we have no or limited prior experience
	•	Payments of cash and the assumption of liabilities of other businesses

      Our inability to manage growth or to integrate any acquisitions or joint ventures could adversely affect our business, operating results and financial condition.

      Our expense levels are based primarily on our estimate of future revenues and are largely fixed in the short-term. In the future, we may not accurately predict the transaction volumes and room rates that directly impact our revenues, the introduction of new or enhanced services by us or our competitors or the degree of customer acceptance of new services. In the short-term, we may also be unable to adjust spending rapidly enough to compensate for any unexpected revenue shortfall. This could adversely impact our business, operating results and financial condition. Accordingly, we believe that period to period comparisons of our operating results should not be relied upon as an indication of future performance.

      Many of our customers are independent hotels, travel agencies and other travel industry participants that are particularly exposed to any downturn in the economy and other factors that adversely impact the hotel industry. Some of these customers may have inadequate financial strength to make current payments to us or remain as going concerns. In some instances we may be unable to collect payments from these customers or we may extend credit to them in the form of unsecured promissory notes or otherwise. Our inability to collect payments from these customers in the future could result in a material adverse effect on our business, operating results and financial condition.

      As of December 31, 2004, we had accounts receivable as a result of our ongoing operations of approximately $31.7 million. Additionally, we had notes receivable of approximately $6.6 million at December 31, 2004, primarily related to the sale of business units to IndeCorp Corporation. Our receivables are monitored by management for collectibility. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of parties to make required payments, including the amounts payable by IndeCorp under promissory notes payable to us. These estimates of losses require judgments that are based on available information and experience, such as the payment histories and known financial conditions of the parties. These estimates are significant because we may incur additional expense for past or future fiscal periods to increase our allowance for doubtful accounts and we may receive less cash than expected if the financial condition of the parties were to deteriorate resulting in an impairment of their ability to make payments.

      We derive a substantial portion of our revenue from customers located outside the United States, primarily in Europe. If the value of foreign currencies relative to the U.S. dollar decreases, our revenues translate to a lower U.S. dollar amount.

      Our international operations are also subject to other risks, including:

	•	Impact of possible adverse political and economic conditions, including difficulties in the repatriation of investments or profits
	•	Potentially adverse tax consequences

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	•	Impact of the policies and regulations of the United States and foreign governments on foreign trade and commerce, such as the USA PATRIOT Act and other laws enforced by the U.S. Office of Foreign Assets Control
	•	Compliance with information privacy laws and related enforcement actions
	•	Reduced protection for intellectual property rights in some countries
	•	Changes in regulatory requirements
	•	Cost of adapting our services to foreign markets
	•	High costs associated with office closures and personnel reductions

      Our success depends upon our proprietary technology and other intellectual property rights. We currently rely upon a combination of trademark, patents, copyright, trade secrets, confidentiality procedures and contractual provisions to protect our proprietary technology and other intellectual property. Despite our current efforts to protect our proprietary rights, these protective measures may not be enforceable or may not be adequate to prevent misappropriation or infringement of our technology. In addition, we may need to litigate claims against other parties to enforce our intellectual property rights, protect our trade secrets, determine the validity and scope of the proprietary rights of others or defend against claims of infringement or invalidity. This litigation could result in substantial cost and diversion of management resources. A successful claim against us could effectively block our ability to use or license our technology and other intellectual property in the United States or abroad. If we cannot adequately protect our proprietary rights, it could adversely affect our competitive edge in the marketplace and consequently our business, operating results and financial condition.

      Our success depends on our ability to retain the services of our current executive officers and other key personnel, and to manage effectively any transition in the event of a change in such key personnel. We cannot guarantee that we will be able to successfully identify, attract, motivate and retain other highly skilled personnel in a timely and effective manner. Our failure to retain our officers and key personnel or to recruit new personnel could adversely affect our business, operating results and financial condition.

      Our operations are subject to the laws and regulations of the United States and numerous states and international jurisdictions. Changes regarding any of these laws and regulations, their enforcement or our understanding of the applicable requirements could force us to change our operations or result in other uncertain adverse consequences. Our efforts to comply with the requirements of the Sarbanes-Oxley Act of 2002, particularly the provisions of Section 404 regarding the certification and audit of our internal controls over financial reporting, have resulted in material expenditures of financial and employee resources and may continue to do so in the future. Also, as a result of our customer relationships, particularly our status as an intermediary with high market share in certain services, any federal, state or foreign governmental authorities, competitors or consumers could raise antitrust or anti-competitive concerns.

      In addition, we are subject to the same federal, state and local laws as other companies conducting business on the Internet and other e-commerce, including with respect to taxation, user privacy, data protection, consumer protection, payment processing, electronic contracts and other issues. Many of these laws and regulations are new, have not yet been thoroughly interpreted by the courts, and are subject to change by many jurisdictions, including federal, state, municipal and international jurisdictions which could have a

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      Provisions in our certificate of incorporation and bylaws could make it more difficult for a third party to acquire us. These provisions include the staggered terms of our Board of Directors, the exclusive right of the Board of Directors to fill vacancies on the board, and restrictions on the right of stockholders to remove members of the Board of Directors. We are also subject to the provisions of Delaware law that restrict certain business combinations with interested stockholders even if such a combination would be beneficial to stockholders. Under Delaware law, a Delaware corporation may opt out of the anti-takeover provisions. We do not intend to opt out of these anti-takeover provisions. In addition, we have a stockholder rights plan. The rights are exercisable only if a person or group of affiliated persons acquires, or has announced the intent to acquire, 20 percent or more of our common stock. In addition, we have certain payment and other obligations that are triggered by a change of control in connection with agreements with certain third parties and employees.

      These provisions could discourage potential acquisition proposals and could delay or prevent a change in control transaction. They could also discourage others from making tender offers for our shares. As a result, these provisions may prevent the market price of our common stock from reflecting the effects of actual or rumored takeover attempts. These provisions may also prevent significant changes in our Board of Directors and our management.

      From time to time, we are involved in legal and other regulatory proceedings. We intend to defend our rights vigorously during any of these proceedings. Regardless of the merits of any issues raised in any of these proceedings, our involvement could result in substantial costs and other liabilities not covered by insurance as well as divert management’s time and attention from our business, which could adversely affect our business, financial condition and results of operations.

      In connection with the sale of the convertible notes in July 2003, we incurred $75 million of indebtedness which increased our interest payment obligations. The degree to which we are leveraged could adversely affect our ability to obtain further financing for working capital, acquisitions or other purposes and could make us more vulnerable to industry downturns and competitive pressures. Our ability to meet our debt service obligations will be dependent upon our future performance, which will be subject to the financial, business and other factors affecting our operations, many of which are beyond our control.

      Our ability to generate cash flow from operations to make interest payments on the convertible notes will depend on our future performance, which will be affected by a range of economic, competitive and business factors, many of which are beyond our control. If our operations do not generate sufficient cash flow from operations to satisfy our debt service obligations, we may need to borrow additional funds to make these payments or undertake alternative financing plans, such as refinancing or restructuring our debt, or reducing or delaying capital investments and acquisitions. We may secure a credit facility as additional protection against short-term liquidity concerns. However, such credit facility, other additional funds or alternative financing may not be available to us on favorable terms, or at all. Our inability to generate sufficient cash flow from

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      At maturity, the entire outstanding principal amount of the convertible notes will become due and payable by us. In addition, on July 16, 2008, July  16, 2013 and July 16, 2018 or if a fundamental change occurs, as defined in the indenture relating to the convertible notes, each holder of the convertible notes may require that we purchase all or a portion of that holder’s notes. We cannot be assured that we will have sufficient funds or will be able to arrange for additional financing to pay the principal amount or purchase price due. In that case, our failure to repay the convertible notes at maturity or to purchase any tendered notes would constitute an event of default under the indenture.

      Holders of the notes are entitled to convert the notes into our common stock, among other circumstances, if the closing sale price of our common stock for at least 20 trading days in the 30 trading day period ending on the last trading day of a calendar quarter equals or exceeds 120% of the conversion price in effect on that last trading day. Pursuant to our adoption of Emerging Issues Task Force Issue 04-8, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share,” we are required to consider the contingently convertible notes in our calculations of diluted earnings per share, regardless of whether the market price trigger has been met. There was no impact on the calculation of diluted net income (loss) per share for the years ended December 31, 2004 and 2003, as the effect was anti-dilutive. However, the impact of the contingently convertible notes may be required to be included in our diluted net income per share calculations in the future, and this would result in a decrease to diluted earnings per share. Volatility in our net income or stock price could cause this condition to be met in one quarter and not in a subsequent quarter, increasing the volatility of our diluted earnings per share.

      Several factors have caused, and may in the future cause, our stock price to be significantly volatile, which may be unrelated to our operating performance in certain cases. Our stock price could be subject to wide fluctuations in response to a variety of factors including the following:

	•	General economic conditions
	•	Acts of terrorism, retaliation for such acts, political instability, health epidemics, natural disasters, war and the prospect of war
	•	Actual or anticipated variations in our quarterly operating results
	•	Our ability to successfully develop, introduce and gain acceptance of new or enhanced products and services to the hotel industry on a timely basis
	•	Unexpected changes in demand for our services and solutions
	•	Adverse findings, conclusions or changes in requirements with respect to our internal controls assessment and audit pursuant to Section 404 of the Sarbanes-Oxley Act of 2002
	•	Unpredictable volume and timing of customer revenues due the terms of customer contracts, changes in the hotel industry and other factors
	•	Purchasing and payment patterns, as well as pricing policies, of our competitors
	•	Announcements of technological innovations or new services by us or our competitors

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	•	Changes in financial estimates, expectations and methodologies by securities analysts
	•	Conditions, trends or perceived prospects in the Internet and online commerce industries
	•	Changes in the market valuations of other similarly situated companies and hospitality and technology stocks in general
	•	Announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments
	•	Unscheduled system downtime
	•	Lack of confidence in the Company’s ability to execute on certain products or services
	•	Sales of substantial amounts of shares of our common stock in the public market, or the perception that those sales may occur

      We have in the past and may in the future make investments in other companies and ventures. There can be no assurance of the success of any such investment. Additionally, Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities,” may require us to consolidate entities with which we have an affiliation but no voting or operational control. In doing so, we may have little or no control over the success of the company or venture and we may be required to record the losses of these consolidated entities in our financial statements.

      Our corporate headquarters is located in a leased facility with approximately 100,000 square feet of space in Dallas, Texas. We also have regional hubs in Scottsdale, London and Singapore with approximately 145,000, 40,000 and 8,000 square feet of leased office space, respectively. In total, we have 17 offices in 12 countries, all of which are leased facilities. We believe that our existing facilities are well maintained and in good operating condition. We believe that our planned and existing facilities are adequate for our anticipated levels of operations.

      Pegasus is subject to certain legal proceedings, claims and disputes that arise in the ordinary course of business. Although management cannot predict the outcome of these legal proceedings, we do not believe these actions will have a material adverse effect on our financial position, results of operations or liquidity.

      No matter was submitted to a vote of our stockholders during the fourth quarter of the fiscal year ended December 31, 2004.

PART II

      Our common stock has been traded on the NASDAQ National Market under the symbol “PEGS” since August 7, 1997. At February 28, 2005, there were approximately 334 record holders of our common stock although we believe that the number of beneficial owners of our common stock is substantially greater.

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      The following table shows the range of quarterly high and low sales prices for Pegasus’ common stock.

      We intend to retain any future earnings for use in our business and do not intend to pay cash dividends in the foreseeable future. The payment of future dividends, if any, will be at the discretion of our Board of Directors and will depend, among other things, upon future earnings, operations, capital requirements, restrictions in financing agreements, requirements related to our convertible debt offering, our general financial condition and general business conditions.

      On September 28, 1998, our Board of Directors declared a dividend distribution of one right for each outstanding share of our common stock to stockholders of record at the close of business on October 13, 1998. Each right entitles the registered holder to purchase from us one one-thousand five hundredth (1/1,500th) of a share of our Series A Preferred Stock for each share of our common stock held at a price of $60. The rights are exercisable only if a person or group of affiliated persons acquires, or has announced the intent to acquire, 20 percent or more of our common stock.

(1)	On November 5, 2004, the Company’s Board of Directors authorized up to 1.5 million shares of the Company’s stock to be repurchased under a Securities and Exchange Commission Rule 10b5-1 stock repurchase plan.
(2)	During the quarter ended December 31, 2004, the Company repurchased 660,688 shares of the 1.5 million shares authorized for an aggregate purchase price of $7.7 million. Repurchases have and will be made in accordance with applicable securities laws in the open market or in private transactions from time to time, depending on market conditions.
(3)	All shares were purchased pursuant to the publicly announced programs.

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      The following selected consolidated financial data as of and for the years ended December 31, 2004 and 2003, and for the year ended December 31, 2002 are derived from the consolidated financial statements of Pegasus that have been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, and are included as Item 8 of this Annual Report on Form 10-K. Selected consolidated financial data as of December 31, 2002, and as of and for the years ended December 31, 2001 and 2000 are derived from Pegasus’ audited financial statements that are not included herein.

      The following data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and with Pegasus’ consolidated financial statements and notes thereto.

(1)	Pegasus’ selected consolidated financial data includes the operating results related to the acquisition of REZ, Inc. in April 2000.
(2)	Pegasus’ selected consolidated financial data includes the operating results of GETS following the acquisition in September 2001.
(3)	Pegasus’ selected consolidated financial data includes the operating results of Unirez following the acquisition in December 2003.
(4)	Effective January 1, 2002, in accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangibles,” Pegasus ceased to record goodwill amortization.
(5)	Revenues have been reclassified to give effect to the 2002 adoption of the Emerging Issues Task Force, or EITF, Issue 01-14, “Income Statement Characterization of Reimbursements Received for “Out-of-Pocket’ Expenses Incurred.”
(6)	In 2004 the Company reclassified bad debt expense to General and Administrative Expenses from Cost of Services. The reclassified amounts totaled $1.3 million, $3.4 million, and $2.9 million in 2002, 2001, and 2000, respectively.

      The Company has not paid any cash dividends during the past five years.

      The following discussion and analysis should be read in conjunction with the selected consolidated financial data included as Item 6 of this Annual Report on Form 10-K and the consolidated financial statements and notes thereto included as Item 8 of this Annual Report on Form 10-K. This discussion and analysis contains forward-looking statements within the meaning of the federal securities laws, including

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Overview

      Pegasus is a global leader in providing technology and services to hotels and travel distributors. Founded in 1989, our customers include a majority of the world’s travel agencies and more than 60,000 hotel properties around the globe. Our services include central reservation systems, electronic distribution services, commission processing and payment services, property management systems, and marketing representation services. Our representation services, including Utell by Pegasus and Unirez by Pegasus, are used by nearly 8,000 member hotels in approximately 140 countries, making Pegasus the hotel industry’s largest third-party marketing and reservations provider. We have 17 offices in 12 countries, including regional hubs in London, Scottsdale and Singapore.

      After several difficult years for the hotel industry, the year ended December 31, 2004 showed gradual but steady recovery in both reservation volumes and average daily room rates. Pegasus benefited from both the improved economic and industry environments as well as the December 2003 strategic acquisition of Unirez, Inc. Strength in foreign currencies, particularly the euro and the British pound, also favorably impacted Pegasus. Offsetting these benefits, increased competition resulted in reduced pricing on contract renewals and new business. In addition, an increase in the percentage of Internet reservations made at hotel chain Internet sites versus third-party Internet sites negatively impacted our distribution services revenues.

      Due to the improved operating environment, we increased discretionary spending in 2004 with a focus on customer satisfaction, sales, marketing, product development and employee retention activities intended to promote long-term growth. We also incurred additional expenses related to compliance with the Sarbanes-Oxley Act of 2002.

      Organizationally, we made leadership changes in key functional areas during 2004, particularly our information technology and product management groups. We also established or enhanced processes throughout the company with the goal of expediting the time to market on new products and improving customer satisfaction. During this transition period, we still met our earnings goals and made significant progress on product development priorities established at the beginning of the year.

      Because our management approach, organizational structure, operating performance assessment and reporting, and operational decision making are performed from a single company perspective, we operate as one reportable segment.

Dependence on the Hotel Industry

      Our business is sensitive to changes in the demand for, and average daily rates associated with, hotel rooms. Historically, after periods of low demand for hotel rooms, average daily rates have lagged behind the recovery in transaction volumes. Since our distribution and reservation services revenues are primarily transaction-based, revenues for these services have recovered more quickly than our hotel representation and financial services, which are based in large part on a combination of reservation volume and average daily

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Revenues

      Representation Services. We offer a variety of hotel representation services to independent hotels and small hotel groups through our Utell by Pegasus and Unirez by Pegasus services. Representation services revenues primarily consist of reservation processing fees, membership fees and fees for various marketing services. Representation services revenues represented approximately 41 percent of service revenues for 2004.

      Reservation Services. We provide CRS services on an ASP basis. Reservation services revenues consist of transaction fees as well as maintenance and support fees related to our RezView CRS software. Reservation services revenues represented approximately 21 percent of service revenues for 2004.

      Financial Services. Our financial services provide comprehensive commission processing and payment solutions to hotels, other travel suppliers and travel agencies. Financial services revenues consist of both travel agency and hotel fees. Travel agency fees are based on a percentage of the value of hotel commissions processed by us on behalf of participating travel agencies. Revenues from travel agency fees can vary substantially from period to period based on the demand for hotel rooms, the types of hotels (such as upscale or economy) at which reservations are made and fluctuations in overall room rates and foreign currency exchange rates. In addition, some participating hotels generally pay fees based on the number of commissionable transactions that Pegasus processes for the hotel. Financial services revenues represented approximately 19 percent of service revenues for 2004.

      Distribution Services. Our distribution services provide the connections and interfaces that enable hotels to distribute their rates and inventory to — and receive reservations from — the four GDSs used by travel agencies worldwide, a growing number of tour operators, wholesalers, and a variety of Internet sites Powered by Pegasus. Distribution services revenues primarily consist of transaction fees, commissions and monthly subscription or maintenance fees. In addition, new hotel customers typically pay a one-time fee for establishing the connection between the hotel’s central reservation system and the electronic distribution technology. New third-party Internet site customers typically pay a one-time fee for establishing the connection between the third-party Internet site and our electronic distribution technology, which is amortized over the related contract period. Distribution services revenues represented approximately 16 percent of service revenues for 2004.

      Property Services. Property services revenues primarily consist of maintenance and support fees related to legacy PMSs acquired from REZ and GETS. In addition, property services revenues include fees from our PegasusCentral PMS, which are recognized monthly. The company remains committed to PegasusCentral and expects to resume billing the InterContinental Hotel Group properties currently using PegasusCentral in 2005. Property services represented approximately 3 percent of service revenues for 2004.

      Other Services. Pegasus regularly seeks to develop new services to capitalize on its existing technology and customer base and to provide additional electronic hotel reservation capabilities and information services to its existing customers and to other participants in the travel distribution process. Pegasus has not received a material amount of revenue from these services, and we cannot assure you that any of these services will produce a material amount of revenue in the future.

      Customer Reimbursements. Revenues applicable to customer reimbursements are primarily related to GDS fees that we pay on behalf of and subsequently bill our customers. In the future, if our customers decide to pay these vendors directly, our customer reimbursements revenue and customer reimbursements cost of services will decrease accordingly. Pegasus’ billings for out-of-pocket expenses, such as third-party vendor GDS and telecommunication charges, are classified as customer reimbursements, which is a component of total revenues, and the related costs are classified as customer reimbursements, which is a component of total costs of services.

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Costs

      Our costs of services, which exclude depreciation and amortization, consist principally of personnel costs relating to information technology; customer service and telemarketing; facilities; and equipment maintenance costs. Costs of services also include the cost of customer reimbursements and certain incentive-based payments. We make incentive-based payments to some demand generators, including third-party Internet sites, because they provide us with access to higher transaction volumes for our services than we could reach otherwise. We also make incentive-based payments to some hotels because they generate high commission volumes for our financial services. These incentive-based payments are generally either based on transaction volumes that are expensed as incurred or consist of lump sum payments that are accounted for as an asset and expensed over the contract term.

      Research and development costs consist principally of personnel costs, related overhead costs and fees paid to outside consultants. General and administrative expenses are primarily personnel, legal and accounting-related, bad debt and certain facilities costs. Marketing and promotion expenses consist primarily of personnel costs, advertising, public relations and participation in trade shows and other industry events. Depreciation and amortization expense includes depreciation of computer equipment, office furniture, office equipment and leasehold improvements, as well as amortization of software and intangible assets.

      Interest income primarily includes income earned on the Company’s investments. Interest expense primarily includes interest and amortization of capitalized issuance costs related to the $75 million convertible debt offering.

Fluctuation of Foreign Currencies

      Pegasus derives a significant portion of its revenue from customers located outside the United States. Particularly in Europe, fluctuations of foreign currencies such as the euro and the British pound relative to the U.S. dollar result in our earning more or less revenue and expending higher or lower in expenses than we otherwise might have earned or spent if currency exchange rates had remained stable.

Years Ended December 31, 2004 and 2003

      Overall, the 2004 results reflect the addition of Unirez by Pegasus operations and, in general, increased reservation volumes and average daily hotel room rates over the prior year. Year-over-year comparisons were favorable in large part due to the war in Iraq, which particularly affected the first half of 2003. For our distribution service line, an increase in the percentage of Internet bookings made at hotel companies’ proprietary Internet sites continued to have a negative impact on Internet transaction volumes and revenues. In addition, reduced pricing on new contracts and renewals prevented us from realizing the full benefit of the improved economy.

      Operating expenses increased slightly compared to 2003, as expected. The increase primarily related to the following:

	•	The addition of Unirez by Pegasus operations;
	•	An increase in the number of and rates for incentive-based payments to third parties, as well as an increase in transaction volume;
	•	An increase in employee related expenses due to merit increases and bonuses in 2004;
	•	An increase in sales and marketing efforts with a focus on increasing revenues and improving customer satisfaction; and
	•	An increase in audit fees and other internal and external costs associated with the internal control requirements of the Sarbanes-Oxley Act of 2002.

      These expense increases were partially offset by the absence of restructure costs in the current year.

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      Revenues. The table and discussion below address revenue by service line for the years ended December 31, 2004 and 2003 (dollars in thousands).

      Representation services revenues increased primarily due to the results of operations of Unirez by Pegasus, which was acquired December 1, 2003 and contributed $14.7 million to revenues in 2004, compared to $874,000 in 2003. Utell by Pegasus revenues increased $586,000, or 1 percent, over 2003 due to a 4 percent increase in reservations and a 9 percent increase in ADR. The improved ADR reflects a strong euro and British pound, which contributed $3.9 million to the increase in representation service revenues. Partially offsetting this increase was a decrease in Utell by Pegasus membership fees due to fewer hotels in the portfolio, and a 6 percent decrease in the average commission percentage earned, resulting from lower pricing on new contracts and contract renewals, as expected, arising out of increased competition from lower-cost competitors.

      Reservation services revenues decreased primarily due to lower per unit pricing on contract renewals, despite a 6 percent increase in net transactions processed. Excluding carryover revenue in early 2003 from three previously terminated contracts, reservation service revenues increased 2 percent over prior year.

      Financial services revenues increased primarily as a result of a 7 percent increase in gross commissions processed and due to improved ADR and the trend of processing more foreign currency payments, which earn additional fees.

      Distribution services revenues decreased despite a 10 percent increase in GDS transactions and a flat number of Internet transactions. Internet transaction volumes reflect an increase in the percentage of Internet bookings made at hotel companies’ proprietary Internet sites; these transactions do not utilize Pegasus’ Internet distribution services. In addition, the decrease in revenue was primarily due to the loss of Unirez as a distribution services customer, which provided $1.5 million in revenue in 2003, reduced pricing on Travelweb transactions, and a decrease in revenue per transaction. In conjunction with Priceline’s acquisition of Travelweb, we extended terms of the services contract, but with lower pricing.

      Property services revenues decreased in 2004 due to lack of revenues from InterContinental Hotel Group for PegasusCentral and declining revenues from an acquired property management system, GuestView, which we plan to sunset in 2005. This system is fully amortized, so there will not be a write-down related to its discontinuance.

      Customer reimbursements increased primarily due to operations of our new Unirez by Pegasus representation service and an overall increase in our customers’ GDS costs because of an increase in GDS transactions.

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      Operating Expenses. The table and discussion below address operating expenses for the year ended December 31, 2004 compared to the year ended December 31, 2003 (dollars in thousands).

      Cost of services, excluding customer reimbursements, increased primarily due to a $3.6 million in added expenses for our Unirez by Pegasus representation service; $1.9 million of severance and related costs incurred in the first quarter of 2004 related to a strategic change in the Company’s information technology organization; a $1.4 million increase in incentive based payments to third parties because of new contracts and increases in transaction volumes and rates; and $2.4 million in increased consulting costs for IT initiatives. Cost of services as a percentage of service revenues was 53 percent in both 2004 and 2003.

      Customer reimbursements increased primarily due to operations of our new Unirez by Pegasus representation service and an overall increase in our customers’ GDS costs because of an increase in GDS transactions.

      Research and development expenses decreased in 2004 compared to 2003 primarily due to cost savings realized from the 2003 restructuring, slightly offset by $593,000 in additional expenses related the Unirez acquisition. Research and development expenses as a percentage of service revenues were 2 percent and 3 percent in 2004 and 2003, respectively.

      General and administrative expenses increased slightly primarily due to $787,000 of bad debt expense in 2004, as compared to zero in 2003, $465,000 in severance and related costs incurred in the first quarter of 2004 related to a strategic change in the Company’s IT organization, $217,000 in added expenses of Unirez by Pegasus, and increase of approximately $900,000 for audit and other fees related to the internal control requirements of the Sarbanes-Oxley Act. These increases were partially offset by a decrease in payroll related expenses and benefit plan costs because of decreased headcount in 2004. General and administrative expenses as a percentage of service revenues were 14 percent in 2004 and 2003.

      Marketing and promotion expenses increased due primarily to increased personnel costs arising from Unirez by Pegasus, a greater focus on marketing and promotion activities, and the cost of a new sales incentive compensation program launched in January 2004. Marketing and promotion expenses as a percentage of service revenues were 11 percent and 10 percent in 2004 and 2003, respectively.

      Depreciation and amortization expenses decreased primarily because certain intangible assets related to the REZ acquisition were fully amortized in March 2003. This was partially offset by a $2.1 million increase in amortization expense related to intangible assets from the December 2003 Unirez acquisition.

      During 2003, the company incurred restructure charges of $5.9 million, related to the reorganization of its operations from a business unit structure into distinct functional areas.

      Interest income. Interest income earned on the company’s investments decreased by $310,000 in 2004 compared to 2003 as the Company’s funds available for investment decreased in conjunction with the stock repurchase plan cash outlays of $55.7 million in 2004.

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      Interest expense. Interest expense increased by $1.4 million compared to 2003 primarily related to interest and amortization of capitalized debt issuance costs for the July 2003 convertible debt offering.

      Gain on sale. On May 3, 2004, Pegasus sold its interest in Travelweb, LLC to an affiliate of Priceline.com, Inc. (Priceline) and received $4.2 million in cash, recognizing a gain of approximately $2.0 million. The sale agreement contained a contingent earn-out valued at approximately $4.7 million; however, we do not currently anticipate that the required conditions will be met to receive the shares of Priceline common stock on the one-year anniversary of the Closing Date.

      Income tax benefit (expense). Pegasus recorded an income tax expense of $5.1 million in 2004, representing an effective tax rate of 39 percent. Pegasus recorded an income tax benefit of $905,000 in 2003, representing an effective tax rate of 33 percent. The effective tax rate for 2004 differed from the statutory rate primarily due to the detriment of state income taxes and nondeductible expenses, offset by the benefit of lower foreign tax rates.

Years Ended December 31, 2003 and 2002

      Overall, 2003 was a challenging year for the travel industry and for Pegasus. The weak economic climate in the United States, the war in Iraq and the continuing threat of terrorism resulted in a decrease in the demand for hotel rooms and, therefore, negatively impacted our revenues. Also, in addition to these factors our service revenues decreased due to the loss of two CRS customer contracts that contributed $10.5 million of revenue in 2002.

      Our services were organized into two business segments — technology and hospitality. During 2003, we completed a restructure to integrate our technology and hospitality segments into one operating unit. As a result, we integrated support functions, including sales and marketing, product development, service delivery, reservation/data management, information technology, finance and human resources functions. The integration plan continued our existing strategy of better aligning our businesses with our customers’ needs, thus allowing for future revenue growth and the realization of further synergies as one fully integrated company. Because we changed our management approach, organizational structure, operating performance assessment and reporting, and operational decision-making from a segment perspective (technology and hospitality) to a single company perspective, we operate as one reportable segment.

      On July 21, 2003, Pegasus issued $75 million aggregate principal amount of convertible senior notes through a private placement. The notes bear interest at an annual rate of 3.875 percent, payable semi-annually, through the maturity date of July 15, 2023, and are further described under “Liquidity and Capital Resources” below. Pegasus used a portion of the proceeds to acquire Unirez, as described above, and expects to use the remaining net proceeds from the offering for working capital and other general corporate purposes, including the stock repurchases described under “Liquidity and Capital Resources” below.

      We were able to offset a large portion of the revenue decline by reducing our expense. We began realizing synergies from our restructure during the third quarter of 2003, and we had strict controls over discretionary spending such as advertising, marketing and travel during the entire year of 2003.

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      Revenues. The table and discussion below address revenue by service line for the years ended December 31, 2003 and 2002 (dollars in thousands).

(1)	Excludes a $3.5 million termination fee included in reservation services in March 2002.

      Representation services revenues decreased primarily due to a decline in domestic and transatlantic bookings for our Utell by Pegasus service, caused primarily by the global economic climate and other world events, as well as an 8 percent decrease in the number of hotels Utell represents, as a result of pricing pressure from lower cost distribution channels. These decreases were partially offset by the favorable impact from a strong euro and British pound relative to the U.S. dollar and the results of operations of Unirez subsequent to the December 1, 2003 acquisition, which contributed $874,000 to revenues.

      Reservation services revenues decreased 29 percent; however, excluding the impact of the $3.5 million termination fee noted above, reservation services revenues decreased $12.4 million, or 24 percent. The decrease was primarily due to the termination of two customer contracts that provided $10.5 million of revenue in 2002, with the remaining decrease caused by lower transaction volumes and pricing pressure on contract renewals.

      Financial services revenues increased in 2003 compared to 2002 primarily due to an increase in electronic reconciliation and tracking services of $816,000 and an increase in fees for our PegsPay service of $522,000. These increases were offset by a 3 percent decrease in gross commissions, resulting from decreased transaction volumes and lower average daily rates charged by hotels.

      Distribution services revenues increased primarily due to a 32 percent increase in Internet transactions in 2003, compared to 2002.

      Property services revenues were essentially flat at $6.5 million in 2003 and 2002, due to delays in the rollout of PegasusCentral because of stability issues.

      Customer reimbursements increased due to an increase in our customers’ GDS costs.

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      Operating Expense. The table and discussion below address operating expenses for the year 2003 compared to the year 2002 (dollars in thousands).

      Cost of services, excluding customer reimbursements, decreased primarily due to a $4.0 million reduction in payroll and related expenses, mostly due to the Company’s 2003 restructuring. This decrease was offset by non-recurring costs of $1.4 million incurred in 2003 for moving the Company’s Scottsdale office and data center to new facilities and transition activities resulting from the Company’s restructure. Cost of services as a percentage of service revenues was 53 percent and 49 percent in 2003 and 2002, respectively.

      The decrease in research and development expenses was primarily due to an increase in capitalized payroll costs associated with an increase in the number of projects that are eligible for capitalization. Research and development expenses as a percentage of service revenues were 3 percent in 2003 and 2002.

      General and administrative expenses decreased primarily due to lower payroll and operating expenses, due to the Company’s 2003 restructuring, as well as reductions in discretionary spending in light of the challenging operating environment. These decreases were slightly offset by higher employee-related and insurance costs in 2003. Additionally, the Company experienced a $1.3 million reduction in bad debt expense due to an overall improvement in the collectibility of the Company’s accounts receivable. General and administrative expenses as a percentage of service revenues were 14 percent and 15 percent in 2003 and 2002, respectively.

      Marketing and promotion expenses decreased primarily due to lower payroll expenses due to the Company’s 2003 restructuring, as well as an increased focus on reducing discretionary spending. Marketing and promotion expenses as a percentage of service revenues were 10 percent in 2003 and 2002.

      The decrease in depreciation and amortization expenses is primarily because in March 2003, we completed the amortization for certain purchased intangible assets related to the REZ acquisition.

      During 2003, the Company incurred restructure charges of $5.9 million, composed of termination benefits and facilities-related charges related to reorganizing its operations from a business unit structure into distinct functional areas.

      Interest income. Interest income increased $146,000 in 2003, compared to 2002, primarily from investing a portion of the proceeds from the July 2003 convertible debt offering.

      Interest expense. Interest expense was $1.6 million in 2003, compared to $53,000 in 2002, primarily due to the July 2003 convertible debt offering.

      Income tax benefit. Pegasus recorded an income tax benefit of $905,000 in 2003, representing an effective tax rate of 33 percent. Pegasus recorded an income tax benefit of $2.1 million in 2002, representing an effective tax rate of 38 percent. The effective tax rate for 2003 differed from the statutory rate primarily due to the detriment of nondeductible expenses, offset by the benefit of lower foreign tax rates.

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Liquidity and Capital Resources

      Historically, Pegasus has primarily relied on cash flows from operations and, to a lesser extent, proceeds from stock option exercises to provide working capital for current and future operations and for capital investments. From time to time, we have also utilized bank lines of credit, proceeds from equity and debt offerings and private debt to supplement our ability to fund operating cash requirements, capital investments and acquisitions.

      We assess our liquidity in terms of our ability to generate cash to fund our operating and investing activities. Key indicators we use to make this assessment are current assets, current liabilities and net cash flow from operating activities.

      In 2003, we issued $75 million aggregate principal amount of convertible senior notes and utilized approximately half of the net proceeds to acquire Unirez in December 2003. We used the remaining net proceeds from the offering for working capital and other general corporate purposes with a portion included in our cash balance at the beginning of 2004. More details on the convertible debt are provided later in this Management’s Discussion and Analysis.

      Our principal sources of capital at December 31, 2004 included cash and cash equivalents of $17.6 million, short-term marketable securities of $6.0 million, and auction rate securities of $5.7 million. During 2004, we generated cash flows from operations of $30.2 million, which was sufficient to provide for working capital requirements. Other sources of cash in 2004 were $5.3 million of proceeds from stock option exercises and $4.2 million of proceeds from selling our stake in Travelweb, LLC. Proceeds from stock option exercises in 2004 were higher than normal due to the departure of several executives. Proceeds from stock option exercises depend on a number of factors, including our stock price, the number and terms of stock options outstanding and the number and terms of future stock option grants. The terms of stock options outstanding and the number and terms of future stock option grants may be affected by the implementation of Statement of Financial Accounting Standards No. 123R, “Share-Based Payment.”

      Cash outlays in 2004 were primarily related to stock repurchases of $55.7 million and capital expenditures of $22.6 million. A significant component of our capital strategy during 2004 was an aggressive stock repurchase program. In addition to the shares repurchased in 2004, we repurchased additional shares totaling $4.9 million during the first two months of 2005. As of February 28, 2005, there were 431,000 shares remaining for repurchase under the current Board approved program. Another component of our capital strategy is investing in software development projects meeting our return on investment criteria. Our capital expenditures primarily consist of personnel costs, interest expense and outside consultant costs for software development, computer hardware, furniture, fixtures and other office equipment.

      We expect to continue incurring capital expenditures related to software development and adding capacity to existing systems and estimate 2005 capital expenditures will total approximately $20 million. This estimate includes approximately $2.2 million related to property and equipment purchases made in 2004 that will be paid for in 2005. We may also collaborate with outside parties for software development or other business needs. The potential capital required for such arrangements is uncertain.

      Further, we expect our cash position at March 31, 2005 to be considerably lower than the December 31, 2004 balance. The anticipated decrease is due to the following:

	•	Seasonality of our operations;
	•	Timing of capital expenditures;
	•	Payment of corporate bonuses; and
	•	Stock repurchases.

      We believe that the company’s financial condition is strong. We also believe that we will be able to generate cash flows from operations sufficient to meet our operating and capital requirements through at least the next twelve months. We may consider liquidating our marketable securities portfolio, including our auction rate securities. While we may obtain a bank line of credit to meet working capital needs, we do not

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      Pegasus had two irrevocable standby letter of credit agreements with JPMorgan Chase Bank totaling $1.7 million at December 31, 2004 and $2.1 million at December 31, 2003, collateralizing the leases for the Dallas and Scottsdale offices. During 2004, as a result of an annual decrease related to the Dallas facility letter of credit, the balance was reduced by $450,000. Subsequent to year end, there was a further reduction of $450,000, releasing the letter of credit for the Dallas facility in full and replacing it with a deposit of $181,000.

      On July 21, 2003, Pegasus issued $75 million aggregate principal amount of convertible senior notes through a private placement. Pegasus utilized a portion of the proceeds of the offering to effect the December 1, 2003 acquisition of Unirez. Pegasus expects to use the remaining net proceeds from the offering for working capital and other general corporate purposes, including stock repurchases.

      The notes bear interest at an annual rate of 3.875 percent, payable semi-annually through the maturity date of July 15, 2023. Each note is convertible into Pegasus’ common stock at a conversion price of approximately $20.13 per share (equal to an initial conversion rate of approximately 49.6808 shares per $1,000 principal amount of notes), subject to adjustment in certain circumstances. Holders of the notes may convert their notes only if (i) the price of Pegasus’ common stock reaches specified thresholds; (ii) the notes have been called for redemption; or (iii) specified corporate transactions occur. The notes and the indenture in connection therewith contain no covenants by the Company to maintain any minimum level of liquidity or any financial ratios.

      Pegasus may redeem all or some of the notes for cash at any time on or after July 15, 2008, at a redemption price equal to the principal amount of the notes plus any accrued and unpaid interest to the redemption date. As noted above, holders may require us to purchase the notes on July 16 of 2008, 2013 and 2018, or in other specified circumstances, at a purchase price equal to the principal amount due plus any accrued and unpaid interest to the purchase date and additional amounts, if any.

      Pegasus currently has no off-balance sheet financing arrangements.

      The following table identifies material future contractual cash obligations of the Company as of December 31, 2004. Operating leases represent our cash obligations associated with agreements to use equipment or facilities that are enforceable and legally binding for fixed terms. Purchase obligations include cash obligations associated with agreements to purchase services or equipment that are enforceable and legally binding for fixed terms, or estimated cash obligations for agreements with variable pricing provisions. Convertible debt represents scheduled principal and interest payments for the Company’s July 2003 convertible debt offering, described above. Other long-term liabilities include commission checks to be

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      In addition to the contractual obligations included in the table above, we also have funding requirements related to our Executive Retirement Program and a United Kingdom defined benefit plan, which is open to certain employees who were part of the Reed Elsevier Pension Scheme in December 1997. During 2002, the Board of Directors adopted the Executive Retirement Program, consisting of (1) the Supplemental Executive Retirement Plan (SERP), which provides supplemental retirement benefits to certain officers based on their compensation and years of service and (2) the Executive Deferred Compensation Plan (DCP), a defined contribution plan that provides supplemental benefits to certain management employees of the company. Commencing in 2003, we are obligated to make annual cash payments to a trust associated with benefits earned under the Executive Retirement Program. The amounts funded to the trust may be available to creditors of the Company, but are generally not available for use in our ongoing operations. For 2005, the Company is required to make payments to the trust of approximately $187,000; however, the Company may, at its discretion, fund additional amounts. We expect that company contributions to the DCP in 2005 will total approximately $437,000. We expect that contributions to the United Kingdom defined benefit plan in 2005 will total approximately $219,000.

Inflation

      Pegasus does not believe that inflation has materially impacted results of operations during the past three years. Substantial increases in costs and expenses could have a significant impact on its results of operations to the extent such increases are not passed along to customers.

Critical Accounting Policies and Estimates

      Preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and judgments that affect the reported financial position and results of operations during the reporting period. Our estimates and judgments are continually evaluated based on available information and experience. Because the use of estimates is inherent in the financial reporting process, actual results could differ from estimates. If there is a significant unfavorable change to current conditions, it will likely result in a material adverse impact to our business, operating results and financial condition.

      Certain accounting policies require higher degrees of judgment than others in their application. Pegasus considers the following to be critical accounting policies due to the estimation processes involved in each. For a detailed discussion of Pegasus’ significant accounting policies, including recently issued accounting standards, see Note 1 to the Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K.

      Our senior management has discussed the development and selection of these critical accounting policies and estimates, and this related disclosure in this report, with our Audit Committee.

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      As of December 31, 2004, Pegasus had accounts receivable as a result of its ongoing operations of approximately $31.7 million. Additionally, we have notes receivable totaling $6.6 million at December 31, 2004, related to the sale of business units. These receivables are monitored by management for collectibility. Pegasus maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. These estimates of losses require judgments that are based on available information and experience, such as the payment histories and known financial conditions of the parties. These estimates are significant because Pegasus may incur additional expense to increase its allowance for doubtful accounts and may receive less cash than expected if the financial condition of the parties was to deteriorate, resulting in an impairment of their ability to make payments. Pegasus’ allowances for doubtful accounts and notes receivable totaled approximately $4.2 million as of December 31, 2004.

      As of December 31, 2004, Pegasus has goodwill totaling approximately $163.6 million related to its acquisitions of REZ, Inc. (“REZ”) in 2000, Global Enterprise Technology Solutions, LLC (GETS) in 2001 and Unirez, Inc. (Unirez) in 2003. Under the guidance of SFAS 142, goodwill is analyzed for impairment at least annually. This analysis requires significant estimates and judgments by management, involving the carrying value and the estimated fair value of the Company. The estimate of fair value requires significant judgment in estimating future cash flows from operations for the various services provided by Pegasus. Pegasus performs an analysis using both market capitalization and discounted future cash flows. While the most recent periodic impairment analysis performed as of September 30, 2004 indicated that no impairment of goodwill exists, variances in actual growth rates, operating margins, or other assumptions may impact future impairment analyses and reduce the carrying values of goodwill.

      As of December 31, 2004, Pegasus has unamortized capitalized software costs totaling $59.3 million, which we review periodically for impairment. This impairment analysis requires the comparison of unamortized carrying values to estimated net realizable values. The estimated net realizable value is based on significant judgments such as estimated future cash flows from the related services, or expected benefits of the software and is based on available information and experience. While the most-recent periodic impairment analysis as of December 31, 2004 indicated that no impairment of capitalized software costs exists, changes in strategy, market conditions or other assumptions may significantly impact these judgments and reduce the carrying values of capitalized software costs. Assumptions used in an impairment analysis of PegasusCentral, valued at $22.4 million, include the number of projected property installations, primarily driven by large hotel chains, an anticipated profit margin on installations and training, variable and fixed expenses, and an estimated effective tax rate.

      In the United States and the United Kingdom, Pegasus sponsors defined benefit plans for certain employees. Our employee pension costs and obligations are dependent upon our assumptions used by actuaries in calculating such amounts. These assumptions include salary growth, long-term return on plan assets, discount rates and other factors. The salary growth assumptions are either stated in the plan or reflect our long-term actual experience and future and near-term outlook. Long-term return on plan assets is determined based on historical results of the portfolio and management’s expectation of the current economic environment. Specific to the plan provided in the United Kingdom, which is a funded plan, a one percent change in expected returns on plan assets would result in a $118,000 change to Pegasus’ annual expense associated with this plan. We base the discount rate assumption on current investment yields, including applicable corporate long-term bond yields. Actual results that differ from our assumptions are accumulated and amortized over the future working life of the plan participants. While we believe that the assumptions used are appropriate, significant differences in actual experience or significant changes in assumptions would affect our pension costs and obligations.

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Recently Issued Accounting Standards

      Information regarding recently issued accounting standards is included in Note 1 to the Consolidated Financial Statements included in Item 8 of the Annual Report on Form 10-K.

      Pegasus is exposed to certain market risks, including the effects of foreign currency exchange rate fluctuations, and uses derivative financial instrument contracts to manage foreign exchange risks. Pegasus has established a control environment that includes policies and procedures for risk assessment and the approval, reporting and monitoring of derivative financial instrument activities. Company policy prohibits holding or issuing derivative financial instruments for trading purposes. We do not currently utilize hedge accounting with regard to these derivatives.

      To reduce the impact of foreign exchange rate fluctuations on consolidated results of operations and future foreign currency denominated cash flows, Pegasus was a party to various forward exchange contracts at December 31, 2004. These contracts reduce exposure to currency movements affecting existing foreign currency denominated assets and liabilities, primarily trade receivables and payables.

      A summary of forward exchange contracts to sell foreign currencies in place as of December 31, 2004 is as follows (in thousands):

      All contracts included above matured no later than February 2005. Because of the short-term nature of these contracts, the fair value approximates the contract value. The difference between the fair value and contract value is included in the consolidated balance sheet as accounts receivable and was not material at December 31, 2004. Pegasus used similar forward exchange contracts and had either sell or purchase forward exchange contracts of a similarly short-term nature in place on December 31, 2003. As of December 31, 2003, Pegasus had approximately $14.3 million in sell forward exchange contracts and $666,000 in purchase forward exchange contracts. Pegasus’ positions with respect to these forward exchange contracts differed as of December 31, 2004 compared to December 31, 2003 because of changes in Pegasus’ non-U.S. denominated trade payables and receivables. For more information on derivative financial instruments see Notes 1 and 6 to the consolidated financial statements included in Item 8 to this Annual Report on Form 10-K.

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Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders

      We have completed an integrated audit of Pegasus Solutions, Inc.’s 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

Consolidated financial statements

      In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations and comprehensive income (loss), changes in stockholders’ equity and cash flows present fairly, in all material respects, the financial position of Pegasus Solutions, Inc. and its subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

Internal control over financial reporting

      Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2004 based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control — Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

      A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;

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      Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

PRICEWATERHOUSECOOPERS LLP

Dallas, Texas

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PEGASUS SOLUTIONS, INC.

CONSOLIDATED BALANCE SHEETS

See accompanying notes to consolidated financial statements.

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PEGASUS SOLUTIONS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)