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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2004

or

For the transition period from              to             

Commission File Number 1-13806

REWARDS NETWORK INC.

(Exact name of registrant as specified in its charter)

Two North Riverside Plaza, Suite 950, Chicago, Illinois 60606

(Address of principal executive offices) (Zip code)

312-521-6767

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report)

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

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

As of November 5, 2004, there were 24,778,069 shares of the registrant’s common stock, par value $.02 per share, outstanding.

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REWARDS NETWORK INC. AND SUBSIDIARIES

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PART I – FINANCIAL INFORMATION

Consolidated Balance Sheets

(in thousands, except per share data)

See accompanying notes to unaudited condensed consolidated financial statements.

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Consolidated Statements of Income

(Unaudited)

(in thousands, except earnings per share data)

See accompanying notes to unaudited condensed consolidated financial statements.

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Consolidated Statements of Cash Flows

(Unaudited)

(in thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

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Unaudited Notes to Condensed Consolidated Financial Statements

(1) Basis of Presentation

These unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments that are of a normal recurring nature necessary to present fairly the consolidated financial position of Rewards Network Inc. and its subsidiaries (collectively, the “Company”) at September 30, 2004, consolidated results of operations for the three and nine months ended September 30, 2004 and 2003 and the consolidated statements of cash flows for the nine-month periods ended September 30, 2004 and 2003 have been made. Operating results for the three and nine months ended September 30, 2004 are not necessarily indicative of the results to be expected for the full year. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2003 filed with the Securities and Exchange Commission (“SEC”) on March 12, 2004. The consolidated balance sheet as of December 31, 2003 is derived from the Company’s audited consolidated financial statements.

Nature of operations: The Company markets and administers loyalty rewards programs that bring its participating merchants and members together. The Company does this by offering rewards in the form of savings and benefits to its members who patronize its participating merchants, principally restaurants and hotels. The Company attracts participating restaurants by purchasing credits for food and beverages in advance and by providing yield management tools such as variable promotions, dining incentives and off-peak pricing in order to fill empty tables and generate incremental business. The Company attracts participating hotels by providing yield management tools in order to fill empty hotel rooms and generate incremental business. The Company offers rewards in the form of cash, airline frequent flyer miles and other currencies to its members who patronize its participating merchants and pay using a payment card they have registered with the Company. The Company partners with significant airlines and banks to obtain and service members.

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

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

(2) Available for sale securities

Investments and marketable securities, all classified as available-for-sale, consisted of the following at September 30, 2004.

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Unaudited Notes to Condensed Consolidated Financial Statements—(Continued)

(3) Certain Relationships and Related Party Transactions

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

On June 25, 2004, the Company entered into an office lease agreement with Equity Office Management, L.L.C., as indirect manager of San Felipe Plaza, Ltd., a limited partnership. Equity Office Management, L.L.C. is an affiliate of Equity Office Properties Trust. Samuel Zell is Chairman of the Board of Trustees of Equity Office Properties Trust. The lease provides for 827 square feet of office space at 5847 San Felipe, Suite 1675, Houston, Texas. The term of the lease is from July 1, 2004 through June 30, 2009.

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

Equity Group Investments, L.L.C. (“EGI”), an affiliate of Samstock, L.L.C., the Company’s largest stockholder, has provided investment and other financial advisory services to the Company. The Company paid $62,500 and $187,500, respectively, to EGI for these services for each of the three and nine-month periods ended September 30, 2004 and 2003. Samuel Zell serves as Chairman of EGI. This arrangement was terminated as of September 30, 2004.

In March 2002, the Company and Responsys Inc. (“Responsys”) entered into an agreement for Responsys to provide e-mail marketing services to the Company. The term of the agreement was from May 31, 2002 to May 31, 2004, and the total payments made were $386,544 for the two years. After May 31, 2004, the Company has continued to employ Responsys on an as-needed basis. At the time the agreement was signed, George S. Wiedemann, the Company’s President and Chief Executive Officer was the President, Chief Executive Officer, a director, and a stockholder of Responsys. Subsequently, Mr. Wiedemann resigned as President, Chief Executive Officer and director of Responsys. The Company paid $77,584 and $215,593 respectively, to Responsys Inc. for the three and nine months ended September 30, 2004 compared to $40,044 and $108,398, respectively, for the three and nine months ended September 30, 2003.

(4) Litigation

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

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Unaudited Notes to Condensed Consolidated Financial Statements—(Continued)

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

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

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

(5) Earnings per Share

Basic earnings per share were computed by dividing net income available to common stockholders by the weighted-average number of shares of the Company’s common stock outstanding for each period presented. Diluted earnings per share were computed by dividing net income available to common stockholders by the weighted-average number of shares of the Company’s common stock and common stock equivalents outstanding for each period presented.

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Unaudited Notes to Condensed Consolidated Financial Statements—(Continued)

(6) Stock-based Compensation

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

The Company uses the Black-Scholes valuation model for estimating the fair value of options granted. During the three months ended September 30, 2004 and 2003 there were no options granted by the Company. The following represents the estimated fair value of options granted and the weighted-average assumptions used in calculating such estimate:

Under the Company’s 2004 Long Term Incentive Plan, certain executives and other key employees were granted restricted stock unit awards for a total of 116,750 shares of the Company’s common stock (“Awards”). The vesting of 106,750 of the Awards is contingent upon the achievement of certain performance and service objectives. If the Company achieves a certain performance target in 2004, the Awards vest ratably over three years, subject to service objectives. If the performance objective is not met at the end of 2004, the employee will

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Unaudited Notes to Condensed Consolidated Financial Statements—(Continued)

forfeit all rights with respect to the Award, and the Award will terminate in its entirety. As such, the Awards are variable until the performance objectives have been achieved. The remaining 10,000 Awards vest ratably over three years, subject to service objectives, and are not contingent on the achievement of any performance targets.

Compensation cost of the Awards is calculated based upon the market value at the date of the grant and amortized over the vesting period. Compensation cost for variable Awards is adjusted each reporting period for increases or decreases in the value of the shares until final measurement. Management has determined that the 2004 performance target will not be met and, accordingly $445,100 of compensation cost accrued as of June 30, 2004 relating to the 106,750 of the Awards was reversed during the third quarter ended September 30, 2004. Compensation costs for the nine month period ended September 30, 2004 for the remaining 10,000 Awards shares was $21,900.

(7) Recently Issued Accounting Pronouncements

In December 2003, the FASB issued revised Interpretation No. 46 (“FIN 46R”), “Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51” (“ARB 51”), which addresses how a business enterprise should evaluate whether it has a controlling interest in an entity through means other than voting rights and accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46 (“FIN 46”), which was issued in January 2003. Before concluding that it is appropriate to apply an ARB 51 voting interest consolidation model to an entity, an enterprise must first determine that the entity is not a variable interest entity. As of the effective date of FIN 46R, an enterprise must evaluate its involvement with all entities or legal structures created before February 1, 2003 to determine whether consolidation requirements of FIN 46R apply to those entities. Application of FIN 46R is required in financial statements of public entities that have interests in variable interest entities or potential variable interest entities commonly referred to as special-purpose entities for periods ending after December 15, 2003. Application by public entities for all other types of entities is required in financial statements for periods ending after March 15, 2004. The Company has adopted both FIN 46 and FIN 46R, and their adoption had no impact on the Company’s consolidated financial position, cash flows or results of operations.

In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 establishes standards for the classification and measurement of certain financial instruments with characteristics of both liabilities and equity. SFAS 150 also includes required disclosures for financial instruments within its scope. For the Company, SFAS 150 was effective for instruments entered into or modified after May 31, 2003 and otherwise will be effective as of January 1, 2004, except with respect to mandatorily redeemable financial instruments. For certain mandatorily redeemable financial instruments, SFAS 150 will be effective for the Company on January 1, 2005. The effective date has been deferred indefinitely for certain other types of mandatorily redeemable financial instruments. The adoption of SFAS 150 did not have an impact on the Company’s consolidated financial position, cash flows or results of operations.

In March 2004, the FASB issued a proposed statement, “Share-Based Payment,” that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The proposed statement would eliminate the ability to account for share-based compensation transactions using APB 25 and generally would require instead that such transactions be accounted for using a fair-value based method. The proposed statement is effective for awards granted, modified, or settled in interim and annual period beginning after June 15, 2005 for public entities that used the fair-value based method of accounting under the original

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Unaudited Notes to Condensed Consolidated Financial Statements—(Continued)

provisions of SFAS No. 123 for recognition or pro forma disclosure purposes. The Company is currently evaluating the impact the proposed statement may have on its consolidated financial position, cash flows or results of operations.

In April 2004, the Emerging Issues Task Force of the FASB issued Statement No. 03-06 “Participating Securities and the Two-Class Method Under FASB Statement No. 128, Earnings Per Share” (“EITF 03-06”). EITF 03-06 addresses a number of questions regarding the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it declares dividends on its common stock. EITF 03-06 also provides further guidance in applying the two-class method of calculating earnings per share, clarifying what constitutes a participating security and how to apply the two-class method of computing earnings per share once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. EITF 03-06 is effective for fiscal periods beginning after March 31, 2004. The Company has adopted EITF 03-06, and its adoption did not have an impact on the Company’s consolidated financial position, cash flows or results of operations.

In September 2004, the Emerging Issues Task Force of the FASB reached consensus on Issue No. 04-08, “The Effect of Contingently Convertible Debt on Diluted Earnings per Share” (“EITF 04-08”). The guidance requires companies to include shares issuable under convertible debt in diluted earnings per share computations (if dilutive) regardless of whether the market price trigger (or other contingent feature) has been met. EITF 04-08 is effective for reporting periods ending after December 15, 2004. The Company will adopt EITF 04-08 as of December 31, 2004. The Company has $70 million of 3 ¹/4% debentures that are convertible into approximately 3.9 million shares of common stock if certain conditions are met. Applying the if-converted method, as required by EITF 04-08, net income for the diluted earnings per share calculation is adjusted for interest expense associated with the convertible debt instrument and diluted weighted average shares outstanding are increased for shares issuable upon conversion. Prior periods diluted shares outstanding and diluted earnings per share amounts will be restated to present comparable information, effective with the Company’s fourth quarter of 2004. The estimated reduction in the Company’s diluted earnings per share for the year ending December 31, 2004 is approximately $0.02 per share.

(8) Business and Credit Concentrations

As of September 30, 2004, the Company had contracts or relationships with nine major airlines that offer frequent flyer miles as rewards. Also for the three and nine months ended September 30, 2004 and 2003, United Airlines and Upromise Inc. individually represented 10% or more of the Company’s sales. The following table illustrates the Company’s partner sales concentration as a percentage of total sales

(9) Subsequent Event

On November 3, 2004, we entered into a $50 million unsecured revolving credit facility with Bank of America, N.A. and LaSalle Bank, N.A. This facility expires on July 13, 2008.

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

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

You should read the following discussion together with our condensed consolidated financial statements and notes to those financial statements, which are included in this report. This report contains forward-looking statements made pursuant to the safe harbor provisions of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The words “anticipates,” “intends,” “expects,” “could,” “should,” “plans,” “believes,” “estimates” or words or phrases of similar import generally identify forward-looking statements. You are cautioned that forward-looking statements are subject to risks, trends and uncertainties that could cause actual results, performance or achievements to differ materially from those expressed in any forward-looking statements. Important factors that could cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by those statements include, but are not limited to, the following: (i) our dependence on our relationships with airlines and other reward program partners for a significant number of our members, (ii) the concentration of a significant amount of our rewards currency in one industry group, the airline industry, (iii) our inability to attract and retain merchants and members, (iv) our inability to maintain an appropriate balance between the number of members and the number of participating merchants in each market, (v) the failure of our program offering members rewards for patronizing select hotels, (vi) the failure of our retail rewards program, (vii) the failure of our expansion into Canada, (viii) changes to card association rules and practices, (ix) our dependence upon our relationships with transaction processors, presenters and aggregators, (x) network interruptions or processing errors, (xi) our susceptibility to a changing regulatory environment, (xii) increased operating costs due to privacy concerns of our marketing partners, payment card processors, merchants and the public, (xiii) the failure of our security measures, (xiv) our susceptibility to restaurant credit risk, (xv) economic changes, (xvi) an adverse change in our loss experience related to Rights to Receive, (xvii) adverse consequences of changes in our programs that affect the rate of rewards received by our members, (xviii) our inability to generate sufficient profit margin on expanded restaurant products offerings, (xix) the loss of key personnel, (xx) adverse determination of lawsuits in which we are a defendant, (xxi) increasing competition, (xxii) our inability to obtain sufficient cash, (xxiii) our control by Samstock, L.L.C. and its affiliates, (xxiv) the ability of our board of directors to issue shares of our preferred stock without stockholder approval, (xxv) possible future sales of restricted and other shares, (xxvi) the price of our common stock could be volatile, and (xxvii) anti-takeover provisions that could delay or prevent a change in our control even if the change in control would be beneficial to our stockholders We undertake no obligation to, and expressly disclaim any such obligation to, update or revise any forward-looking statements to reflect changed assumptions, the occurrence of anticipated or unanticipated events or changes to future results over time or otherwise. See the cautionary statements included as Exhibit 99.1 to this quarterly report on Form 10-Q for a more detailed discussion of the foregoing and other factors that could cause actual results to differ materially from those included in the forward-looking statements and that, among others, should be considered in evaluating our outlook.

Overview

We market and administer loyalty rewards programs that bring our participating merchants and members together. We do this by offering rewards in the form of savings and benefits to our members who patronize our participating merchants, principally restaurants and hotels. We attract participating restaurants by purchasing credits for food and beverages in advance and by providing yield management tools such as variable promotions, dining incentives and off-peak pricing in order to fill empty tables and generate incremental business. We attract participating hotels by providing yield management tools in order to fill empty hotel rooms and generate incremental business. We offer rewards in the form of cash, airline frequent flyer miles and other currencies to our members who patronize our participating merchants and pay using a payment card they have registered with us. We partner with significant airlines and banks to obtain and service members.

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

Effective December 9, 2003, we changed our corporate name to Rewards Network Inc. from iDine Rewards Network Inc. Shares of our common stock are traded on the American Stock Exchange under the symbol IRN.

Participating Merchants

Restaurants

As of September 30, 2004, we had approximately 10,611 participating restaurants in over 55 metropolitan markets in more than 40 states in the United States and in Canada. We primarily offer two plans for our participating restaurants—the Dining Credits Purchase Plan and the Revenue Management Plan.

Dining Credits Purchase Plan. Under this plan, we purchase food and beverage credits (“Rights to Receive”) from participating restaurants typically for cash and at a discount from the retail price for which they sell the food and beverages. We then market to our members rewards in the form of savings or benefits for dining in our participating restaurants (in some cases, on certain days of the week or times of day, set at the discretion of the restaurant). When a member dines at a restaurant that participates in the Dining Credits Purchase Plan, we are entitled to a percentage of the total transaction amount, and we generally debit this amount from the participating restaurant’s bank account. We believe that the Dining Credits Purchase Plan is designed so that participating restaurants can make a wholesale profit in advance through the sale of food and beverage credits that are utilized through subsequent dining transactions at the restaurants by our members.

If we do not purchase additional Rights to Receive from participating restaurants after the initial Rights to Receive are used and the participating restaurants do not terminate their agreements with us, then in some cases they continue to be included on our website list of participating merchants, and in those cases our members continue to earn rewards and savings by dining in those restaurants. In these cases, we receive a smaller percentage of the total transaction amount from the merchant in an arrangement similar to the Revenue Management Plan.

Revenue Management Plan. Under this plan, our members earn rewards by dining at participating restaurants (in most cases, on certain days of the week or times of day, set at the discretion of the restaurant). Under the Revenue Management Plan, we receive a marketing fee from the merchant equal to a percentage of the total transaction amount from the merchant. Although our revenue from these transactions is less than under the Dining Credits Purchase Plan, revenue management transactions do not require us to purchase any Rights to Receive from merchants. Our Revenue Management Plan is designed for restaurants that choose to take advantage of only our marketing services.

Hotels

In the second quarter of 2003, we launched a hotel revenue management product that initially focused principally on independent hotels, which typically do not have their own loyalty or rewards programs. In October 2003, we announced that we had entered into a relationship with Travelweb LLC, a travel distribution company, to expand our hotel rewards program by including additional independent hotels as well as certain major U.S. hotel chains. Although our hotel rewards program remains in its early stages, as of September 30, 2004, the number of participating hotels had grown to approximately 11,111. This number represents both hotels sourced through the Travelweb network as well as hotels under direct contract with us. Typically, our members have access to reduced rates at participating hotels and also earn rewards by using the payment cards they register with us to pay for hotel stays after making reservations through our website or call center. Under our Revenue Management Plan for hotels, we receive a marketing fee equal to a percentage of the hotel room rate. At September 30, 2004, participation in our hotel rewards program was available to approximately 70% of our members.

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

Members

As of September 30, 2004, we had approximately 3.7 million active member accounts (i.e., members with at least one transaction with one of our participating merchants during the last 12 months). An active member account may consist of more than one payment card registered with us and may have more than one person associated with the account, although we consider each member account to be held by one “member.” Our members come from a variety of sources and marketing efforts, including through direct solicitation or through our affiliations with major airlines, large banks, credit card issuers and other affinity partners. In our affiliate programs, members may be solicited for enrollment or may be directly enrolled by our affiliate partner. We offer a choice of member programs. Membership in our programs that provide for cash rewards generally requires an annual fee, and membership in our programs that provide rewards to members in other currencies, such as airline frequent flyer miles, does not require an annual fee. Our membership programs consist of the following:

Rewards Network No Fee Program. Our no-fee program offers alternative currency rewards, predominantly airline frequent flyer miles on charges for food, beverages, tax and tip at participating restaurants and on charges for room rates at participating hotels. Members of this program are members of various loyalty program providers.

Rewards Network Program. This is a fee-based program that typically offers up to 20% cash savings on charges for food, beverage, tax and tip at participating restaurants and up to 15% cash savings on charges for room rates at participating hotels. Members typically pay an upfront $49 annual fee. Alternatively, members may elect to “earn” their fee. In this case, we retain benefits and rewards until the member has reached the same $49 fee level, after which point the member receives a benefit and we (by not providing a benefit until $49 of benefits has accumulated) have effectively received a fee.

Corporate Program. We offer this program as a travel and entertainment expense reduction program to large corporations. The corporate client enrolls some or all of its corporate payment cards in the Rewards Network Program and we typically pay the rewards and savings directly to the corporate client. We typically earn an annual fee by retaining rewards or savings for each member account enrolled in the program.

Registered Card Platform

A critical part of the administration of our loyalty and rewards programs is our registered card platform. Members in our programs have at least one major payment card registered with us. Members then present that registered payment card while transacting at a participating merchant. Based on our agreements with various processors and presenters throughout the United States and Canada, we aggregate data for all the payment card transactions at our participating merchants. The transactions are then matched to a file containing our members’ registered card information. The matched transactions are qualified via business rules as to whether they are eligible for a reward. Qualified transactions are then used to provide member savings, airline frequent flyer miles or other currency benefits, as well as to invoice and collect from merchants, principally via an electronic debit to the merchant’s bank account.

Rewards

The vast majority of rewards are delivered to members in the form of a direct credit to their payment card account, a cash-denominated reward to a loyalty or rewards program account, or a mileage credit to their frequent flyer account. Cash rewards typically represent up to 20% of the member’s total transaction amount with participating restaurants and typically up to 15% of the member’s room rate with participating hotels. Loyalty partner program members may receive rewards either in cash or in alternative currencies such as airline frequent flyer miles, depending on the particular program. Members receiving airline frequent flyer miles

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

generally earn up to ten miles for each dollar spent at participating restaurants and up to five miles for each room rate dollar spent at participating hotels, provided that they make the hotel reservation through us. We communicate reward opportunities to our members via a variety of communication tools: email, our website, newsletters, directories, toll-free numbers, fax back services and wireless devices such as personal digital assistants.

Canada

In June 2004, we launched our dining rewards programs in Canada in the provinces of Ontario and British Columbia. As of September 30, 2004, we had approximately 56 participating restaurants in Canada.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our discussion and analysis of our financial condition and results of operations is based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires that we make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to the provision for Rights to Receive losses, the valuation allowance, if any, for net deferred tax assets, investments and intangible assets. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our condensed consolidated financial statements.

Allowance for Rights to Receive Losses

We provide allowances for Rights to Receive losses based on our estimate of losses that would result from the inability or unwillingness of participating merchants to perform their obligations to us and enable us to recover outstanding Rights to Receive. If the financial condition of our merchant base were to deteriorate beyond our expectations, resulting in certain participating merchants’ inability to provide food and beverage to our members thereby reducing the recoverability of Rights to Receive, additional allowances may be required.

We review our ability to realize Rights to Receive on a periodic basis and provide for anticipated losses on Rights to Receive from restaurants that have ceased operations, restaurants that otherwise fail to pay us for unused Rights to Receive and restaurants whose Rights to Receive are not being utilized by our members. All other balances are segregated and evaluated based on the size of balance and the number of months required to recover the Rights to Receive outstanding. Losses are reduced by recoveries of Rights to Receive previously provided for. Account balances are charged off against the allowance after collection efforts have been exhausted.

Deferred Tax Assets Valuation Allowance

We record a valuation allowance to reduce our deferred tax assets when future realization is in question. We consider future taxable income and available tax planning strategies in assessing the need for the valuation allowance. In the event we determine that we would not be able to realize all or part of our net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period in which such determination is made.

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

Impairment Loss of Unamortized Goodwill

At least on an annual basis, we evaluate whether events and changes in circumstances warrant the recognition of an impairment loss of unamortized goodwill. The conditions that would trigger an impairment assessment of unamortized goodwill include a significant, sustained negative trend in our operating results or cash flows, a decrease in demand for our programs, a change in the competitive environment and other industry and economic factors. Recoverability of an asset is measured by comparison of its carrying amount to the expected future cash flows that the asset is expected to generate. Any impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair market value. Significant management judgment is required in the forecasting of future operating results that are used in the preparation of projected cash flows, and, if different conditions prevail or judgments are made, a material write-down of goodwill could occur.

We comply with SFAS No. 142, “Goodwill and Other Intangible Assets,” the current standard for periodic assessment of the carrying value of intangible assets, including goodwill. We assess the impact of SFAS No. 142 using a two-step approach to assess goodwill based on applicable reporting units and reassessed any intangible assets, including goodwill, recorded in connection with our previous acquisitions. There were no impairment charges recorded as a result of our assessments. As of September 30, 2004, we had unamortized goodwill of $9,671.

Revenue Recognition

We recognize revenue when our members patronize our participating merchants and pay using a payment card they have registered with us. Revenue is recognized only if the member’s transaction qualifies in accordance with the rules of the particular marketing program. The amount of revenue recognized is that portion of the member’s total transaction amount that we are entitled to receive in cash, in accordance with the terms of our contract with the participating merchant.

Membership Fee and Other Income

Membership fee and other income consists principally of renewal fees paid by cash reward Rewards Network Program members and is recognized over the membership period, which is usually twelve months beginning in the month the fee is received. Cardholder membership fees are cancelable and refunded to members, if requested, on a pro rata basis based on the remaining portion of the membership. Rewards and savings retained by us for “earn your fee” members are amortized against member rewards and savings over the membership period.

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

(a) Results of operations—Comparison of the quarters ended September 30, 2004 and 2003

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

As more fully discussed below, net revenue for the third quarter of 2004 decreased primarily from a decrease in sales, due to a decline in the average transaction amount coupled with lower sales yield and an increase in the rate of provision for losses.

Qualified transaction amounts at our participating merchants (which are transactions where our members are entitled to receive rewards or savings) declined 1.1% for the third quarter of 2004 as compared to the same period in 2003. While Dining Credit Purchase Plan qualified transactions increased 0.7% to $107,258 during the third quarter of 2004 as compared with the third quarter of 2003, Revenue Management Plan qualified transaction amounts decreased 7.5% to $28,599 when compared with the same period in 2003. Qualified transaction amounts declined in the third quarter of 2004 compared with the third quarter of 2003 because of a lower average transaction amount and the impact of the hurricanes that made landfall in the southeastern United States during August and September 2004, partially offset by an increase in the number of transactions.

A decrease in the average transaction amount to $48.12 for the third quarter of 2004 from $49.46 for the same period in 2003 was partially offset by the increase in number of transactions, which increased by 1.6% to approximately 2,824 during the third quarter of 2004 as compared with 2,778 for the third quarter of 2003. Included in qualified transaction amounts were dining qualified transaction amounts, which decreased 3.0% to $132,731 for the third quarter of 2004 compared with $136,901 for the third quarter of 2003. The average dining transaction amount decreased 4.2% to $47.24 for the third quarter of 2004 compared with $49.31 for the third quarter of 2003. This was partially offset by an increase in hotel qualified transaction amounts to $3,058 for the third quarter of 2004 compared with $500 for the third quarter of 2003. Although hotel qualified transaction amounts increased, the average hotel transaction amount also decreased to $244.41 for the third quarter of 2004 compared with $297.56 for the third quarter of 2003. We believe that the lower average dining transaction amount in the three months ended September 30, 2004 compared with the three months ended September 30, 2003 was due to a number of factors, including the replacement of some merchants in our programs with merchants with lower menu prices, our expansion into secondary markets where the average transaction amount

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

tends to be lower and decreased sales in some large primary markets and increased weekday revenues where transaction amounts tend to be slightly lower. We believe that the lower average hotel transaction amount in the third quarter of 2004 compared with the third quarter of 2003 was due to the availability in the 2004 quarter of over 10,000 additional hotels as compared with the 2003 quarter and generally lower room rates at the hotels in this larger offering. The increase in the number of transactions was primarily the result of a 12.7% increase in the number of our active member accounts at September 30, 2004 as compared with September 30, 2003. Although the active member accounts increased by 12.7% at September 30, 2004 as compared with September 30, 2003, we did not experience a corresponding increase in the number of qualified transactions because we experienced an increased rate of attrition in our restaurant merchants that resulted in a decline in the number of restaurant merchants in the third quarter of 2004 compared with the third quarter of 2003. An active member account is an account with at least one qualified transaction with one of our participating merchants during the previous 12 months.

Sales yield, which represents sales as a percentage of qualified transaction amounts, decreased to 63.9% for the third quarter of 2004 compared with 65.2% for the third quarter of 2003. The decline in the sales yield reflects the changing mix in business propositions marketed to our merchants. We continue to work to improve restaurant merchant products to meet the needs of new merchants and reduce attrition of existing merchants. Many of these products have more favorable business propositions to our merchants and have resulted in lower sales yield from Dining Credit Purchase Plan and Revenue Management Plan qualified transaction amounts. Dining qualified transaction amounts included in the Revenue Management Plan decreased $4,930 to $25,473 for the third quarter of 2004 compared with $30,403 for the same quarter in 2003 and hotel qualified transaction amounts included in the Revenue Management Plan increased $2,558 to $3,058 for the third quarter of 2004 compared with $500 for the same quarter in 2003. Dining Revenue Management Plan qualified transactions typically have a higher sales yield than hotel qualified transactions and, therefore, the decrease in dining qualified transaction amounts to 89.1% of total Revenue Management Plan qualified transaction amounts for the third quarter of 2004 compared with 98.4% of total Revenue Management Plan qualified transaction amounts for the third quarter of 2003 resulted in lower overall yield from the Revenue Management Program Plan. We expect that all of our future product lines such as our retail rewards program will be of a Revenue Management nature, which results in a lower sales yield than Dining Credit Purchase Plan qualified transactions.

Accordingly, we expect that in the future our sales yield percentage will further decline as qualified transactions from our Revenue Management Plan represent a larger percentage of our total qualified transactions, as our hotel qualified transaction amounts increase, and to the extent we offer our restaurant merchants more favorable economics to address the increased rate of attrition we have been experiencing and to attract new restaurant merchants. The extent to which we are successful in reducing restaurant merchant attrition and attracting new restaurant merchants and the amount of increased sales that result from having more restaurant merchants will determine how much we are able to offset the impact of the lower sales yield.

Sales for the third quarter of 2004 decreased $2,712 or 3.0% when compared to the same period in 2003, primarily as a result of the reduction in the average transaction amount and lower sales yield.

Cost of sales, which is composed of the cost of dining credits and related processing fees increased to 48.7% of sales during the third quarter of 2004 compared to 47.9% of sales for the same period in 2003. Contributing to the increase in the cost of sales percentage was the decrease in sales under our Revenue Management Plan to 7.9% of total sales for the third quarter of 2004 compared to 9.3% of total sales for the same period in 2003. There is no cost of sales associated with sales under our Revenue Management Plan and, therefore, the relative decrease in these sales as a percentage of total sales results in a higher total cost of sales percentage.

The provision for losses increased to 7.8% of total sales and 8.5% of Dining Credits Purchase Plan sales for the third quarter of 2004 compared to 5.0% of sales and 5.5% of Dining Credits Purchase Plan sales for the same

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

period in 2003. We perform a quarterly analysis of the adequacy of our allowance for doubtful accounts on the balance sheet and, if necessary, adjust this allowance. This analysis is based on a number of factors, including the aging of the Rights to Receive and the overall size of the portfolio.

Member rewards and savings decreased to 17.9% of sales for the third quarter of 2004 compared to 20.6% of sales for the same period in 2003. There are two primary reasons for the decrease in the rate of rewards during the 2004 period. First, in some cases, as part of the changes in merchant deal economics, we have reduced member benefit levels. Secondly, we have continued the program of variable benefits whereby some of our member rewards and savings are tied to their level of participation in our programs. The reduced rate of rewards paid to less engaged members has resulted in a lower overall effective rate of reward earned by our total membership base.

Membership fees and other income decreased $250 or 22.3% for the third quarter of 2004 compared with the same period in 2003. The decrease can be primarily attributed to the decline in membership fee income and reflects the continuing effects of a change in our marketing strategy. In the fourth quarter of 1999, we reduced our marketing of the fee-based membership due to changes in the regulatory environment regarding direct marketing solicitations and we shifted our marketing strategy to focus mainly on marketing a no-fee dining program to key affinity and loyalty partners where we could take advantage of the registered card platform and enroll large quantities of accounts at a reduced cost of acquisition and solicitation.

Salaries and benefits decreased $904 or 21.3% for the third quarter of 2004 compared with the same period in 2003 primarily due to the reversal of $1,751 of previously accrued management incentive compensation and restricted stock awards. Both of these incentive compensation programs were based on us achieving certain financial performance targets which at the end of the second quarter of 2004 management believed would be achieved. However, management has now determined that these financial performances targets will not be met. Excluding the reversal of the previously accrued incentive compensation, salaries and benefits increased $847 or 19.9% for the third quarter of 2004 compared with the same period in 2003 primarily as a result of a planned increase in the number of employees, annual merit increases and higher employee benefit costs. The planned increase in the number of employees was principally in information technology, marketing, corporate development and customer services.

Sales commissions and expenses decreased $290 or 5.5% for the third quarter of 2004 compared with the same period in 2003, and sales commissions and expenses amounted to 5.8% of sales for the third quarter of 2004 compared with 5.9% for the third quarter of 2003. The $290 decrease in sales commissions during the third quarter of 2004 compared with the third quarter of 2003 reflects lower sales and the reversal of $125 of previously accrued salespersons’ incentive compensation which at the end of the second quarter of 2004 management believed would be achieved. However, management has now determined that these financial performances targets will not be achieved. In January 2004, we changed our sales consultants’ compensation plan to increase the incentive for sales consultants to grow their merchant portfolios. Sales consultants continue to earn a commission only when one of our members transacts at one of our participating merchants. We no longer anticipate that this new sales consultant compensation plan will result in decreased sales commission rate in 2004. This change in outlook is because of the loss of some of our more experienced sales consultants and the replacement of such sales consultants with less experienced sales consultants who earn a fixed salary as part of their compensation. We continue to include in sales commissions and expenses for the third quarter of 2004 and 2003 all costs associated with generating sales, including the cost of sales managers’ salaries, which in 2003 were included in salaries and benefits.

Member and merchant marketing expenses increased $327 or 18.9% for the third quarter of 2004 compared with the same period in 2003 primarily due to increases in the compensation we paid to loyalty program partners and bonus incentive rewards paid to our members.

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

Printing and postage expenses decreased $153 or 11.7% for the third quarter of 2004 compared with the same period in 2003. This is primarily due to the marketing initiative we began in the second half of 2003, replacing national directories with a customized, pocket-sized, eight-panel directory of restaurant listings in a member’s frequent dining areas (which we call “Fold-N-Go statements”) for segments of our membership base. These Fold-N-Go statements are less expensive to produce and distribute than the directories.

General and administrative expenses increased $1,408 or 31.5% for the third quarter of 2004 compared with the same period in 2003. The increase is primarily the result of an impairment of $500 on an investment in a development stage entity, increases in professional fees primarily related to compliance with the Sarbanes-Oxley Act and legal matters and rent and other office expenses related to our option to increase the space rented in the Chicago executive offices.

Interest expense and financing costs related to our securitization facility and convertible subordinated debentures increased $168 or 31.8% for the third quarter of 2004 compared to the same period in 2003. The increase in our interest expense is a result of our having an additional $10,000 of debt outstanding in the third quarter of 2004 compared to the third quarter of 2003 and a fixed interest rate on our convertible subordinated debentures that were outstanding in the third quarter of 2004 that is higher than the floating rate on the securitization facility under which we had outstanding debt in the third quarter of 2003.

Our effective tax rate for the third quarter of 2004 was 40.4% compared with 39.5% for the third quarter of 2003 due to the increase in the weighted average effective state tax rate resulting from a shift in the apportionment factors among the states in which we conduct business.

Net income decreased $1,445 or 32.6% for the third quarter of 2004 compared with the same period in 2003. Diluted earnings per share decreased to $0.12 for the third quarter of 2004 compared to $0.17 for the third quarter of 2003, and there were 3.2% less diluted weighted average shares outstanding in the third quarter of 2004 than in the third quarter of 2003.

(b) Results of operations—Comparison of the nine months ended September 30, 2004 and 2003

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