10-K 1 a13-1362_110k.htm 10-K

Table of Contents

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

(Mark One)

 

[ X ]                                                                        ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Fiscal Year Ended December 31, 2012

or

 

[     ]                                                                         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934

 

Commission File Number: 0-22334

 

LodgeNet Interactive Corporation

(Exact name of registrant as specified in its charter)

 

Delaware

46-0371161

(State of Incorporation)

(IRS Employer Identification Number)

 

3900 West Innovation Street, Sioux Falls, South Dakota 57107

(Address of Principal Executive Offices)    (Zip Code)

 

(605) 988 - 1000

(Registrant’s telephone number, including area code)

 

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

 

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

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes __  No X

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yes __  No X

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes X  No__

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) 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.   [  ]

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large Accelerated Filer __

Accelerated Filer __

 

 

Non-accelerated Filer X

Smaller reporting company __

(Do not check if a smaller reporting company)

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

Yes __  No  X

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter.  $24,583,194

 

The number of shares of common stock of the registrant outstanding as of March 19, 2013, was 29,610,595 shares.

 

 



Table of Contents

 

Table of Contents

 

Item 1 – Business

1

 

 

Overview

1

Competitive Strengths

3

Business Strategy

3

Overview of Markets Served

4

Hospitality and Advertising Services

4

Healthcare

11

Competition

13

Regulation

15

Employees

16

Corporate Information and Website Access to SEC Filings

16

 

 

Item 1A - Risk Factors

17

 

 

Item 1B - Unresolved Staff Comments

18

 

 

Item 2 - Properties

19

 

 

Item 3 - Legal Proceedings

19

 

 

Item 5 - Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

20

 

 

Performance Graph

21

Issuer Purchases of Equity Securities

21

Dividends

22

 

 

Item 6 - Selected Financial Data

23

 

 

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

25

 

 

Executive Overview

25

Hospitality and Advertising Services Businesses

27

Healthcare Business

32

General Operations

33

Liquidity and Capital Resources

33

Seasonality

37

Results of Operations — Years Ended December 31, 2012 and 2011

38

Results of Operations — Years Ended December 31, 2011 and 2010

42

Critical Accounting Policies

43

Recent Accounting Developments

43

 

 

Item 7A - Quantitative and Qualitative Disclosures About Market Risk

44

 

 

Item 8 - Financial Statements and Supplementary Data

44

 

 

Item 9 - Changes In and Disagreements with Accountants on Accounting and Financial Disclosure

45

 

 

Item 9A - Controls and Procedures

45

 

 

Item 9B - Other Information

45

 

 

Item 10 – Directors, Executive Officers and Corporate Governance

46

 

 

Item 11 - Executive Compensation

50

 

 

Item 12 - Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

68

 

 

Item 13 - Certain Relationships and Related Transactions, and Director Independence

70

 



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Item 14 - Principal Accounting Fees and Services

70

 

 

Item 15 - Exhibits and Financial Statement Schedules

73

 

 

 

 

As used herein (unless the context otherwise requires) “LodgeNet” and/or the “registrant,” as well as the terms “we,” “us,” “our” and “the Company” refer to LodgeNet Interactive Corporation (f/k/a LodgeNet Entertainment Corporation) and its consolidated subsidiaries.

 

“LodgeNet,” “On Command,” “Envision,” “eCompendium,” “eConcierge,” and the LodgeNet logo are trademarks or registered trademarks of LodgeNet Interactive Corporation.  All rights reserved.  The trademarks iPhone, iPad and iPod are trademarks of Apple, Inc.  All other trademarks or service marks used herein are the property of their respective owners.

 


 


Table of Contents

 

PART I

 

Item 1 – Business

 

Overview

 

We are the largest provider of interactive media and connectivity services to the hospitality industry in the United States, Canada and Mexico.  Our primary offerings include guest-paid entertainment, such as on-demand movies, advertising services and hotel-paid services, including cable television programming, Internet access services and interactive applications through our Envision and Mobile platforms.  As of December 31, 2012, we provided interactive media and connectivity services to approximately 1.5 million hotel rooms in North America and select international markets, primarily through local or regional licensees.  In addition, we also have a growing presence in the healthcare market, where we sell and maintain interactive television systems which provide on-demand patient education, information and entertainment to healthcare facilities throughout the United States.  As of December 31, 2012, our systems were installed in 82 healthcare facilities, representing approximately 18,600 beds.

 

The interactive media and connectivity services we offer the hospitality industry generally comprise a wide range of guest-paid entertainment options, including movies, games, music and on-demand television programming delivered through the television.  We refer to these offerings as Guest Entertainment content, which guests typically purchase on a per-view, hourly or daily basis.  We also provide services for which hotels pay us a monthly service fee, which we refer to as Hotel Services.  These offerings include cable television programming, Internet access support services and hotel services interactive applications, which run on our new Envision and Mobile platforms.  We also sell Internet access and interactive television systems and equipment to hotels, including related professional design, project management and installation services.  These services are reported under System Sales and Related Services.  Through our advertising and media services subsidiary, we deliver advertising-supported media into select segments of our interactive television room base, from which we earn revenue from the sale of television commercials, sponsorships or other marketing-based programs; such revenue is reported as Advertising Services.

 

In the healthcare industry, we generate revenue from the sale of interactive television system hardware, software licenses and installation services.  Additionally, we earn recurring revenues from the sale of on-demand and television entertainment content, patient education content, software and hardware maintenance and technical support services.

 

During 2012, we faced increasing liquidity challenges as a result of several business trends and debt servicing issues that negatively impacted our liquidity position.  We experienced a significant decrease in total revenue during 2012.  The rate of decline in our movie revenue per room for 2011 was approximately 6% versus 2010.  The decline accelerated in 2012 and the annual rate of decline more than doubled to approximately 13% versus the prior year.  Although significant declines were experienced in the first six months of 2012, the decline in revenue experienced during the third quarter of 2012 was even greater than what we had previously estimated.  At the same time, two of our major vendors required us to enter into payment plans.  Therefore, during September 2012, we entered into forbearance agreements with these two major vendors.  These events created considerable liquidity constraints to our operations and related financial results during the third and fourth quarters of 2012.  We were out of compliance with our Credit Facility leverage covenant at the end of the third quarter and we entered into a forbearance agreement with our lenders.  Our inability to comply with the financial covenants under our existing Credit Facility, our liquidity constraints and our bankruptcy case under Chapter 11 of the Bankruptcy Code have raised substantial doubt about our ability to continue as a going concern.

 

In December 2012, we announced that we entered into an investment agreement with a syndicate formed by an affiliate of Colony Capital, LLC (the “Colony Syndicate”) pursuant to which the Colony Syndicate agreed to provide $60.0 million of new capital to support a proposed recapitalization of the Company, with the Colony Syndicate becoming the controlling stockholder of the Company.  The investment agreement contains certain conditions precedent, including closing conditions which are described in more detail in Note 1 to the Consolidated Financial Statements, and terminates on April 30, 2013.  In addition, our lenders have agreed to our reorganization plan and to restructure our existing $346.4 million secured credit facility to a new five year term loan.

 

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This transaction is being implemented through an expedited Chapter 11 bankruptcy process, at the conclusion of which the Colony Syndicate will become the controlling stockholder of the Company.  The Company commenced a prepackaged Chapter 11 process in the United States Bankruptcy Court for the Southern District of New York on January 27, 2013.  Pursuant to the completion of the Chapter 11 process, holders of the preferred and common stock will have their interests cancelled and will not receive any distributions.

 

 

On March 7, 2013, the Bankruptcy Court entered an order confirming the plan.  The plan provides that it will become effective upon the completion of certain conditions precedent, including closing conditions under the investment agreement with the Colony Syndicate.  We expect to have all conditions precedent completed and the transaction closed in late March of 2013.

 

The following is a summary of the significant terms of the plan. This summary highlights certain substantive provisions of the plan only, and is not a complete description of the plan, and is qualified in its entirety by reference to the full text of the plan as confirmed.

 

Summary of the Plan

 

The plan provides for the reorganization of the Company. On the effective date, the Colony Syndicate will purchase 100% of the shares of new common stock in the reorganized company for $60.0 million and certain investors will purchase warrants to purchase additional shares of new common stock.

 

All creditors of the Company will be paid in full, with interest, in respect of allowed claims.  The holders of the Company’s secured debt, however, will receive an amended and restated credit agreement providing a new five year term loan for the existing $346.4 million secured credit facility plus the amount of accrued and unpaid interest at the non-default rate.  In addition, the Company will enter into a revolving credit facility of up to $20.0 million.

 

All shares of the Company’s common stock and the Company’s 10% Series B Cumulative Convertible Perpetual Preferred Stock will be cancelled and holders of these securities will not receive any distributions.  All options and warrants to purchase any securities of the Company will also be cancelled.

 

Share information

 

At February 27, 2013, prior to the reorganization of the Company and the effective date of the plan, there were approximately 29,610,595 shares of the Company’s common stock outstanding and 42,016 shares of the Company’s 10% Series B Cumulative Convertible Perpetual Preferred Stock outstanding.  All such shares will be cancelled without distribution pursuant to the completion of the Chapter 11 process.  Each holder of an existing equity interest shall neither receive nor retain any property or interest in property on account of such equity interest.

 

Assets and liabilities

 

As of February 28, 2013, the Company had total assets of $281.7 million and total liabilities of $480.7 million.

 

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Competitive Strengths

 

Leading Market Position.  We are the largest provider of interactive television systems to the hospitality industry and we have the majority share of the hospitality VOD-served market, reaching approximately 500 million travelers annually.  We focus on the mid-scale through luxury hotel segments, where we believe demand for our content and services is strongest.  Currently, over 75% of our room base is in upper chain scales and higher-end independent properties.  Our existing installed base of rooms enables us to achieve attractive economies of scale for content and advertising services distribution as well as new product and technology development.

 

Long-term Relationships.  We maintain agreements with many of the leading hotel franchising organizations in North America, and have contracts with approximately 7,000 individual hotel properties executed by their specific ownership or management companies.  We have been a distribution partner of many of the major Hollywood movie studios since the early 1980s, and have distribution relationships with leading cable television channels and video distributors such as DirecTV and HBO.  During September 2012, we were required by these vendors to enter into payment plans in order to maintain service.  Despite these forbearance agreements, these suppliers have continue to provide service and work with us as we work through our liquidity matters.  Our contracts with the major motion picture studios provide us with access to the latest Hollywood content prior to its release to the home video and Internet-streaming markets.  We believe no other competitor matches the duration and breadth of our relationships with the major entertainment content providers.

 

Business Strategy

 

Upon the closing of our reorganization plan, we expect our strategy will continue to leverage our operating scale and installed base of approximately 1.5 million hotel rooms.  We expect the infusion of the $60.0 million of new capital will permit new strategic opportunities.  Additionally, we expect there will be several strategic changes made by the Colony Syndicate, the new board of directors and the management team.  Some of the changes may include:

·                  A closer working relationship with DirecTV as a result of a new operating agreement between Colony Capital and DirecTV.  This agreement is to include expanded financing options for hotels and hospitals, new programming options that fit varied hotel needs and unique revenue generating and connectivity options.

·                  Increased partnership with hotels that return more control over the media experience to the hotel and allows more focus on branding opportunities and improving the guest experience.

·                  A conversion away from the existing, proprietary technology platform to an open, common platform that is expected to foster innovation through the growth of distributed development.

·                  Increased focus on delivering new and existing services on multiple screens: TV, PC, tablet and mobile.

 

Our installed room base gives us the scale to launch new product innovations, such as enhanced interactive television and mobile applications, interactive television programming and targeted advertising.  These products and services are generally intended to benefit our hotel customer’s hotel operations, create new revenue or reduce operating costs, or to enhance the hotel guest’s experience.  Our goal is to continue enhancing our position as the leading provider of interactive media and connectivity services to the hospitality and healthcare industries in the United States, Canada, Mexico, and internationally in select markets and to expand the revenue generated per average room served.

 

We expect to continue to be an attractive distribution channel for studios and select technology providers, as we believe our in-room entertainment sales provide a high-margin revenue opportunity for the studios and attractive technology implementation opportunities for our technology providers.

 

We also believe we are in the early stages of penetrating the large and attractive healthcare market, as we serve only 2% of the existing hospital beds in the United States.  We believe there are strong underlying growth drivers for us in the healthcare market due to growing demand for healthcare services and the increasing focus by hospitals on interactive patient education.

 

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The following table presents selected operations data for the period 2008 through 2012.  Dollar amounts are in thousands, except for room data:

 

 

 

Year Ended December 31,

 

 

 

2012

 

2011

 

2010

 

2009

 

2008

 

Financial Highlights:

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

364,689

 

$

421,262

 

$

452,172

 

$

484,492

 

$

533,879

 

Operating income (loss)

 

(103,799)

 

28,460

 

23,410

 

21,692

 

(5,071)

 

Depreciation and amortization

 

63,766

 

72,235

 

83,236

 

100,309

 

124,060

 

Share-based compensation and restricted stock

 

1,278

 

1,618

 

1,762

 

1,724

 

2,275

 

Net loss

 

(134,287)

 

(631)

 

(11,685)

 

(10,155)

 

(48,418)

 

Net loss attributable to common stockholders

 

$

(139,844)

 

$

(6,375)

 

$

(17,435)

 

$

(13,269)

 

$

(48,418)

 

 

 

 

 

 

 

 

 

 

 

 

 

Selected Operations Data:

 

 

 

 

 

 

 

 

 

 

 

Hospitality

 

 

 

 

 

 

 

 

 

 

 

Total rooms served (1)

 

1,489,223

 

1,621,529

 

1,829,712

 

1,909,323

 

1,977,015

 

Total Guest Entertainment rooms (2) (8)

 

1,359,615

 

1,477,442

 

1,680,322

 

1,779,979

 

1,866,353

 

Total High Definition rooms (3) (8)

 

372,474

 

309,239

 

270,384

 

231,588

 

191,491

 

Percentage of Total Guest Entertainment rooms

 

27.4%

 

20.9%

 

16.1%

 

13.0%

 

10.3%

 

Total Envision rooms (4) (8)

 

98,881

 

18,542

 

-

 

-

 

-

 

Percentage of Total Guest Entertainment rooms

 

7.3%

 

1.3%

 

-

 

-

 

-

 

Total Television Programming (FTG) rooms (5) (8)

 

856,199

 

938,270

 

1,030,437

 

1,087,860

 

1,105,754

 

Percentage of Total Guest Entertainment rooms

 

63.0%

 

63.5%

 

61.3%

 

61.1%

 

59.2%

 

Total Internet rooms (6) (8)

 

97,037

 

143,491

 

178,047

 

201,936

 

229,003

 

 

 

 

 

 

 

 

 

 

 

 

 

Advertising

 

 

 

 

 

 

 

 

 

 

 

Total Advertising and Media Services rooms (7) (8)

 

1,049,975

 

1,105,893

 

1,173,808

 

1,207,465

 

893,738

 

 

 

 

 

 

 

 

 

 

 

 

 

Healthcare

 

 

 

 

 

 

 

 

 

 

 

Total systems installed

 

82

 

68

 

56

 

45

 

28

 

Total beds served

 

18,632

 

15,931

 

12,224

 

9,192

 

6,543

 

 

(1)

 

Total rooms served include rooms receiving one or more of our services, including rooms served by international licensees.

(2)

 

Guest Entertainment rooms are equipped with our interactive television systems.

(3)

 

High Definition rooms are equipped with high-definition video-on-demand capabilities through our iHDTV platform.

(4)

 

Guest Entertainment rooms installed with our Envision interactive platform.

(5)

 

Television programming (which we refer to as “free-to-guest” or FTG) rooms receiving basic or premium television programming.

(6)

 

Represents rooms receiving high-speed Internet service.

(7)

 

Includes rooms receiving satellite-delivered and server-based channels.

(8)

 

Included in total rooms served.

 

Overview of Markets Served

 

HOSPITALITY AND ADVERTISING SERVICES

 

In the hospitality market, we provide our interactive media and connectivity services to hotel customers and their guests throughout the United States, Canada and Mexico, and through licensing arrangements with companies in other select countries.  Our hospitality business is focused on:  Guest Entertainment services, which includes content guests purchase on a pay-per-view or similar basis; Hotel Services, which includes cable television programming, hotel services applications on our Envision and Mobile platforms and Internet access services we provide to hotels; System Sales and Related Services, which includes the sale of cable television equipment, Internet access equipment and iHDTV installations; and Advertising Services, which consists of the sale of advertising directed to hotel guests and carriage services to programming providers by our advertising subsidiary.  Except for Guest Entertainment and Advertising Services, our services are sold directly to hotels and do not involve guest purchases.

 

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Markets and Customers

 

Diversified Customer Base.  The primary market for our interactive media services is the mid-size and large hotel segments within the United States, Canada and Mexico.  We believe our hotel base is well diversified in terms of location, demographics and customer contracts.  As of December 31, 2012, no single state or province accounted for more than 12% of the hotel properties served by us.  We provide our services to various hotel chains, ownership groups and management companies representing some of the finest hotels in the world, including Hilton Worldwide (Hilton, Doubletree, Embassy Suites, Hampton Inn & Suites, Hilton Garden Inn, Homewood Suites, Conrad Hotels & Resorts and The Waldorf Astoria Collection); Marriott International, Inc. (J.W. Marriott, Ritz-Carlton, Gaylord, Renaissance, Courtyard by Marriott, Fairfield Inn & Suites, Residence Inn, Springhill Suites and Towne Place Suites); Starwood Hotels & Resorts (aloft, Element, Westin, W Hotels, Sheraton, Four Points by Sheraton, St. Regis Hotels, Le Meridien Hotels and The Luxury Collection); InterContinental Hotel Group (InterContinental, Crowne Plaza, Holiday Inn, Holiday Inn Express, Holiday Inn & Suites, Holiday Inn Select, Hotel Indigo and Staybridge); Hyatt Hotels Corporation (Andaz, Hyatt, Hyatt Regency, Park Hyatt and Hyatt Place); Four Seasons, Fairmont; Harrah’s; Kimpton Hotels & Restaurants; Wyndham Hotels & Resorts (Wyndham, Wyndham Garden, Tryp by Wyndham, Wingate by Wyndham); Host Hotels & Resorts, Omni Hotels; Loews Hotels, Outrigger; Boyd Gaming, Grand Casino; Felcor; Interstate; White Lodging, John Q. Hammons, Davidson Hotels & Resorts, Winegardner & Hammons; Las Vegas Sands Corporation (Venetian Resort Hotel Casino, Four Seasons Hotel Macau, Sands Macau Hotel, Venetian Macau Resort Hotel); and Sage Hospitality, as well as many independent properties.  During 2012, our two largest brands covered by master services agreements, Hilton Worldwide and Marriott International, represented approximately 17.8% and 16.7%, respectively, of our consolidated revenue.  Properties owned and operated by Hilton accounted for approximately 1.6% of consolidated revenue, as most of the hotels served under the Hilton agreement are independently owned.  Marriott does not own any of the properties served under the Marriott agreement.  The properties are all independently owned.  Each property is subject to an individual long-term property level agreement.  No other master service agreement accounted for more than 10% of our consolidated revenue.  Additionally, our room base is geographically diversified, which mitigates our reliance on any one geographic sector.

 

We also provide services in select international markets through licensing arrangements with companies in these areas.  Under these arrangements, we sell the equipment and license our interactive television system and technologies to the licensee and receive annual fees.  Our future strategies in international markets may change with our reorganization.

Financial information related to our domestic and international operations is included in Note 17 of the Consolidated Financial Statements.

 

Products and Services

 

Guest Entertainment

 

Approximately 50% of our revenue within the hospitality market comes from the sale of on-demand entertainment content, which the hotel guest buys on a per-view, hourly or daily basis.  We design, develop and operate interactive television systems installed at hotel properties, and it is through these systems our Guest Entertainment revenues are generated.

 

Our interactive television systems provide a broad array of guest entertainment and other interactive services, including:

 

Ø     on-demand movies;

Ø     on-demand television programming;

Ø     on-demand digital music programming;

Ø     on-screen controls which allow the guest more viewing control and flexibility; and

Ø     interactive guest marketing and merchandising capabilities.

 

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The vast majority of these systems are owned by us, although, in some cases, hotels purchase the systems from us.  The interactive system connects each individual hotel room to a server, referred to as the “headend,” located within the hotel.  Because of the flexible and modular design of the system architecture, we can typically upgrade our software and hardware to support the introduction of new interactive services and integrate new technologies as they become commercially available and economically viable.

 

The Guest Entertainment revenues generated from our interactive television services are dependent upon a number of factors, including:

 

Ø     the number of rooms equipped with our interactive television system;

Ø     the number of rooms equipped with our iHDTV platform;

Ø     the range of interactive and high definition television content and services offered at each hotel;

Ø     the popularity, amount and timeliness of content offered;

Ø     the ease and ability of guests to access entertainment via other devices;

Ø     the profile of the guest at each property;

Ø     the price of the service purchased by the hotel guest;

Ø     the occupancy rate at the property; and

Ø     general economic conditions and consumer sentiment.

 

The number of rooms served by our interactive television system is dependent on a number of factors, including the amount of capital we elect to allocate to installation activities, the desirability of our interactive television technology, new hotel construction and the number of hotels which choose to purchase a system from us.  Revenues vary with the number, availability and popularity of major motion pictures and the guests’ other entertainment alternatives.  The price charged for each interactive programming option is established by us and is segmented according to the guest mix profile at each property and overall economic conditions.  Movie prices are set on a title-by-title and property-by-property basis and may be higher in some locations and for more popular titles.  In addition, our content management systems allow us to refresh interactive menus; promote different products and different titles to different demographics; and change pricing of our products, selection and promotions, among other marketing efforts to the guest.  Our systems allow us to measure guests’ entertainment selections and we adjust our programming and the pricing of the programming to respond to viewing patterns.  Occupancy rates vary by property based on the property’s competitive position within its marketplace, seasonality factors and as a result of changes in general economic conditions.  Typically, occupancy rates are higher during the second and third quarters due to seasonal travel patterns, and these quarters typically generate our strongest Guest Entertainment revenues.

 

A number of our existing hotels, while profitable to operate, do not generate enough revenue per month to justify an upgrade to an iHDTV system without a significant capital contribution from the hotel.  If the hotel does not elect to fund the upgrade, the Company offers a lower cost, non-high definition upgrade alternative.  The LodgeNet Certified Digital System (“CDS”) is an interactive television system which delivers in-room entertainment, information and guest services in standard definition.  The CDS allows for increased revenue potential, expanded entertainment options and improved branding and customization opportunities for the hotel.

 

Hotel Contracts.  We provide our interactive television services under contracts with lodging properties, which generally are for a term of five years.  Our contracts typically require that we will be the exclusive provider of in-room, interactive television entertainment services to the hotels, permit us to set prices for the interactive services, and allow us to terminate the contract and remove our system if the results of operations do not meet our return on investment criteria.  Under these contracts, we generally install our interactive television network in the hotel and retain ownership of all equipment utilized in providing our services (except for the television sets and other in-room equipment, which are paid for by the hotels).  The length of each agreement is determined based on a number of factors, including the revenue potential of the hotel, the amount of capital we are investing in the equipment and other considerations.  A term of five years is generally adequate to assure we receive the expected return on our invested capital and, to the extent this is not the case, we generally require the hotel to contribute a portion of the capital required.  Our capital and investment strategy is expected to change upon completion of our reorganization.

 

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While a separate service agreement is executed with each property, we also enter into agreements which govern the terms on which services will be rendered to the properties affiliated with various hotel brands.  Historically, these agreements gave us status as a “preferred provider” for the term of the agreements and specified the terms on which our systems would be made available to all properties affiliated with the brands covered by the agreements and established standards which required franchise properties to install certain types of systems.  While such agreements were beneficial in that they required any hotels owned or managed by the brands to execute hotel level agreements and authorized (but did not require) franchised hotels to sign property level agreements, they also typically specified the financial terms of all agreements with the affiliated brands and required systems be made available on the contracted terms without regard for the return on investment for a particular property.  Increasingly, franchisors have exhibited a reluctance to enforce brand standards related to in-room video systems and, in some cases, have eliminated such standards altogether, particularly in economy or select service properties.  Existing agreements also created problems for management groups which owned properties affiliated with a number of brands and faced conflicting contract requirements specified by the various existing agreements.  In order to address these issues, we changed our approach to major brand relations by moving to standard pricing terms for the largest brands, with the understanding we could adjust pricing terms periodically, and limited our obligation to install systems in properties which did not meet specified minimum performance criteria.  Our agreements in the future may change with our reorganization.

 

For the on-demand programming which is purchased by the hotel guest, the hotel generally collects such charges on our behalf, along with the collection of room and other charges made by the hotel guest, and the hotel remits funds to us on a monthly basis.  The hotel retains a commission for such services, which varies depending on the size and profitability of the system and other factors.  We generally seek to extend and renew hotel contracts in advance of their expiration.

 

Hotel Services, System Sales and Related Services and Other Diversified Revenue

 

One of our principal business goals is to diversify our sources of revenue through the following products and services:

 

Television Programming.  We offer a wide variety of satellite-delivered television programming paid for by the hotel and provided to guests at no charge.  The television programming is primarily delivered via satellite through DirecTV, pursuant to an agreement, and distributed to guest rooms over the internal hotel network, and typically includes premium channels such as HBO and Showtime, which broadcast major motion pictures and specialty programming, as well as non-premium channels, such as CNN and ESPN.  With the launch of our iHDTV system, we also began offering high-definition television programming to the extent available from broadcast sources and DirecTV.

 

The television programming is generally provided under contracts with hotel properties which generally run for the same period as the interactive television contract for a given property.  The hotel pays a fixed fee per room per month for this programming, which in turn is provided to the guest without charge.  We categorize this recurring revenue as Hotel Services revenue.  We also generate revenue through the sales of the system equipment necessary to provide this service to the hotels.  This revenue is categorized as revenue from System Sales and Related Services.

 

Envision.  During 2012, we continued the deployment of our cloud connected, interactive television platform, called Envision, which connects our interactive, high-definition guest room televisions to Internet-sourced content and information.  As of December 31, 2012, we had 284 Envision systems installed and providing services to over 98,000 rooms, with 39.2% of the installed rooms subscribing to premium apps.  The continuation of our Envision deployment will be dependent on the new strategies under our reorganization plan.

 

Mobile Application.  In 2011, we developed the software and technology to deliver the LodgeNet Mobile App, which brings together guest entertainment, hotel services and local area guide information.  We launched the LodgeNet Mobile App in January 2012 and, as of December 31, 2012, it was available in over 670,000 rooms.  The app provides travelers with in-room television control and on-demand content discovery capabilities, along with hotel and local area information and services.  For hotels, the app can be utilized to provide guests with customized brand and property information services.  The continuation of our Mobile services will be dependent on the new strategies under our reorganization plan.

 

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Internet System Sales, Service and Support.  We also design, install and operate wired and wireless Internet access systems at hotel properties.  These systems control access to the Internet, allow hotels to charge or provide the access as a guest amenity and provide bandwidth management tools.  We generate revenue through the sale and installation of the equipment and we provide ongoing maintenance, service and call center support services to hotel properties installed by us and also to hotel properties installed by other providers.  While this is a highly competitive area, we believe we have important advantages as a result of our existing hotel customer relationships, our expertise in integrating and customizing connectivity services for hospitality, our nationwide field service network and a 24-hour call center to support calls from hotel customers.  Additionally, we have a strategic technology partnership with Nomadix, Inc. and its corporate parent, DOCOMO interTouch Pte Ltd., giving us access to industry-leading access control and management technology and preferential reseller pricing.

 

Contracts for Internet access services to hotels generally have a term of three years.  Pursuant to these agreements, the hotel pays us a fixed fee per room per month for providing 24-hour help desk services to their guests having questions about accessing the Internet.  In some cases, we also enter into technical service agreements, for which the hotel pays an incremental fixed fee per room per month.  We also provide technical service under an hourly service charge arrangement.  We categorize the recurring monthly revenue as Hotel Services revenue and the revenue from equipment sales as revenue from System Sales and Related Services.

 

System Sales and Related Services.  In addition to the sale of Internet connectivity systems and satellite television reception equipment to our hotel customers, we also generate revenue from the sale of interactive television systems to our international licensees.  We also offer hotel properties which do not meet our economic and/or demographic profile, or wish to accelerate the installation of their system, the opportunity to purchase our interactive television system.  We then program, operate and maintain the system and receive a percentage of revenue generated from Guest Entertainment purchases.  We categorize the revenue generated from these sales as System Sales and Related Services.  Our Professional Services team provides services to hotels such as system planning, technical installations, project management and support services, primarily focused on high-definition television and low voltage wiring installations.

 

Hospitality Operations and Structure

 

Sales and Marketing.  For the hospitality market, we focus our sales and marketing strategies on acquiring new contracts from hotels, extending and retaining existing contracts, and marketing our interactive services to hotel brands, management companies, ownership groups and individual hotels.  Our sales organization includes national account representatives, who maintain relationships with national hotel brands, and regional sales representatives, who maintain relationships primarily with franchise organizations and management groups, regional hotel management and ownership organizations.  Our sales organization also includes a corporate sales group who concentrate on maintaining relations with existing lower-revenue hotels in order to extend and retain them as Guest Entertainment customers, while at the same time working on selling them new products and free-to-guest services.  We market our services and products to hotels by advertising in industry trade publications, attending industry trade conferences, trade shows and direct marketing.  Sales activities are coordinated from our headquarters.  Given our long operating history and reputation for service and innovation, we believe we are well recognized in the market among our existing and potential customers.

 

We market our services to hotel guests through a variety of means, including an interactive, image-based menu and purchasing protocol using on-screen graphics, promotions and programming information.  Our system also generates a “Welcome Channel,” which appears on-screen when the television is turned on and describes the programming and interactive services available through our system.  Our systems also generally have a promotion channel located within the television lineup which presents movie trailers and other information about the services available on the system.

 

Our sales and marketing strategies may change under our reorganization plan.

 

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Installation Operations.  Our installation personnel prepare engineering surveys for each site, install our systems, train the site staff to operate the systems and perform quality control tests.  Due to our geographically diversified customer base, we have determined it is usually more cost effective to utilize subcontracted installation teams, which are managed and coordinated by our in-house or regionally based installation employees.  We work closely with our company-trained subcontractors, and provide continuing education programs which reflect technology enhancements as well as best practices.  We also have a separate quality control department to regularly monitor quality standards and perform on-site training.

 

Service Operations.  We believe high quality and consistent systems support and maintenance are essential to our continued competitive success.  We emphasize the use of company employed service personnel operating from locations throughout the United States, Canada and Mexico, but also use company trained subcontractors in areas where there is not a sufficient concentration of company served hotels to warrant a company employed service representative.  Service personnel are responsible for all preventive and corrective systems maintenance.  Our service organization is also utilized to support our Internet systems.

 

Contact Center Operations.  We maintain a toll-free customer support hot line, which is staffed 24 hours a day, 365 days a year.  The online diagnostic capability of our systems enables us to identify and resolve most reported system service issues from our service control center without visiting the hotel.  When a service visit is required, the modular design of our systems permits service personnel to replace only those components which are defective at the site.

 

Component Suppliers.  We contract directly with various electronics firms for the manufacturing and assembly of certain system hardware, the design of which is controlled by us.  We have found these suppliers to be dependable and generally able to meet delivery schedules on time.  We believe, in the event of a termination of any of our sources, with proper notification from the supplier, alternate suppliers could be located without incurring significant costs or delays.  Certain electronic component parts used within our products are available from a limited number of suppliers and can be subject to temporary shortages because of general economic conditions and the demand and supply for such component parts.  If we were to experience a shortage of any given electronic part, we believe alternative parts could be obtained or system design changes implemented.  In such event, we could experience a temporary reduction in the rate of new installations or conversions to high definition and/or an increase in the cost of such installations.  All other components of our systems are standard commercial products, such as computers, hard drives, routers, modulators and amplifiers, which are available from multiple sources.  We believe our business can be accommodated through existing suppliers.

 

Programming.  We obtain non-exclusive rights to show recently released major motion pictures from motion picture studios pursuant to an agreement with each studio, which is typically two to three years in length.  The royalty rate for each movie is generally predetermined, with the studio receiving a percentage of the gross revenue from the movie.  For recently released motion pictures, we typically obtain rights to exhibit the picture while it is still in theatrical release and prior to its release to the home video or Internet-streaming markets or for exhibition on cable television.  For our television on-demand programming, we obtain the rights to exhibit television on-demand content for which we pay a predetermined percentage of gross revenue or a one-time fixed fee.  In addition, we distribute satellite-delivered cable television programming, including high definition (“HD”) format programming, through an agreement with DirecTV.  We also have agreements with certain other select television programming providers, such as HBO.  We pay our television programming providers a fixed, monthly fee for each room or subscriber receiving the service.  We believe our relationships with the television programming suppliers are good and expect to renew these contracts as necessary on competitive terms.  We obtain independent films, most of which are non-rated and intended for mature audiences, for a one-time fixed fee.  We also obtain non-exclusive rights to digital music content, through an agreement with one of our subsidiaries, whereby we pay a predetermined percentage of the gross revenue from the music service.  We also obtain certain video games and pay a monthly fee equal to a percent of revenue generated from the sale of the video game services.

 

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Technology, Product Development, and Patents.  We design and develop our own interactive television systems. Because we utilize an open architecture design incorporating industry standard interfaces, historically we have been able to upgrade system software to support the introduction of new services or integrate newer technologies as they become economically viable.  Our interactive television system incorporates commercially manufactured, off-the-shelf electronic and computer components and hardware.  Our design and development strategy may change under our reorganization plan.

 

Our system architecture utilizes a proprietary, two-way digital communications design to process and respond in near real time to input commands from guests through the television in each guest room.  This capability, combined with our menus and guest interface screens, enables us to provide guests with sophisticated interactive television services which include: on-demand movies with pause, skip, forward, back and save functionality; network-based video games; music services; on-demand television programming; access to Internet-sourced content and information, and a variety of other interactive services.  Our interactive television and mobile platforms also interface with hotel operations software systems, allowing guests to use the television remote or their mobile device as a remote to perform activities from the television, such as reviewing room charges, in-room dining orders, checking out, taking guest surveys and viewing interactive information about the hotel and its services.

 

Our interactive television systems consist of equipment located within the guest room and associated equipment required for the generation, reception, storage, transmission, amplification and modulation of signals located elsewhere in the hotel.  Typical in-room equipment includes a television-embedded or separate terminal unit and a hand-held television remote control.  Video and music programming originates from the system headend and is transmitted to individual rooms over the hotel’s coax-based (“RF”) or Internet Protocol (“IP”) Local Area Network.  Keystrokes and other system commands and communications are transmitted from the room using our proprietary communications infrastructure and the video and other signals are transmitted to the guest room over the RF or IP network.  The system computer controls the delivery of the interactive services to the guest room and also records purchase transactions and billing data to the hotel’s accounting system, which posts the charge to the guest’s bill.

 

In addition, we are continuing to develop and integrate technologies which enable us to deliver high-definition television and Internet-sourced content to our hotels and their guests.  These developments extend our digital platform with new technology, including specially-equipped digital televisions and set-top or set-back boxes which are able to receive RF signals or IP video data and decrypt and decode this digital content and render menus in the guestroom.  These iHDTV systems are contrasted with our traditional systems, which deliver an analog signal to the room from either a digital storage device or analog tape-based storage.  The digital content is encrypted to protect the rights of content owners, who consider this protection when granting us distribution rights.  Our new digital video and IP solutions leverage our current headend-based platform and our industry-leading content management and distribution technology, providing scalability, reliability and lower costs than many other models.

 

Our content management systems allow us to refresh interactive menus, by brand or even down to a specific property level, if desired; promote different products and titles to different demographics; and change pricing of our products, selection and promotions, among other marketing efforts to the guest.

 

At those properties where we have sold Internet systems, we offer a selection of technology systems, which consist of commercial off-the-shelf networking equipment used to provide wired and wireless connections to guests’ computers.  To support these systems, we are transitioning from using our own proprietary Visitor Based Network (“VBN”) software, which manages connections between the guest and the Internet, to utilizing licensed VBN software.  The connection to the Internet is provided by either the hotel or an Internet Service Provider contracted by us.

 

Our policy is to apply for patents on those product designs which management believes may be of significance to our business.  We currently hold 24 United States and foreign patents, and have other applications for patents pending, which pertain to various aspects of our interactive systems.  We also license industry-related technology from third parties.

 

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Advertising and Media Services

 

Our advertising and media services subsidiary provides a platform to create and generate revenue for us through paid advertising or sponsorships. The subsidiary’s primary business is presenting advertisers with the opportunity to target attractive demographic groups, such as business professionals, affluent consumers and travelers.  These “mobile professionals” represent a coveted demographic to many marketers, and we provide a set of programs to reach this audience.  In 2012, we had advertisers from industries such as pharmaceutical corporations, airlines and telecommunications.

 

During 2012, we continued to evaluate the transition of our ad insertion business from our analog platform to an expanded high definition platform capable of inserting targeted advertising into an existing nationwide direct-broadcast satellite signal.  This transition will enable us to deliver advertising content in a more cost-effective manner across a much larger segment of our existing room base.  The platform is being designed to have the scale to attract national advertisers.  Currently, the new high definition ad insertion platform is being evaluated, and our transition plan may change under our reorganization.

 

HEALTHCARE

 

Through our wholly owned subsidiary, LodgeNet Healthcare, Inc., we sell a variety of products to acute care and specialty hospitals, including an interactive television solution which provides innovative ways for hospitals to educate, entertain and engage their patients with personalized communications.  Revenue is generated from the sale of system hardware, software licenses and professional services.  Additionally, we earn recurring revenues from the sale of patient education, movie and television content, software maintenance and technical support services.  The interactive patient solution is built on the same system architecture used in Hospitality, with additional enhancements needed to meet the unique needs of the healthcare environment, including secure patient communication applications and clinical system integrations.  Contract terms are typically for five years, with many sites implementing services in phases, providing future growth opportunities.  Systems are sold through direct sales and sales referral agents who have established relationships with healthcare facilities.  As of December 31, 2012, we had 82 facilities installed with our interactive television system.

 

Healthcare Market and Customers

 

The United States healthcare market consists of over 940,000 beds located in approximately 5,800 facilities across the country.  Research suggests there is approximately 10-15% penetration of interactive television (“iTV”) services in these hospitals, creating an opportunity for LodgeNet Healthcare.  This opportunity has been further amplified by recent changes to federal law that Medicare payments be based on outcomes that are believed to be impacted by patient engagement.  The Company believes the combination of new hospital economic drivers, coupled with the increased need for effective inpatient communication resulting support the need for our interactive solution.

 

LodgeNet Healthcare intends to continue developing interactive solutions across the entire care continuum, and provide device choice with television and tablet based delivery options.  Hospitals typically purchase iTV systems to address patient engagement or to improve the experience of the patient and family.  Budgets are often tied to expansions and renovation projects to leverage their facility investments to improve patient satisfaction and enhanced patient experiences.

 

LodgeNet Healthcare’s customer base represents some of the most highly regarded hospitals and health systems in the United States, including Brigham and Women’s Hospital in Boston; The University of Texas MD Anderson Cancer Center in Houston; Children’s Pittsburgh, of the UPMC Health System; Baylor Plano/Baylor Heart in Texas; Kaiser Oakland/Sunnyside in California; The University of Chicago Northshore Healthcare System in Illinois; and Cedars-Sinai Medical Center in Los Angeles.

 

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Healthcare Market Services and Products

 

LodgeNet Healthcare offers care facilities a variety of products and solutions, including the following:

 

Ø

interactive patient engagement solution with specialized applications and integrated services delivered via television, smart phone, tablet, PC or web-enabled devices;

Ø

professional services – including cable plant design, modification and installation, as well as television installation services;

Ø

DirecTV satellite television equipment sales and programming;

Ø

digital signage and messaging solutions; and

Ø

service agreements covering the facility’s cable plant, satellite television equipment, television and interactive system support.

 

Additional applications available through our interactive television system include:

 

Ø

guest entertainment options including movies on-demand, music channels and interactive games;

Ø

custom channels including a welcome channel, hospital information channel, digital promotional open channel and a relaxation channel;

 

Ø

interactive information about the hospital and its services, as well as a patient’s care team, schedule, health conditions, medications, safety and more;

 

Ø

assigned education - enables care providers to assign specific videos to patients based on their diagnoses; includes ability to track viewing and comprehension and the ability to chart the information in the patient’s electronic medical record;

Ø

patient requests - allows patients to submit common requests through the television directly to the person responsible for fulfillment, allowing nursing staff to focus on patient care;

Ø

patient surveys - designed to capture and build in-service recovery so patient issues can be identified and addressed by the care staff while the patient is still in the hospital; and

Ø

retail promotions - for revenue-generating services such as outpatient pharmacy, home medical equipment, health clubs, meal ordering, which provides information on diet types and allows patients to order meals based on diagnosis and allergies, and other outreach/continuum-of-care services.

 

Sales and Marketing.  LodgeNet Healthcare’s sales and marketing strategy is focused on acquiring new contracts with care facilities and health systems, repositioning ourselves as a healthcare company and promoting the value of our patient engagement solution.  Our approach utilizes both an internal sales team and third-party referral agents who have key relationships in the industry.  We primarily target hospital CEOs, CIOs and nursing staff via direct mail campaigns, trade advertising, online strategies, whitepapers, webinars and trade shows.

 

Installation and Service Operations.  LodgeNet Healthcare utilizes both internal personnel and subcontractors to install contracted equipment and services to healthcare facilities.  To manage the cost and quality of our installations, we assemble the systems at our corporate headquarters and use the same group of subcontractors who install our Hospitality iTV systems.  We also leverage the Hospitality field service operations and customer support services to provide high quality, consistent support and maintenance for systems deployed in healthcare facilities.  In limited cases, we staff support personnel in the field to support large facilities or multiple sites in close proximity.

 

Programming.  LodgeNet Healthcare sells programming to healthcare facilities through various third-party distributors.  We obtain the rights to show major motion pictures, which are typically offered to patients at no charge, as well as patient education content, pursuant to non-exclusive programming agreements.  These agreements are typically three to five years in length, with programming royalties based on the number of beds at each healthcare facility receiving services.  In addition, we also utilize our existing relationships with DirecTV for television programming and Nintendo for video game services.

 

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Technology and Product Development.  For the most part, LodgeNet Healthcare leverages the technology and architecture utilized in the Hospitality market to provide reliable solutions and services to healthcare facilities, with modifications and customizations to tailor the system to the healthcare market.  LodgeNet Healthcare is supported by a development and testing team dedicated to healthcare products.  Development also includes clinical integrations to hospitals’ health information and electronic medical record systems, which allows for a more personalized solution and empowers patients to be active participants in their care.

 

Competition

 

Hospitality

 

Based on the number of hotels and rooms served, we are the largest provider of interactive media and connectivity services to the hospitality industry in the United States, Canada and Mexico.  Competitors for media and connectivity services include, but are not limited to:

 

Ø

other interactive television service providers, such as Hospitality Networks, Inc. (a wholly-owned subsidiary of Cox Communications, Inc.), NXTV, Kool Connect, SuiteLinq, Guest-Tek, iBAHN, Tivus, Roomlinx, Tangerine Global and international providers, such as Acentic, DOCOMO interTouch, Locatel and Quadriga;

Ø

other providers of basic and premium television programming, such as Charter Communications, Comcast, Cox Cable, Dish Network, DirecTV, Time Warner, BulkTV, Televue, PureHD and World Cinema;

Ø

television networks and programmers, such as ABC, NBC, CBS, FOX, HBO, and Showtime;

Ø

companies which provide streaming Internet content, such as Netflix, Amazon and Hulu;

Ø

Internet websites providing free television programming, short feature films or mature content;

Ø

other Internet access service providers, such as iBAHN, Guest-Tek, EthoStream, SuperClick, Comcast, Time Warner, Verizon, AT&T, Wi-Fi Venue Services, Influx, Xeta and T-Mobile; and

Ø

companies which offer in-room computers with Internet access.

 

Other indirect competition for guest attention and revenue include: portable media devices such as iPods/iPads and DVD players; other devices such as laptop computers and cell phones; smart devices, such as iPhones and iPads, which can access web content; websites which offer on-demand and streaming videos, television programs and movies; and other forms of entertainment and information such as newspapers, magazines and books, concerts, sporting events and movie theaters.  Given the high level of innovation in communications technology, we expect to continue to confront new sources of competition.

 

A number of potential competitors, including those identified above, could use their existing infrastructure to provide in-room entertainment and Internet access services to the hospitality industry.  Some of these potential competitors are already providing guest entertainment, television programming or Internet-related services to the hospitality industry.  Some of these companies have substantially greater financial and other resources than we do, and it is possible such competitors have or may develop a technology which is more cost effective than ours.  To respond to competition, we will need to continue to enhance our interactive systems, expand our operations and meet the increasing demands for competitive pricing, service quality and availability of value-added product offerings.

 

Competition with respect to hotel contracts centers on a variety of factors, depending upon the features important to a particular hotel.  Among the more important factors are:

 

Ø

the features and benefits of the service offering, and Internet or interactive system;

Ø

the quality of the vendor’s technical support and maintenance services;

Ø

the financial terms and conditions of the proposed contract, including commissions to the hotel or capital cost of the system; and

Ø

the ability to complete system installation in a timely and efficient manner.

 

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Over the past several years, we have experienced a significant loss of rooms under contract.  In the basic and premium television programming market, the local franchised cable operator in a hotel’s market may have a substantial market presence.  Although such operators generally offer the hotel owner only standard packages of programming, typically developed for the residential market rather than the hospitality market, and at a fixed price per room based on all the channels provided, we believe a large portion of this room loss is attributable to hotels switching to the local cable programming package.

 

Competitive pressures in the interactive television, basic and premium television programming and Internet access segments could result in reduced market share for us, higher hotel commissions, lower margins and increased expenditures for marketing, product development and systems installation, each of which could adversely affect our financial condition and operating results.

 

Advertising and Media Services

 

Our advertising subsidiary occupies a unique niche in the advertising industry, providing commercial branding and promotional programs targeted towards hotel guests based on our hotel relationships and distribution network.  This consumer group, which contains many affluent and business travelers, represents an important, and at times, elusive, target for many companies and brands.  Advertisers do have other options when considering how to best reach and engage with these potential consumers.  Although there are but a few known “in-hotel” competitors which offer programs such as sampling and public space digital advertising, there are many others which target travelers and the business community in other ways.  This includes:

 

Ø

Airport Advertising: Place-based OOH media found in airports, represented by companies such as CNN Airport, RMG Networks, Viacom, CBS Outdoor and JC Decaux;

Ø

Airline Advertising:  Television programming supported with commercials during flight, tray-top ads and ad-supported in-flight magazines and airline sampling programs, represented by companies such as IdeaCast and Brand Connections; and

Ø

Office Advertising: Place-based digital media in office buildings, office elevators, etc., represented by companies such as Wall Street Journal, Captivate Media and others.

 

More generally, we compete against the full array of media and marketing services companies.  This includes television broadcasters and cable companies, such as FOX, CBS, NBC, ABC, CNN, and ESPN.  It also includes magazine and web publishers, especially those focused on travelers, affluent and business markets.  These broader media companies offer superior reach, but are generally not as targeted as our advertising programs.

 

We believe our competitive advantages include:

 

Ø

significant experience in the hotel space, with well established hotel relationships;

Ø

ability to leverage the LodgeNet field support and technical infrastructure;

Ø

broad array of advertising options, including hotel television media, VOD media and in-room promotion;

Ø

hotel television media which is Nielsen monitored, rated and guaranteed for advertisers;

Ø

ideal environmental factors for ad receptivity – no DVRs, few distractions, comfortable setting;

Ø

consumer engagement which is both long and of a high quality;

Ø

ability to integrate our marketing programs – combining media with promotion;

Ø

sophisticated technology allowing “telescoping,” where consumers can click from a linear commercial to an interactive ad menu; and

Ø

large size of our existing customer base.

 

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Healthcare

 

Our competitors include, but are not limited to:

 

Ø

other interactive patient care providers, such as GetWell Network, Skylight and Allen Technologies;

Ø

companies which primarily sell or lease television sets and also offer some phone and television-based interactive services, which include TVRC and TeleHealth;

Ø

other providers of basic and premium television programming, such as Charter Communications, Comcast, Cox Cable, Dish Network, DirecTV and Time Warner; and

Ø

tablet vendors who are developing interactive applications which run on patient-owned or hospital-provided devices.

 

Our competitive advantages include:

 

Ø

our significant experience with interactive technology from 30 years of service in the lodging sector;

Ø

the technical reliability of our solution;

Ø

the ability to provide our services over cable or IP infrastructure;

Ø

our access to HD content with Pro:IdiomTM encryption technology;

Ø

our understanding of interactive television and guest ease-of-use;

Ø

our nationwide service and support organization; and

Ø

our call center support with 24/7 coverage.

 

Regulation

 

Hospitality

 

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

 

The FCC rules define a multi-channel video programming distributor as “a person such as, but not limited to, a cable operator, a multi-channel multipoint distribution service, a direct broadcast satellite service, or a television receive-only satellite program distributor, who make available for purchase, multiple channels of video programming.”  We may be considered to be a multi-channel multipoint distribution service.  As such, we may be subject to various provisions of the Communications Act.  The Communications Act includes laws and regulations which would benefit our operations, such as provisions which ensure our access to programming on fair, reasonable and nondiscriminatory terms, as well as provisions which may subject us to additional requirements, such as the requirement to obtain consent from broadcasters in order to retransmit their signal over our systems.

 

Internet Access.  The FCC has classified high-speed Internet access as an interstate information service as defined by the Communications Act.  To date, the FCC has not imposed any regulations on information service providers, although it may do so in the future.

 

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Consumer Information.  As part of our marketing and mobile initiatives, we have begun to serve as a conduit for personal information to third-party credit card processors, service partners and others.  As our revenue diversification efforts increase, we may begin to gather and retain more consumer data, potentially including personally identifiable information (“PII”).  The handling of such consumer data requires compliance with a variety of federal, state and industry requirements which collectively create the need for legally-sufficient notice and consent, impose limitations on use and/or re-disclosure of such information, and establish baseline expectations for data security.  Some of these laws and regulations impose content-specific limitations on consumer data collection and retention, most notably the Video Privacy Protection Act, which specifically targets the video rental industry and generally prohibits the retention of records related to an individual’s viewing preferences beyond the time necessary to complete the applicable transaction.  In conjunction with our direct billing by credit card payment option for hotel guests, we are also subject to the requirements of the Payment Card Industry Data Security Standard in the collection and use of confidential cardholder data.  Other requirements which may impact our collection and use of consumer data, as well as contractual agreements with hotels and other third parties, include state and federal consumer protection regulations of general application.  In particular, the regulation and enforcement of privacy and data security has, and will continue to be, a priority within the Federal Trade Commission (“FTC”), acting under its general consumer protection authority.  This area of law is rapidly changing, and we anticipate new laws and regulations will be enacted and existing laws will be expanded in scope.  A number of companies have also been the subject of litigation and/or investigation by the FTC with respect to the content of, and their adherence to, privacy policies, use of consumer data and the like.  We intend to actively monitor developments in this area to assure our use of personal information complies with all applicable laws, regulations and industry standards.

 

Healthcare

 

The Health Insurance Portability and Accountability Act (“HIPAA”) addresses the security and privacy of health data.  The privacy and security rules promulgated under HIPAA apply only to “covered entities” – health plans, healthcare clearinghouses and healthcare providers.  If LodgeNet Healthcare enters into a contract with a healthcare facility which makes it a business associate, or a company which performs functions or activities involving the use or disclosure of protected health information on behalf of a covered entity, we must comply with the terms and conditions of such contract, which will require us to appropriately safeguard the confidentiality, integrity and availability of the protected health information it receives or transmits on behalf of the covered entity.

 

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

 

Employees

 

As of December 31, 2012, we had 840 employees in the United States, Canada and Mexico.  We have not experienced any significant labor problems and believe our relationships with our employees are good.

 

Corporate Information and Website Access to SEC Filings

 

We are a Delaware corporation with our principal executive offices located at 3900 West Innovation Street, Sioux Falls, South Dakota 57107.  Our telephone number is (605) 988-1000.

 

Our website address is http://www.lodgenet.com.  We make our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, including all amendments to those reports, available free of charge on our website as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission (“SEC”).

 

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Item 1A - Risk Factors

 

We experienced sustained revenue decline and net losses in 2012, 2011 and 2010.  If we are not profitable in the long-term it could have a harmful effect on our results of operations and business.  We reported net losses of $134.3 million (including a goodwill impairment charge of $92.6 million), $0.6 million and $11.7 million for the fiscal years ended December 31, 2012, 2011 and 2010, respectively.  Our financial results for the fiscal year 2013 and beyond will be dependent to a significant degree on our ability to successfully execute our business plan and a new strategic direction expected under the new Colony Syndicate ownership.

 

We may not be successful in our recapitalization efforts and restructuring our credit facility.  Our inability to comply with the financial covenants under our existing Credit Facility, uncertainty over our ability to remain in compliance with these covenants, our bankruptcy case under Chapter 11 of the Bankruptcy Code, and our liquidity constraints, have raised substantial doubt about our ability to meet our ongoing financial obligations.  We are experiencing significant liquidity constraints, and our ability to continue as a going concern is dependent upon maintaining adequate liquidity levels and satisfying our vendor obligations, a successful restructuring of our existing Credit Facility and closing of the investment agreement with the Colony Syndicate.  There can be no assurance that we will be able to close the investment agreement with the Colony Syndicate and to complete the restructuring of our Credit Facility.  The liquidity constraints, our non-compliance with certain of our debt covenants and our bankruptcy case have resulted in there being substantial doubt about our ability to continue as a going concern.

 

We have not been successful in renewing hotel properties to long-term contracts, which has reduced our room base.  We have rooms in our renewal window where we generally seek to extend and renew hotel contracts.  We may not be successful in renewing a portion of those rooms due to certain hotels electing to only provide their guests with free television programming.  We experienced a higher level of de-installation activities during 2012 and 2011, where our Guest Entertainment room base declined approximately 320,000 rooms.  If the higher level of de-installation were to continue it could have a harmful effect on our results of operations and business.

 

Our business is generally impacted by conditions affecting the hospitality industry’s performance.  Our results are generally connected to the performance of the hospitality industry, where occupancy rates may fluctuate resulting from various factors.  Reduction in hotel occupancy and consumer buy rates resulting from business, economic or other events, such as generally weak economic conditions, significant international crises, acts of terrorism, war or public health issues, adversely impacts our business, financial condition and results of operations.  The general economic conditions over the last several years have adversely affected the hotel industry and our business.   The overall travel industry and consumer buying pattern can be, has been in the past and/or currently is, adversely affected by weaker general economic climates, consumer sentiment, geopolitical instability and concerns about public health.

 

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Our Guest Entertainment revenue per room is impacted by a variety of factors, including certain factors beyond the control of the Company.

 

Ø

The occupancy rate at the property. Our revenue varies depending on hotel occupancy rates, which are subject to a number of factors, including seasonality, general economic conditions and world events;

Ø

The number of rooms equipped with our high-definition (“HD”) systems. We can increase revenue by increasing the number of HD rooms served. Our ability to expand our HD room base is dependent on a number of factors, including availability of capital resources from the hotels and the Company to invest in HD televisions and equipment;

Ø

The popularity, availability, timeliness and amount of content offered at the hotel. Our revenues vary, to a certain degree, with the number, timeliness and popularity of movie content available for viewing. Historically, a decrease in the availability of popular movie content has adversely impacted revenue;

Ø

The effectiveness of our merchandising initiatives. The Company has several merchandising efforts, including tiered pricing on Hollywood movies starting at $4.99; an improved user interface and navigational experiences for hotel guests and alternative payment options;

 

Ø

The availability of alternative programming and portable devices. We compete directly for customers with a variety of other content providers delivering content across different portable devices. Competing content providers include cable and satellite television companies; Internet streaming services, including Netflix, Hulu and Amazon; and Internet web sites which provide access to free adult content, including streaming video. These sources of alternative content can be delivered across a variety of portable viewing devices, such as laptop computers, smart phones and iPads or similar tablets; and

 

Ø

Consumer sentiment. The willingness of guests to purchase our entertainment services is also impacted by the general economic environment and its impact on consumer sentiment. Historically, such impacts were not generally material to our revenue results; however, since the last half of 2008, economic conditions have had a significant, negative impact on our revenue levels.

 

We operate in a very competitive business environment and competition has reduced our revenue and our cash flow.  Our business generates significant revenue from Guest Entertainment and Hotel Services, which are highly competitive categories.  If we are unable to compete effectively with large diversified entertainment service providers and large technology service providers who have substantially greater resources than we have, our operating margins and market share could continue to be reduced and the growth of our business would continue to be inhibited.  Our competitors may also offer services sooner and at more competitive rates than we do.  We may need to reduce our prices or license additional programming to remain competitive, and we may be unable to sustain future price levels as competition increases.  Our failure to achieve or sustain market acceptance of our offered services at desired pricing levels could impair our ability to generate free cash flow over time, which could harm our business.

 

Diversification activities may not be successful.  We have sought to diversify our business and decrease reliance on revenue from Guest Entertainment offerings.  These activities have included sales of systems to healthcare facilities, the sale of advertising within the hospitality market, the sale of media systems and services to hotels and the sale of in-room Internet access.  We may pursue additional markets in the future which we consider to be complementary to our other businesses.  However, the diversification into areas in which we do not have the same experience as our traditional business, involves a variety of risks, such as increased capital expenditures and diversion of limited resources and personnel from our traditional business, as well as management’s time and attention.  In addition, our newer business activities may generate less revenue and lower margins than our Guest Entertainment offerings.  Our financial results for the fiscal year 2013 and beyond will be dependent on our ability to successfully execute our new business plan and strategies under a successful transition to the new Colony Syndicate.

 

Item 1B - Unresolved Staff Comments

 

None.

 

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Item 2 - Properties

 

Our headquarters, including our distribution center and principal executive offices, are located in Sioux Falls, South Dakota.  Our owned facility is used for executive, administrative and support functions; assembly and distribution; and warehouse space.  We believe our facility will be sufficient to accommodate foreseeable local operational space requirements.

 

We lease 22 facilities, in various locations, from unaffiliated third parties.  These facilities include administrative offices for our subsidiaries and combination warehouse/office facilities for our installation and service operations, and are located throughout the United States, Canada and Mexico.

 

Item 3 - Legal Proceedings

 

We are subject to litigation arising in the ordinary course of business.  As of the date hereof, we believe the resolution of such litigation will not have a material adverse effect upon our financial condition, results of operations or cash flows.

 

On January 27, 2013, the Company and its domestic subsidiaries filed a “prepackaged” voluntary petition under chapter 11 of the U.S. Bankruptcy Code in the United States Bankruptcy Court for the Southern District of New York.  The court confirmed the Company’s plan of reorganization on March 7, 2013.  Details of this proceeding and the Company’s plan of reorganization are discussed above.

 

On July 11, 2008, LinkSmart Wireless Technology, LLC, a California limited liability company based in Pasadena, California, filed several actions for patent infringement in the U.S. District Court in Marshall, Texas.  The suits allege the Company and numerous other defendants infringe a patent issued on August 17, 2004, entitled “User Specific Automatic Data Redirection System.”  All pending cases have been consolidated.  The complaint does not specify an amount in controversy.  The Company believes it does not infringe the patent in question, has filed responsive pleadings and is vigorously defending the action.  The case was stayed in October 2010, pending a re-examination of the patent by the U.S. Patent and Trademark Office (the “PTO”).  In January 2012, the PTO issued a notice it intended to re-issue the patent with certain claims canceled, other claims confirmed, and other claims modified.  In February 2012, the Court removed the stay, but in light of the substantial changes to the patent, cleared the docket by denying all outstanding motions without prejudice.  The parties are in the process of examining the case in light of the significant revisions to the patent.  The Company believes the changes to the scope of the patent may reduce or eliminate liability for past infringement and the patent as amended remains subject to further review by the PTO and by the Court.  As a result of these events, the case remains at a very preliminary stage, and the Company believes any possible loss would be immaterial to the consolidated financial position, results of operations or cash flows.

 

On January 4, 2013, 10th Avenue Media, LLC, an Oregon limited liability company based in Portland, Oregon, filed a patent infringement action against the Company in the Central District of California.  The suit alleges that the Company infringes a patent issued on September 18, 2007 entitled “Digital Content Delivery System Transaction Engine”.  The complaint, which has not yet been served, does not specify an amount in controversy.  The Company contends that it does not infringe upon the patent in question, and intends to vigorously defend the action in the event it is properly served.  10th Avenue Media filed an objection to the Company’s plan of reorganization, seeking, among other things to have funds set aside in the event of a recovery.  This objection was denied by the Bankruptcy Court.

 

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PART II

 

Item 5 - Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Our common stock was previously traded on the NASDAQ Global Select Market (“NASDAQ Exchange”) under the symbol “LNET.”  Our common stock began trading on the NASDAQ Exchange on October 14, 1993 upon the effectiveness of our initial public offering, and was delisted on January 14, 2013.  As of March 19, 2013, there were outstanding 29,610,595 shares of common stock.

 

The following table sets forth, for the fiscal quarters indicated, the range of high and low sales prices of our common stock as reported by NASDAQ:

 

Quarter Ended

 

High

 

Low

 

Quarter Ended

 

High

 

Low

March 31, 2012

 

4.09

 

2.41

 

March 31, 2011

 

4.81

 

2.76

June 30, 2012

 

4.44

 

1.12

 

June 30, 2011

 

3.76

 

3.02

September 30, 2012

 

1.48

 

0.30

 

September 30, 2011

 

3.28

 

1.53

December 31, 2012

 

0.87

 

0.04

 

December 31, 2011

 

2.70

 

1.31

 

In December 2012, we announced that we entered into an investment agreement with the Colony Syndicate pursuant to which they will provide $60.0 million of new capital to support a proposed recapitalization of the Company.  In addition, the lenders have agreed to provide a new five year term loan for our existing $346.4 million secured credit facility plus the amount of accrued and unpaid interest.  In addition, the Company expects to enter into a revolving credit facility of up to $20.0 million.

 

This transaction is being implemented through an expedited Chapter 11 bankruptcy process, at the conclusion of which the Colony Syndicate will become the controlling stockholder of the Company.  The Company commenced a prepackaged Chapter 11 process in the United States Bankruptcy Court for the Southern District of New York on January 27, 2013.  Pursuant to the completion of the Chapter 11 process, holders of the preferred and common stock will have their interests cancelled and will not receive any distributions.  We expect to have all conditions precedent completed and the transaction closed in late March of 2013.

 

On March 19, 2013, the closing price of our common stock was $0.02 on the OTC markets.  Pursuant to the completion of the Chapter 11 process, holders of the common stock will have their interests cancelled and will not receive any distribution.  As of March 19, 2013, we have 101 stockholders of record with approximately 97.9% of the shares held in “street name.”

 

We also have 5,000,000 shares of preferred stock authorized at $0.01 par value per share, of which 42,016 10% Series B cumulative perpetual convertible shares were issued and outstanding as of March 19, 2013, with a liquidation preference of $1,000 per share.  Pursuant to the completion of the Chapter 11 process, holders of the preferred stock will have their interests cancelled and will not receive any distribution.

 

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Performance Graph

 

The following graph compares the percentage change in the Company’s cumulative total stockholder return on its common stock with (i) the cumulative total return of the NASDAQ Market Index, (ii) the cumulative total return of companies (the “SIC Code Index”) with the four-digit standard industrial code (“SIC”) of 4841 – Cable and Other Pay Television Services and (iii) the cumulative total return of all companies (the “Peer Group”) with the same SIC as the Company (SIC 4899 – Communication Services, NEC) over the period from January 1, 2007 through December 31, 2012.  The graph assumes an initial investment of $100 in each of the Company, the NASDAQ Market Index and the Peer Group and reinvestment of dividends.  The Company did not declare or pay any dividends on its common stock in 2012.  The graph is not necessarily indicative of future price performance.

 

This graph shall not be deemed incorporated by reference by any general statement incorporating by reference this Annual Report on Form 10-K into any filing under the Securities Act or under the Exchange Act, except to the extent the Company specifically incorporates this information by reference, and shall not otherwise be deemed filed under such Acts.

 

 

Issuer Purchases of Equity Securities

 

During 2012, we did not repurchase any shares of our common stock.

 

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Dividends

 

No dividends have been paid to date on our common stock.  The terms and conditions of our bank Credit Facility contain covenants, which restrict and limit payments or distributions in respect of our common stock.

 

Subject to the declaration of dividends by our Board of Directors, cumulative dividends on the preferred stock will be paid at a rate of 10% per annum of the $1,000 liquidation preference per share, starting from the date of original issue, June 29, 2009.  Dividends accumulate quarterly in arrears on each January 15, April 15, July 15 and October 15, beginning on October 15, 2009.  Our Board of Directors determined not to declare dividends with respect to the six months ended December 31, 2012.  Accordingly, we have not recorded the preferred stock dividends for such period.  However, the preferred stock dividends have been included in our earnings per share computation (see Note 2) for the year ended December 31, 2012 pursuant to ASC 260-10-45-11.  The amount in arrears is also included in preferred stock dividends on the Consolidated Statements of Operations for the year ended December 31, 2012.  The deferred dividends of $2.7 million will accumulate in accordance with the terms of the preferred stock and, as of December 31, 2012, the total arrearage on the preferred stock was $2.7 million.

 

Pursuant to the completion of the Chapter 11 process, holders of the preferred stock will have their interests cancelled and will not receive any distribution or dividend payment.

 

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Item 6 - Selected Financial Data

 

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

 

 

 

Year Ended December 31,

 

 

2012

 

2011

 

2010

 

2009

 

2008

Select Financial Data:

 

 

 

 

 

 

 

 

 

 

Revenues:

 

 

 

 

 

 

 

 

 

 

Hospitality and Advertising Services

 

$

 353,228

 

$

 410,919

 

$

 443,654

 

$

 476,658

 

$

 527,810

Healthcare

 

11,461

 

10,343

 

8,518

 

7,834

 

6,069

Total revenues

 

364,689

 

421,262

 

452,172

 

484,492

 

533,879

 

 

 

 

 

 

 

 

 

 

 

Income (loss) from operations (1)

 

(103,799)

 

28,460

 

23,410

 

21,692

 

(5,071)

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

(134,287)

 

(631)

 

(11,685)

 

(10,155)

 

(48,418)

Preferred stock dividends

 

(5,557)

 

(5,744)

 

(5,750)

 

(3,114)

 

-

Net loss attributable to common stockholders

 

$

 (139,844)

 

$

 (6,375)

 

$

 (17,435)

 

$

 (13,269)

 

$

 (48,418)

 

 

 

 

 

 

 

 

 

 

 

Net loss per common share (basic and diluted)

 

$

 (5.48)

 

$

 (0.25)

 

$

 (0.71)

 

$

 (0.59)

 

$

 (2.16)

 

 

 

 

 

 

 

 

 

 

 

Other Data:

 

 

 

 

 

 

 

 

 

 

Investing activities:

 

 

 

 

 

 

 

 

 

 

Capital expenditures (2)

 

$

 35,631

 

$

 27,318

 

$

 21,825

 

$

 21,341

 

$

 64,407

Average cost per iHDTV room

 

$

 141

 

$

 140

 

$

 177

 

$

 279

 

$

 343

 

 

 

 

 

 

 

 

 

 

 

Average Hospitality and Advertising Services revenue per room

 

$

 20.70

 

$

 21.36

 

$

 21.29

 

$

 21.73

 

$

 23.69

 

 

 

As of December 31,

 

 

2012

 

2011

 

2010

 

2009

 

2008

Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

 15,373

 

$

 14,019

 

$

 8,381

 

$

 17,011

 

$

 10,800

Total assets

 

$

 272,092

 

$

 408,672

 

$

 444,006

 

$

 508,354

 

$

 589,786

Total debt

 

$

 347,267

 

$

 363,300

 

$

 373,639

 

$

 469,946

 

$

 588,520

Total stockholders’ deficiency

 

$

 (185,502)

 

$

 (50,941)

 

$

 (54,349)

 

$

 (70,987)

 

$

(128,748)

 

 

 

Year Ended December 31,

 

 

2012

 

2011

 

2010

 

2009

 

2008

Statement of Cash Flows Data:

 

 

 

 

 

 

 

 

 

 

Cash provided by operating activities

 

$

 57,997

 

$

 52,040

 

$

 101,706

 

$

 86,172

 

$

 89,853

Property and equipment additions

 

(35,631)

 

(27,318)

 

(21,825)

 

(21,341)

 

(64,407)

 

 

$

 22,366

 

$

 24,722

 

$

 79,881

 

$

 64,831

 

$

 25,446

 

(1)                                 Significant items effecting our loss from operations in 2012 include goodwill impairment charges of $92.6 million, reorganization costs consisting of legal and other professional costs related to our Chapter 11 filing and reorganization efforts of $14.6 million and restructuring costs of $7.6 million.

(2)                                 Presented as cash used for property and equipment additions as reported in the Statement of Cash Flows.

 

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Special Note Regarding Forward-Looking Statements

 

Certain statements in this report or documents incorporated herein by reference constitute “forward-looking statements.” When used in this report, the words “intends,” “expects,” “anticipates,” “estimates,” “believes,” “goal,” “no assurance” and similar expressions, and statements which are made in the future tense or refer to future events or developments, are intended to identify such forward-looking statements. Such forward-looking statements are subject to risks, uncertainties and other factors which could cause the actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. In addition to the risks and uncertainties discussed in Item 1A of this Annual Report on Form 10-K for the year ended December 31, 2012, in any prospectus supplement or any report or document incorporated herein by reference, such factors include, among others, the following:

 

Ø              our ability to remain in compliance with the terms of our agreements with our lenders;

Ø              our ability to make timely payments to our vendors, as required by our forbearance agreements and our agreements with them;

Ø              our ability to successfully refinance our outstanding debt or restructure the Company;

Ø              our ability to close the Colony Syndicate transaction;

Ø              our ability to continue as a going concern;

Ø              our ability to maintain adequate liquidity levels; and

Ø              other factors detailed, from time to time, in our filings with the Securities and Exchange Commission.

 

These forward-looking statements speak only as of the date of this report.  We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

 

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

 

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

 

Executive Overview

 

We are the largest provider of interactive media and connectivity services to the hospitality industry in the United States, Canada and Mexico.  Our primary offerings include guest-paid entertainment, such as on-demand movies, advertising services and hotel-paid services, including cable television programming, Internet access services and interactive applications through our Envision and Mobile platforms.  As of December 31, 2012, we provided interactive media and connectivity services to approximately 1.5 million hotel rooms in North America and in select international markets, primarily through local or regional licensees.  In addition, we also have a growing presence in the healthcare market, where we sell and maintain interactive television systems which provide on-demand patient education, information and entertainment to healthcare facilities throughout the United States.  As of December 31, 2012, our systems were installed in 82 healthcare facilities, representing approximately 18,600 beds.

 

During 2012, we faced increasing liquidity challenges as a result of several business trends and debt servicing issues that negatively impacted our liquidity position.  We experienced a significant decrease in total revenue during 2012.  The rate of decline in our movie revenue per room for 2011 was approximately 6% versus 2010.  The decline accelerated in 2012 and the annual rate of decline more than doubled to approximately 13% versus the prior year.  Although significant declines were experienced in the first six months of 2012, the decline in revenue experienced during the third quarter of 2012 was even greater than what we had previously estimated.  At the same time, two of our major vendors required us to enter into payment plans.  Therefore, during September 2012, we entered into forbearance agreements with these two major vendors.  These events created considerable liquidity constraints to our operations and related financial results during the third and fourth quarters of 2012.  We were out of compliance with our Credit Facility leverage covenant at the end of the third quarter and we entered into a forbearance agreement with our lenders.  Our inability to comply with the financial covenants under our existing Credit Facility, our liquidity constraints and our bankruptcy case under Chapter 11 of the Bankruptcy Code have raised substantial doubt about our ability to continue as a going concern.

 

In December 2012, we announced that we entered into an investment agreement with a syndicate formed by an affiliate of Colony Capital, LLC (the “Colony Syndicate”) pursuant to which the Colony Syndicate agreed to provide $60.0 million of new capital to support a proposed recapitalization of the Company.  The investment agreement contains certain conditions precedent, including closing conditions which are described in more detail in Note 1 of the consolidated financial statements, and terminates on April 30, 2013. In addition, our lenders have agreed to restructure our existing $346.4 million secured credit facility to a new five year term loan.

 

This transaction is being implemented through an expedited Chapter 11 bankruptcy process, at the conclusion of which the Colony Syndicate will become the controlling stockholder of the Company.  The Company commenced a prepackaged Chapter 11 process in the United States Bankruptcy Court for the Southern District of New York on January 27, 2013.  Pursuant to the completion of the Chapter 11 process, holders of the preferred and common stock will have their interests cancelled and will not receive any distributions.

 

On March 7, 2013, the Bankruptcy Court entered an order confirming the plan.  The plan provides that it will become effective upon the completion of certain conditions precedent, including closing conditions under the investment agreement with the Colony Syndicate.  We expect to have all conditions precedent completed and the transaction closed in late March of 2013.

 

The following is a summary of the significant terms of the plan. This summary highlights certain substantive provisions of the plan only and is not a complete description of the plan, and is qualified in its entirety by reference to the full text of the plan as confirmed.

 

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Summary of the Plan

 

The plan provides for the reorganization of the Company. On the effective date, the Colony Syndicate will purchase 100% of the shares of new common stock in the reorganized company for $60.0 million and certain investors will purchase warrants to purchase additional shares of new common stock.

 

All creditors of the Company will be paid in full, with interest, in respect of allowed claims.  The holders of the Company’s secured debt, however, will receive an amended and restated credit agreement providing a new five year term loan for the existing $346.4 million secured credit facility plus the amount of accrued and unpaid interest at the non-default rate.  In addition the Company will enter into a revolving credit facility of up to $20.0 million.

 

All shares of the Company’s common stock and the Company’s 10% Series B Cumulative Convertible Perpetual Preferred Stock will be cancelled upon completion of the Chapter 11 process and holders of these securities will not receive any distributions.  All options and warrants to purchase any securities of the Company will also be cancelled.

 

These liquidity constraints, our non-compliance with certain of our debt covenants and our bankruptcy case under Chapter 11 of the Bankruptcy Code have resulted in there being substantial doubt in our ability to continue as a going concern. Despite these factors, the accompanying consolidated financial statements have been prepared assuming that we will continue as a going concern. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts and the amount of liabilities that might be necessary should we be unable to continue as a going concern.  As a result of our non-compliance with our debt covenants, our liquidity constraints  and our bankruptcy case under Chapter 11 of the Bankruptcy Code, we classified our outstanding debt obligations, contractually due in April 2014, as current in our consolidated balance sheet as of December 31, 2012.

 

Financial Summary

 

Our total revenue for 2012 was $364.7 million, a $56.6 million or 13.4% decline, compared to 2011.  Guest Entertainment revenue decreased $50.5 million, while our non-Guest Entertainment products and services decreased $6.1 million.  The decrease in Guest Entertainment revenue resulted primarily from an 11.3% reduction in the average number of Guest Entertainment rooms served and a 12.8% decline in Guest Entertainment revenue per room.

 

Hotel Services revenue was $126.7 million in 2012, an $8.1 million or 6.0% decrease from the prior year, driven primarily from a decrease in the number of rooms receiving cable television programming and the number of rooms receiving high-speed Internet service.  System Sales and Related Services revenue per room improved 24.0% over 2011, driven primarily by programming fees and equipment sales.  Additionally, our Healthcare subsidiary generated $11.5 million of revenue during the current year, an increase of $1.1 million or 10.8%, resulting from a 13.7% increase in the number of beds generating recurring revenue as well as higher revenue on current year system sales, installations and related professional services.

 

Total direct costs decreased $19.1 million or 8.1%, to $218.2 million in 2012 as compared to $237.3 million in 2011.  Direct costs declined due to lower sales volume driving lower royalties and hotel commissions.  Advertising Services fixed costs also decreased year over year, driven by lower costs as a result of the transition from our analog platform.  Gross margins decreased year over year, at 40.2% in 2012 as compared to 43.7% for the prior year.

 

System operations expenses and selling, general and administrative (“SG&A”) expenses decreased $9.5 million or 11.7%, to $71.8 million in 2012 as compared to $81.3 million in 2011.  Factors driving the improvement period over period include reduced professional services expenses, system repair costs, property taxes, and travel. We also incurred lower facilities costs and administrative labor as a result of cost savings initiatives.  Additionally, we incurred $14.6 million of legal and other professional costs related to our Chapter 11 filing and reorganization efforts.

 

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We generated $58.0 million of cash from operating activities during 2012, as compared to $52.0 million in 2011.  Cash used for capital investments was $35.6 million in 2012, compared to $27.3 million in 2011.  During the year, we also used cash to repay term loan principal of $37.2 million and we made net borrowings against our revolving line of credit totaling $21.0 million.

 

In 2012, we installed approximately 66,000 iHDTV rooms, ending the year with over 372,000 rooms or 27.4% of our Guest Entertainment room base.  We have seen an approximately 20.3% decrease in the cost to install an iHDTV room, declining from an average of $177 in 2010 to $141 for 2012.

 

Hospitality and Advertising Services Businesses

 

Guest Entertainment (includes purchases for on-demand movies, network-based video games, music and music videos and television on-demand programming).  One of our main sources of revenue, generating 47.0% of total revenue for the year ended December 31, 2012, is providing in-room, interactive guest entertainment, for which the hotel guest pays on a per-view, hourly or daily basis.

 

Our total guest-generated revenue depends on a number of factors, including:

 

Ø              The number of rooms on our network.  Our ability to maintain our room base is dependent on a number of factors, including the number of newly constructed hotel properties or properties serviced by a competitor, and the attractiveness of our technology, service and support to hotels currently serviced by us.

Ø              The occupancy rate at the property.  Our revenue also varies depending on hotel occupancy rates, which are subject to a number of factors, including seasonality, general economic conditions and world events, such as terrorist threats or public health issues.  Occupancy rates for the properties we serve are typically higher during the second and third quarters due to seasonal travel patterns.  We target higher occupancy properties in diverse demographic and geographic locations in an effort to mitigate occupancy-related risks.

Ø              The buy rate of hotel guests.  This is impacted by a number of issues, some of which are not under our control.  Specific issues impacting buy rate include:

o                 The number of rooms equipped with our iHDTV systems.  We typically earn higher revenue from a property when we convert it to our iHDTV platform.  Our ability to expand our iHDTV room base is dependent on a number of factors, including availability of capital resources from the hotels and the Company to invest in HD televisions and equipment.  Our installation plan may change upon the completion of our reorganization.

o                 The popularity, timeliness and amount of content offered at the hotel.  Our revenues vary, to a certain degree, with the number, timeliness and popularity of movie content available for viewing, and whether the content is presented in digital or analog format.  Historically, a decrease in the availability of popular movie content has adversely impacted revenue, and the availability of high definition content has increased revenue.  Although not completely within our control, we seek to program and promote the most popular available movie content and other content to maximize revenue and profitability.

o                 The price of the service purchased by the hotel guest.  Generally, we control the prices charged for our products and services, and manage pricing in an effort to maximize revenue and overall profitability.  We establish pricing based on such things as the demographics of the property served, the popularity of the content and overall general economic conditions.  Our technology enables us to measure the popularity of our content and make decisions to best position such content and optimize revenue from such content.

o                 The effectiveness of our promotional and marketing campaigns.  We believe we can promote increased browsing activity through: tiered pricing; an improved user interface and navigational experiences for hotel guests; and enhanced merchandising and marketing of the latest content in our exclusive hotel window.  By increasing browsing activity, attracting new buyers and lifting buy rates, we believe we can improve theatrical movie revenue per room.  Certain merchandising and promotional pricing programs may, in some cases, have a negative impact on revenue before they are modified or suspended.

 

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o                 The availability of alternative programming and portable devices.  We compete directly for customers with a variety of other content providers delivering content across different portable devices.  Competing content providers include cable and satellite television companies; Internet streaming services, including Netflix, Hulu and Amazon; and Internet web sites which provide access to free adult content, including streaming video.  These sources of alternative content can be delivered across a variety of portable viewing devices, such as laptop computers, smart phones and iPads or similar tablets.

o                 Consumer sentiment.  The willingness of guests to purchase our entertainment services is also impacted by the general economic environment and its impact on consumer sentiment.  Historically, such impacts were not generally material to our revenue results; however, since the last half of 2008, economic conditions have had a significant, negative impact on our revenue levels.

 

The primary direct costs of providing Guest Entertainment are:

 

Ø              license fees paid to major motion picture studios, which are variable and based on a percent of guest-generated revenue, for non-exclusive distribution rights of recently released major motion pictures;

Ø              commissions paid to our hotel customers, which are also variable and based on a percent of guest-generated revenue;

Ø              license fees, which are based on a percent of guest-generated revenue, for television on-demand, music, music videos, video games and sports programming; and

Ø              fixed monthly Internet connectivity costs.

 

Hotel Services (includes revenue from hotels for services such as television channels and recurring Internet service and support to the hotels). Another major source of our revenue is providing cable television programming, hotel services applications on our Envision and Mobile platforms and Internet access services to the lodging industry, for which the hotel pays a fixed monthly fee.

 

Ø              Cable Television Programming.  We offer a wide variety of satellite-delivered cable television programming paid for by the hotel and provided to guests at no charge.  The cable television programming is delivered via satellite, pursuant to an agreement with DirecTV, and is distributed over the internal hotel network.  It typically includes premium channels such as HBO and Showtime, which broadcast major motion pictures and specialty programming, as well as non-premium channels, such as CNN and ESPN.  With the launch of the high-definition configuration of our interactive television system, we also began offering high-definition cable television programming to the extent available from broadcast sources and DirecTV.

 

Ø              Envision.  During 2012, we continued the deployment of our cloud connected, interactive television platform, called Envision, which connects our interactive, high-definition guest room televisions to Internet-sourced content and information.  As of December 31, 2012, we had 284 Envision systems installed and providing services to over 98,000 rooms, with 39.2% of the installed rooms subscribing to premium apps.  The continuation of our Envision deployment will be dependent on the new strategies under our reorganization plan.

 

Ø              Mobile Applications.  In 2011, we developed the software and technology to deliver the LodgeNet Mobile App, which brings together guest entertainment, hotel services and local area guide information.  We launched the LodgeNet Mobile App in January 2012 and, as of December 31, 2012, it was available in over 670,000 rooms.  The app provides travelers with in-room television control and on-demand content discovery capabilities, along with hotel and local area information and services.  For hotels, the app can be utilized to provide guests with customized brand and property information services.  The continuation of our Mobile services will be dependent on the new strategies under our reorganization plan.

 

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Ø              Internet Service and Support.  We also design, install and operate wired and wireless Internet systems at hotel properties.  These systems control access to the Internet, provide bandwidth management tools and allow hotels to charge guests or provide the access as a guest amenity.  Post-installation, we generate recurring revenue through the ongoing maintenance, service and call center support services to hotel properties installed by us and also to hotel properties installed by other providers, or through a revenue-share model in which hotel guests pay for Internet and we pay a commission to our hotel customers.  While this is a highly competitive area, we believe we have important advantages as a result of our proactive monitoring interface with hotel systems to improve up time, existing hotel customer relationships and our nationwide field service network.

 

System Sales and Related Services. We also generate revenue from other products and services within the hotel and lodging industry, including sales of interactive television and Internet access systems, HD programming reception equipment, Internet conference services and professional services, such as network design, project management and installation services.

 

Advertising Services.  We deliver advertising-supported media into select hotel segments, from which we earn revenue from the sale of traditional television advertising, place-based digital advertising and promotional marketing solutions.  The demographic and professional profile of the traveler within our room base tends to have characteristics we believe are attractive to consumer marketing organizations.  By approaching guests with relevant messaging when they are in the comfort of a hotel room, free of distractions, advertisers have a prime opportunity to capture the attention of and connect with these desired consumers.  In addition to market demands, our revenue is also dependent on rooms available to promote customer products and services.  As of December 31, 2012, we provided advertising and media services to approximately 1.0 million hotel rooms.

 

During 2012, we continued to evaluate the transition of our ad insertion business from our analog platform to an expanded high definition platform capable of inserting targeted advertising into an existing nationwide direct-broadcast satellite signal.  This transition will enable us to deliver advertising content in a more cost-effective manner across a much larger segment of our existing room base.  The platform is being designed to have the scale to attract national advertisers.  Currently, the new high definition ad insertion platform is being evaluated, and our transition plan may change under our reorganization.

 

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Key Metrics:

 

Rooms Served

 

One of the metrics we monitor within our Hospitality and Advertising Services businesses is the number of rooms we serve with our various services. As of December 31, we had the following number of rooms installed with the designated service:

 

 

 

2012

 

2011

 

2010

Total rooms served (1)

 

1,489,223

 

1,621,529

 

1,829,712

Total Guest Entertainment rooms (2)

 

1,359,615

 

1,477,442

 

1,680,322

Total iHDTV rooms (3)

 

372,474

 

309,239

 

270,384

Percent of Total Guest Entertainment rooms

 

27.4%

 

20.9%

 

16.1%

Total Envision rooms (4)

 

98,881

 

18,542

 

-

Percent of Total Guest Entertainment rooms

 

7.3%

 

1.3%

 

-

Total Mobile rooms (5)

 

672,533

 

-

 

-

Percent of Total Guest Entertainment rooms

 

49.5%

 

-

 

-

Total Cable Television Programming (FTG) rooms (6)

 

856,199

 

938,270

 

1,030,437

Percent of Total Guest Entertainment rooms

 

63.0%

 

63.5%

 

61.3%

Total Broadband Internet rooms (7)

 

97,037

 

143,491

 

178,047

 

(1)                                 Total rooms served include rooms receiving one or more of our services, including rooms served by international licensees.

(2)                                Guest Entertainment rooms, of which 95.1% were digital as of December 31, 2012, receive one or more Guest Entertainment services, such as movies, video games, music or other interactive and advertising services.

(3)                                 iHDTV rooms are equipped with high-definition capabilities.

(4)                                 Guest Entertainment rooms installed with our Envision interactive platform.

(5)                                 Guest Entertainment rooms compatible with the LodgeNet Mobile App.

(6)                                 Cable television programming (FTG) rooms receive basic or premium cable television programming.

(7)                                 Represents rooms receiving high-speed Internet service.

 

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High Definition Room Growth

 

We also track the penetration of our interactive, high-definition television (“iHDTV”) system, since rooms equipped with iHDTV services typically generate higher revenue from Guest Entertainment and Hotel Services than rooms equipped with our analog systems.  iHDTV room growth occurs as we install our iHDTV system in newly contracted rooms or convert certain existing rooms to the iHDTV system in exchange for contract extensions.  The installation of an iHDTV system typically requires a capital investment by both the Company and the hotel operator.  During the past four years, iHDTV growth has been constrained by reduced hotel capital spending on HD televisions, given the negative impact of the economy on the hospitality industry and is currently constrained by our liquidity issues.  We installed our iHDTV systems in the following number of net new rooms as of December 31:

 

 

 

2012

 

2011

 

2010

 

Net new iHDTV rooms

 

63,235 

 

39,018 

 

38,633 

 

 

iHDTV rooms, including new installations and major upgrades, are equipped with high-definition capabilities.

 

Capital Investment Cost Per Installed Room

 

The average investment cost per room associated with an installation can fluctuate due to engineering efforts, component costs, product segmentation, cost of assembly and installation, average number of rooms for properties installed, certain fixed costs and hotel capital contributions.  The following table sets forth our average installation cost per room during the years ended December 31:

 

 

 

2012

 

2011

 

2010

 

 

 

 

 

 

 

 

 

Average cost per installed iHDTV room

 

  $

141

 

  $

140

 

  $

177

 

 

The decrease in the average cost per iHDTV room from 2010 to 2012 was primarily driven by lower component, installation and other related costs.

 

Average Revenue Per Room

 

We monitor the average revenue we generate per Hospitality and Advertising Services room.  Guest Entertainment revenue can fluctuate based on several factors, including occupancy, consumer sentiment, mix of travelers, the availability of high definition and alternative programming, the popularity of movie content, the mix of services purchased and the overall economic environment.  Hotel Services revenue can fluctuate based on the percentage of our hotels purchasing cable television programming services from us, the type of services provided at each site, as well as the number of hotels purchasing Internet service and support from us.  System Sales and Related Services revenue can fluctuate based on the number of system and equipment sales, including Internet systems sales.  Advertising Services revenue can fluctuate based on the demand for advertising and the performance of products and services sold to business and leisure travelers, as well as the number of rooms available to promote within.  The following table sets forth the components of our Hospitality and Advertising Services revenue per room for the years ended December 31:

 

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2012

 

2011

 

2010

 

Average monthly revenue per room:

 

 

 

 

 

 

 

Hospitality and Advertising Services

 

 

 

 

 

 

 

Guest Entertainment

 

  $

10.06

 

  $

11.54

 

  $

12.41

 

Non-Guest Entertainment

 

 

 

 

 

 

 

Hotel Services

 

7.42

 

7.01

 

6.53

 

System Sales and Related Services

 

2.84

 

2.29

 

1.88

 

Advertising Services

 

0.38

 

0.52

 

0.47

 

 

 

10.64

 

9.82

 

8.88

 

Total Hospitality and Advertising Services revenue per room

 

  $

20.70

 

  $

21.36

 

  $

21.29

 

 

Average Direct Costs Per Room

 

Guest Entertainment direct costs vary based on content license fees, the mix of Guest Entertainment products purchased and the commission earned by the hotel.  Hotel Services direct costs include the cost of cable television programming and the cost of Internet support services.  The cost of System Sales and Related Services primarily includes the cost of the systems and equipment sold to hotels.  Advertising Services direct costs include the cost of developing and distributing programming.  The overall direct cost margin primarily varies based on the composition of revenue.  The following table sets forth our Hospitality and Advertising Services direct costs per room for the years ended December 31:

 

 

 

2012

 

2011

 

2010

 

Average monthly direct costs per room:

 

 

 

 

 

 

 

Hospitality and Advertising Services

 

 

 

 

 

 

 

Guest Entertainment

 

  $

4.09

 

  $

4.56

 

  $

4.85

 

Hotel Services

 

6.19

 

5.80

 

5.64

 

System Sales and Related Services

 

2.07

 

1.44

 

1.25

 

Advertising Services

 

0.06

 

0.27

 

0.25

 

Total Hospitality and Advertising Services direct costs per room

 

  $

12.41

 

  $

12.07

 

  $

11.99

 

 

Healthcare Business

 

The healthcare market in the United States consists of over 940,000 hospital beds across approximately 5,800 facilities.  We believe most hospitals currently do not have any form of interactive television services.  The primary reasons hospitals purchase interactive television systems are to increase patient satisfaction, to improve clinical outcomes and to increase operational efficiencies.  Our Healthcare revenue is generated through a variety of services and solutions provided to care facilities, including:

 

Ø              revenue generated from the sale of the interactive system hardware, software licenses and installation services;

Ø              revenue from the sale and installation of satellite television equipment and related programming;

Ø              revenue from recurring support agreements for interactive content, software maintenance and technical field service support, including service agreements covering cable plant, satellite television equipment and interactive systems; and

Ø              revenue generated from cable plant design, modification and installation, as well as television installation services.

 

As of December 31, these services and solutions were installed as follows:

 

 

 

2012

 

2011

 

2010

Systems installed

 

82

 

68

 

56

Beds served

 

18,632

 

15,931

 

12,224

 

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General Operations

 

Total Operating Expenses

 

System operations expenses consist of costs directly related to the operation and maintenance of systems at hotel sites.  Selling, general and administrative expenses (“SG&A”) primarily include payroll costs, share-based compensation, engineering development costs and legal, marketing, professional and compliance costs.  Reorganization items for 2012 was driven by $14.6 million of legal and other professional costs incurred related to our Chapter 11 filing and reorganization efforts.  The following table sets forth the components of our operating expenses per room for the years ended December 31:

 

 

 

2012

 

2011

 

2010

 

System operations expenses

 

  $

2.02

 

  $

2.05

 

  $

2.06

 

SG&A expenses

 

2.19

 

2.18

 

2.31

 

Depreciation and amortization (D&A)

 

3.74

 

3.75

 

4.00

 

Impairment charge

 

5.43

 

-    

 

-    

 

Restructuring charge

 

0.44

 

0.10

 

0.02

 

Reorganization items

 

0.85

 

-    

 

-    

 

Other operating expense (income), net

 

-    

 

-    

 

(0.01)

 

 

 

  $

14.67

 

  $

8.08

 

  $

8.38

 

 

 

 

 

 

 

 

 

System operations as a percent of total revenue

 

9.4%

 

9.3%

 

9.5%

 

SG&A as a percent of total revenue

 

10.2%

 

10.0%

 

10.6%

 

D&A as a percent of total revenue

 

17.4%

 

17.2%

 

18.4%

 

Total operating expenses as a percent of total revenue

 

68.6%

 

36.9%

 

38.6%

 

 

Liquidity and Capital Resources

 

Effective March 22, 2011, we entered into a First Amendment (the “First Amendment”) to our bank Credit Facility.  The First Amendment included terms and conditions which required compliance with leverage and interest coverage covenants.  As of September 30, 2012, our actual consolidated leverage ratio was 4.52, which was above the maximum allowable ratio of 4.00.  As such, we were not in compliance with the required consolidated leverage ratio for the quarter ended September 30, 2012.  Effective October 15, 2012, we entered into a Forbearance Agreement and Second Amendment to the Credit Facility (the “Forbearance Agreement”).  Under the terms of the Forbearance Agreement, the lenders agreed to forbear from exercising their respective default-related rights and remedies under the Credit Facility until the earlier of December 17, 2012, or the occurrence of further defaults under the Credit Facility (the “Forbearance Period”).  Through a series of amendments, the forbearance agreement with the lenders was extended until the filing of our prepackaged plan of reorganization under Chapter 11.  As a result of our non-compliance with our debt covenants, our liquidity constraints and our bankruptcy case under Chapter 11 of the Bankruptcy Code, we have classified our outstanding debt obligations, contractually due in April 2014, as current in our consolidated balance sheet as of December 31, 2012.

 

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In consideration of the forbearance, we agreed to certain additional terms and conditions, including the following: (a) the retention of a strategic planning officer, (b) the provision of certain specific information regarding the Company and required management conference calls and meetings, as well as monthly and weekly reports, (c) the elimination of certain available baskets for incurring debt, disposing of property, and making investments, and a limitation of $5,000,000 on indebtedness outstanding and secured by permitted liens to finance the acquisition of fixed or capital assets, (d) the limitation on making capital expenditures to only those made in the ordinary course and not in excess of $10.5 million during the Forbearance Period, and (e) the requirement that the Company maintain Consolidated EBITDA of at least $4,543,000 for the period beginning October 1, 2012 and ending October 31, 2012 and Consolidated EBITDA of at least $8,701,000 for the period beginning October 1, 2012 and ending November 30, 2012.  In addition, the Forbearance Agreement adjusted certain other covenants and definitions of the Credit Agreement.  The Company was also required to pay certain fees and expenses in connection with the Forbearance Agreement.  These interim financial covenants did not extend beyond November and, through a series of amendments, the Forbearance Agreement was extended until approval of the reorganization plan under Chapter 11, at which time the Credit Facility is to be restructured.

 

For 2012, cash provided by operating activities was $58.0 million, and we used $35.6 million of the cash we generated for property and equipment additions.    During the year, we also used cash to repay term loan principal of $37.2 million and we made net borrowings against our revolving line of credit totaling $21.0 million.  We also utilized $4.3 million for payment of preferred stock dividends.  During 2011, cash provided by operating activities was $52.0 million, and we used cash for property and equipment additions of $27.3 million.  During the same period, we prepaid $2.0 million against our Credit Facility, in addition to the required payments totaling $8.5 million.  We also used $5.8 million for preferred stock dividend payments in 2011.  We ended the year with cash of $15.4 million as compared to $14.0 million as of December 31, 2011.

 

In April 2007, we entered into a $675.0 million bank Credit Facility, comprised of a $625.0 million term loan, which was to mature in April 2014, and a $50.0 million revolving loan commitment, which was to mature in April 2013.  The term loan originally required quarterly repayments of $1,562,500, which began September 30, 2007.  The term loan originally bore interest at our option of (1) the bank’s base rate plus a margin of 1.0% or (2) LIBOR plus a margin of 2.0%.  The Credit Facility is collateralized by substantially all of the assets of the Company.

 

Effective March 22, 2011, we entered into the First Amendment to the bank Credit Facility.  The First Amendment modified certain terms of the Credit Facility, including an increase in the permitted consolidated leverage ratio, the creation of a specific preferred stock dividend payment basket and the potential to extend the term beyond its expiration in April 2014.  The restricted payment basket within the First Amendment allowed for dividend payments not to exceed $5,750,000 per year.  The First Amendment also reduced the commitments under the revolving loan commitment, increased the interest rate and required quarterly repayment amount and adjusted other covenants.  In 2011, the Company incurred $2.7 million of debt issuance costs related to certain fees and expenses in connection with this First Amendment.

 

Under the First Amendment, the $50.0 million revolving loan commitment was reduced to $25.0 million.  The First Amendment also required us to make quarterly term loan repayments of $2.5 million, beginning June 30, 2011, through December 31, 2012, and $3.75 million beginning March 31, 2013 through December 31, 2013.  The amended term loan and revolving loan commitment bear interest at our option of (1) the bank’s base rate plus a margin of 4.0% or (2) LIBOR plus a margin of 5.0%.  In addition, a LIBOR floor of 1.5% was established under the First Amendment.

 

The Credit Facility originally provided for the issuance of letters of credit up to $15.0 million, subject to customary terms and conditions.  Under the terms of the First Amendment, this amount was reduced to $7.5 million.  As of December 31, 2012, we had outstanding letters of credit totaling $350,000, which reduces amounts available under the revolving loan commitment.  The lenders are not required to permit the issuance of additional letters of credit under the Credit Facility pursuant to the terms of the Forbearance Agreement.  During 2012, we borrowed $62.0 million under the revolving loan commitment and repaid $41.0 million.

 

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Historically, the Company followed a practice of reducing outstanding debt under our Credit Facility by making prepayments on our debt.  These additional debt payments contributed to our historical debt covenant compliance.  However, during 2012, our practice of making additional debt payments was achieved in part by delaying certain payments to our vendors, including major vendors such as DirecTV and HBO.  During the third quarter of 2012, each of these vendors required us to enter into payment plans.  In order to maintain continued service from these vendors, we entered into forbearance agreements with each of them. Through a series of amendments, the forbearance agreements with each of these vendors were extended until the filing of our prepackaged plan of reorganization under Chapter 11.

 

In December 2012, we announced that we entered into an investment agreement with the Colony Syndicate, pursuant to which the Colony Syndicate agreed to provide $60.0 million of new capital to support a proposed recapitalization of the Company.  In addition, our lenders have agreed to restructure our existing $346.4 million secured credit facility to a new five year term loan, as well as expect to have a revolving line loan commitment in place at that time.  This transaction is being implemented through an expedited Chapter 11 bankruptcy process, at the conclusion of which the Colony Syndicate will become the controlling stockholder of the Company.  The investment agreement contains certain conditions precedent, including closing conditions which are described in more detail in Note 1 of the Consolidated Financial Statements, and terminates on April 30, 2013.  The Company commenced a prepackaged Chapter 11 process in the United States Bankruptcy Court for the Southern District of New York on January 27, 2013.

 

On March 7, 2013, the Bankruptcy Court entered an order confirming the plan.  The plan provides that it will become effective upon the completion of certain conditions precedent, including closing conditions under the investment agreement with the Colony Syndicate.  We expect to have all conditions precedent completed and the transaction closed in late March of 2013.

 

The following sets forth the terms and conditions of the restructuring of the Company’s existing credit agreement.   The restructuring will provide that all outstanding principal of loans under the existing credit agreement, and all accrued and unpaid interest thereon, shall be capitalized and restructured on the closing date of the investment agreement with the Colony Syndicate.

 

It is expected that the new credit agreement will consist of a $346.4 million five year term loan, plus capitalized interest accrued (i) pre-petition and (ii) post-petition through the earlier of the closing date and date that is 90 days after the petition date, in each case at the non-default contract interest rate.  The interest rate is to be 6.75% per annum and the maturity date is to be five years after the closing date.  The principal payments are expected to be 1.00% each year of the outstanding principal amount thereof on the Closing Date, payable in equal quarterly installments.  The financial covenants consisting of a maximum leverage ratio and a minimum interest coverage ratio are to be measured each fiscal quarter-end commencing March 31, 2014.  The credit agreement is to contain mandatory prepayment terms and is to be collateralized by substantially all of the assets of the Company, subject to the priority claims under the revolving credit facility in the following paragraph.  In addition, the credit agreement is to include certain affirmative and negative covenants including compliance with laws and regulations, delivery of financial statements and restrictions on additional indebtedness, liens, sales of assets, restricted payments, capital expenditures and investments.

 

The Company expects to enter into a revolving credit facility agreement of up to $20.0 million, including a $5.0 million sub-limit for letters of credit.  Advances under the revolving credit facility will be limited to the lesser of (a) the sum of (i) up to 85% of eligible accounts receivable, plus (ii) an amount equal to the lesser of (x) $5,000,000 and (y) 75% of the appraised fair market value of Company’s eligible owned real estate; or (b) $20,000,000 minus such reserves as the lender may establish in good faith.  All obligations will be secured by first priority liens on all of Company’s existing and future accounts receivable, inventory, intercompany notes and intellectual property and other intangible assets less a priority claim that DirecTV will have on all accounts receivable related to DirecTV programming or financing and (ii) the Company’s owned real estate.  The revolving credit facility will mature 4.5 years after the closing date and will bear interest at a rate equal to 1-, 2- or 3-month LIBOR plus 225 basis points or Base Rate plus 125 basis points, at the election of the Company.  The revolving credit facility will contain representations and warranties, covenants, and events of default that are usual and customary for similar revolving credit facilities.

 

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Our principal sources of liquidity in future periods will be our cash from operations, the new capital from the Colony Syndicate and the revolving credit facility.  As of December 31, 2012, working capital was negative $386.3 million, compared to negative $18.4 million at December 31, 2011.  Much of this increase is the result of the current classification of our Credit Facility.

 

Our inability to comply with the financial covenants under the Credit Facility, uncertainty over our ability to be in compliance with these covenants in the future, our bankruptcy case under Chapter 11 of the Bankruptcy Code and our liquidity constraints, have raised substantial doubt about our ability to meet our ongoing financial obligations.  We are experiencing significant liquidity constraints and our ability to continue as a going concern is dependent upon maintaining adequate liquidity levels and satisfying our vendor obligations, a successful refinancing or restructuring of our existing Credit Facility, and closing of the new capital agreement with the Colony Syndicate.  These liquidity constraints and our non-compliance with certain of our debt covenants have resulted in there being substantial doubt about our ability to continue as a going concern.

 

The collectability of our receivables is reasonably assured, as supported by our broad customer base.  Our interactive hotel base is well diversified in terms of location, demographics and customer contracts.  We provide our services to various hotel chains, ownership groups and management companies.  In accordance with our hotel contracts, monies collected by the hotel for interactive television services are held in trust on our behalf, thereby limiting our risk from hotel bankruptcies.

 

Obligations and commitments as of December 31, 2012 were as follows (dollar amounts in thousands):

 

 

 

 

 

Payments due by period

 

 

 

 

 

Less than

 

2 – 3

 

4 – 5

 

Over

 

 

 

Total

 

1 year

 

years

 

years

 

5 years

 

Contractual obligations:

 

 

 

 

 

 

 

 

 

 

 

Long-term debt(s)

 

  $

347,267

 

  $

346,691

 

  $

512

 

  $

64

 

  $

-

 

Interest on long-term debt (1)

 

8,267

 

8,250

 

16

 

1

 

-

 

Operating lease payments

 

2,269

 

1,043

 

1,086

 

140

 

-

 

Purchase obligations and royalties (2)

 

5,933

 

3,959

 

1,864

 

110

 

-

 

Minimum royalties (3)

 

1,467

 

724

 

743

 

 

-

 

Total contractual obligations

 

  $

365,203

 

  $

360,667

 

  $

4,221

 

  $

315

 

  $

-

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amount of commitment expiration per period

 

 

 

 

 

Less than

 

2 – 3

 

4 – 5

 

Over

 

 

 

Total

 

1 year

 

years

 

years

 

5 years

 

Other commercial commitments:

 

 

 

 

 

 

 

 

 

 

 

Standby letters of credit

 

  $

350

 

  $

350

 

  $

-

 

  $

-

 

  $

-

 

 

 

 

(1)

Interest payments are estimates based on current LIBOR, Forbearance Agreement interest rates and scheduled debt amortization.

(2)

Consists of open purchase orders and commitments.

(3)

In connection with our programming-related agreements, we may guarantee minimum royalties for specific periods or by individual programming content.  See Note 10 to the Consolidated Financial Statements.

 

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Seasonality

 

Our quarterly operating results are subject to fluctuation, depending upon hotel occupancy rates and other factors, including travel patterns and the economy.  Our hotel customers typically experience higher occupancy rates during the second and third quarters, due to seasonal travel patterns and, accordingly, we historically have higher revenue and cash flow in those quarters.  However, quarterly revenue can be affected by the availability of popular content during those quarters and by consumer purchasing behavior.  We have no control over when new content is released or how popular it will be, or the effect of economic conditions on consumer behavior.

 

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Results of Operations — Years Ended December 31, 2012 and 2011

 

Revenue Analysis.  Total revenue for 2012 was $364.7 million, a $56.6 million or 13.4% decline, compared to $421.3 million in 2011.  The decrease in revenue was primarily from Guest Entertainment, Hotel Services and Advertising revenues, partially offset by increases in revenue from System Sales and Related Services and Healthcare.  The following table sets forth the components of our revenue (dollar amounts in thousands) for the years ended December 31:

 

 

 

2012

 

2011

 

 

 

 

 

Percent

 

 

 

Percent

 

 

 

 

 

of Total

 

 

 

of Total

 

Revenues:

 

Amount

 

Revenues

 

Amount

 

Revenues

 

Hospitality and Advertising Services

 

 

 

 

 

 

 

 

 

Guest Entertainment

 

  $

171,585

 

47.0%

 

  $

222,111

 

52.7%

 

Hotel Services

 

126,739

 

34.8%

 

134,832

 

32.0%

 

System Sales and Related Services

 

48,471

 

13.3%

 

44,020

 

10.4%

 

Advertising Services

 

6,433

 

1.8%

 

9,956

 

2.4%

 

Total Hospitality and Advertising Services

 

353,228

 

96.9%

 

410,919

 

97.5%

 

Healthcare

 

11,461

 

3.1%

 

10,343

 

2.5%

 

 

 

  $

364,689

 

100.0%

 

  $

421,262

 

100.0%

 

 

Hospitality and Advertising Services revenue, which includes Guest Entertainment, Hotel Services, System Sales and Related Services and Advertising Services, decreased $57.7 million or 14.0%, to $353.2 million in 2012 compared to $410.9 million in 2011.  Average monthly Hospitality and Advertising Services revenue per room was $20.70 for 2012, a decrease of 3.1% as compared to $21.36 per room in the prior year.  The following table sets forth information with respect to Hospitality and Advertising Services revenue per room for the years ended December 31:

 

 

 

2012

 

2011

 

Average monthly revenue per room:

 

 

 

 

 

Hospitality and Advertising Services

 

 

 

 

 

Guest Entertainment

 

  $

10.06

 

  $

11.54

 

Hotel Services

 

7.42

 

7.01

 

System Sales and Related Services

 

2.84

 

2.29

 

Advertising Services

 

0.38

 

0.52

 

Total Hospitality and Advertising Services revenue per room

 

  $

20.70

 

  $

21.36

 

 

Guest Entertainment revenue, which includes on-demand entertainment such as movies, television on-demand, music and games, decreased $50.5 million, or 22.7%, to $171.6 million from $222.1 million in 2011.  The decrease in revenue resulted primarily from an 11.3% reduction in the average number of Guest Entertainment rooms served and a 12.8% decline in Guest Entertainment revenue per room.  Guest Entertainment revenue per room decreased due to lower non-theatrical movies, music, games, on-demand television purchases and television Internet access purchases.  As a result, monthly Guest Entertainment revenue for 2012 declined 12.8%, to $10.06 compared to $11.54 for 2011.  Average monthly movie revenue per room was $9.52 for 2012, a 12.5% reduction as compared to $10.88 per room in the prior year.  Non-movie Guest Entertainment revenue per room decreased 18.2%, to $0.54 for 2012, driven by reductions in music, games and on-demand television purchases.

 

Hotel Services revenue, which includes recurring revenue from hotels for cable television programming and Internet service and support, decreased $8.1 million or 6.0%, to $126.7 million during 2012 versus $134.8 million in 2011.  On a per-room basis, monthly Hotel Services revenue for 2012 increased 5.8%, to $7.42 compared to $7.01 for 2011.  Monthly cable television programming revenue per room increased 6.4%, to $6.83 for 2012 as compared to $6.42 for 2011.  These increases resulted primarily from price increases on cable television programming over the prior year period.  Recurring Internet revenue per room for 2012 decreased to $0.55 versus $0.59 for 2011.

 

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System Sales and Related Services revenue includes the sale of cable television programming equipment, Internet equipment, HDTV installations and other services to hotels.  For 2012, revenue increased $4.5 million or 10.1%, to $48.5 million as compared to $44.0 million for 2011.  The increase was driven by programming fees and equipment sales.

 

Advertising Services revenue consists of revenue generated by our advertising services subsidiary.  Revenue decreased 35.4% to $6.4 million during 2012 as compared to $10.0 million for 2011.  This decrease was expected as it was the result of the shutdown of our analog ad insertion platform as part of our transition to a high-definition platform.

 

Healthcare revenue includes the sale of interactive systems and services to healthcare facilities.  Our Healthcare subsidiary revenue increased by 10.8% to $11.5 million for 2012 versus $10.3 million in 2011, primarily from programming and recurring service and maintenance agreement revenues, as the number of beds generating recurring revenue increased 13.7%.  During 2012, we installed 14 facilities and 2,701 beds compared to 12 facilities and 3,707 beds in 2011.

 

Direct Costs (exclusive of operating expenses and depreciation and amortization discussed separately below).  Total direct costs decreased $19.1 million or 8.1%, to $218.2 million in 2012 as compared to $237.3 million in 2011.  Total direct costs were 59.8% of revenue for 2012 as compared to 56.3% for 2011.  Direct costs related to the Hospitality and Advertising Services businesses, which includes Guest Entertainment, Hotel Services, System Sales and Related Services and Advertising Services, were $211.8 million for 2012 compared to $232.2 million in 2011, a decrease of 8.8%.  We had a lower sales volume in Guest Entertainment and Hotel Services, driving lower royalties, hotel commissions and programming fees.  Advertising Services had lower costs during 2012 due to the shutdown of our analog ad insertion platform.

 

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

 

 

 

2012

 

2011

 

 

 

 

 

Percent

 

 

 

Percent

 

 

 

 

 

of Total

 

 

 

of Total

 

 

 

Amount

 

Revenues

 

Amount

 

Revenues

 

Operating expenses:

 

 

 

 

 

 

 

 

 

System operations

 

  $

34,455

 

9.4%

 

  $

39,386

 

9.3%

 

Selling, general and administrative

 

37,340

 

10.2%

 

41,918

 

10.0%

 

Depreciation and amortization

 

63,766

 

17.4%

 

72,235

 

17.2%

 

Impairment charge

 

92,614

 

25.5%

 

-

 

-

 

Restructuring charge (1)

 

7,570

 

2.1%

 

1,923

 

0.4%

 

Reorganization items (2)

 

14,574

 

4.0%

 

-

 

0.0%

 

Other operating expense (income)

 

(32)

 

0.0%

 

31

 

0.0%

 

Total operating expenses

 

  $

250,287

 

68.6%

 

  $

155,493

 

36.9%

 

 

(1)      Restructuring costs are defined as costs associated with the closing, disposal or exit of certain duplicate facilities or operations, including termination benefits and costs to consolidate facilities or relocate employees, and costs associated with a reduction in force, including termination benefits.  The Company will not realize future benefits from these costs.

(2)      Reorganization items consists of $14.6 million of legal and other professional costs incurred related to our Chapter 11 filing and reorganization efforts.

 

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System operations expenses decreased $4.9 million or 12.5%, to $34.5 million in 2012 as compared to $39.4 million in 2011.  The decrease was driven by lower system repair costs, property taxes, and content distribution costs in addition to lower labor and facilities costs due to initiatives implemented to gain operating efficiencies by reducing the number of service operation locations and reorganizing departments and management structure.  As a percentage of total revenue, system operations expenses increased to 9.4% this year as compared to 9.3% in the prior year.  Per average installed room, system operations expenses also decreased, to $2.02 per room per month for 2012 compared to $2.05 for 2011.

 

Selling, general and administrative (“SG&A”) expenses decreased $4.6 million or 10.9%, to $37.3 million in 2012 as compared to $41.9 million in 2011.  The decrease resulted from lower professional services and labor due to initiatives implemented to gain operating efficiencies by reducing the number of service operation locations and reorganizing departments and management structure.  As a percentage of revenue, SG&A expenses were 10.2% in the current year compared to 10.0% in the prior year.  SG&A expenses were $2.19 per average installed room per month in 2012 compared to $2.18 in 2011.

 

Depreciation and amortization expenses were $63.8 million in 2012 as compared to $72.2 million in 2011.  The decline was due to the reduction in capital investments over the past three years, lower cost systems being installed and certain assets becoming fully depreciated.  As a percentage of revenue, depreciation and amortization expenses were 17.4% in 2012 compared to 17.2% in 2011.

 

The declines in Guest Entertainment revenue and room base during 2012 caused the Company to reassess and update our financial plans to reflect these changes in our Hospitality business.  These matters were qualitative factors impacting the recovery of our Hospitality reporting unit goodwill, and triggered an assessment of goodwill on an interim basis during the second quarter of 2012.  As a result of our impairment test, we recorded a non-cash asset impairment charge in our Hospitality segment of $92.6 million for all of the remaining Hospitality goodwill.  In addition, we recorded a $1.4 million non-cash asset impairment charge related to intangible assets in our Hospitality segment under depreciation and amortization expenses.  See Note 6 to the Consolidated Financial Statements.

 

Reorganization items consists of $14.6 million of legal and other professional costs incurred related to our Chapter 11 filing and reorganization efforts.

 

In 2012, we implemented initiatives to gain operating efficiencies by reducing the number of service operation locations and reorganizing departments and management structure.  These initiatives included a reduction in workforce, by approximately 11%, and vacating leased warehouse/office facilities.  As a result of these actions and a change in executive structure, we incurred costs of $7.6 million during 2012.  During 2011, we had costs of $1.9 million related to workforce reduction activities.  Additional accruals and cash payments related to these activities are dependent upon reduction in force or subleasing arrangements, which could change our expense estimates.

 

Operating Income.  As a result of the factors described above, we had an operating loss of $103.8 million in 2012 as compared to operating income of $28.5 million in the prior year.

 

Interest Expense.  Interest expense was $25.3 million in the current year versus $31.2 million in 2011.  The all-in weighted average interest rate was 7.1% for the current year versus 8.4% for 2011.  The decrease resulted from the change in the weighted average outstanding balance of our debt under our Credit Facility and the quarterly payments on our interest rate swap commitment during the first half of 2011 at approximately 5%.  The interest rate swaps expired effective June 30, 2011.  The outstanding balance of our debt under the Credit Facility decreased to $346.4 million at December 31, 2012 from $362.6 million at the end of the prior year.  Interest expense for 2011 included a net $1.5 million non-cash interest gain related to our interest rate swap position.

 

Loss on Early Retirement of Debt.  In 2012, we made additional prepayments on the term loan of $32.0 million and, as result of these prepayments, expensed $0.3 million of unamortized debt issuance costs.  During 2011, we made an additional prepayment of $2.0 million on our term loan.  As a result of this prepayment and the First Amendment to our Credit Facility, we expensed $0.2 million of unamortized debt issuance costs.

 

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Taxes.  During 2011, we recorded a net tax benefit of $2.6 million, consisting of taxes incurred of $0.7 million, primarily for state franchise taxes and foreign income taxes, and a $3.3 million Canadian tax benefit.  Our deferred tax assets decreased $3.3 million because the Company believes it is more likely than not that the deferred tax assets in Canada will not be realized due to changes in expectations and a revision of our forecasts during the fourth quarter of 2012.  In addition, we recorded additional tax expense of $0.4 million, primarily for state franchise taxes and foreign income taxes resulting in a total tax expense of $3.7 million.

 

Net Loss.  As a result of the factors described above, net loss was $134.3 million for 2012 compared to a net loss of $0.6 million in the prior year.

 

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Results of Operations — Years Ended December 31, 2011 and 2010

 

Revenue Analysis.  Total revenue for 2011 was $421.3 million, a $30.9 million or 6.8% decline, compared to 2010.  The decrease in revenue was primarily from Guest Entertainment and Hotel Services revenues, partially offset by increases in revenue from System Sales and Related Services, Healthcare and Advertising Services.

 

Hospitality and Advertising Services revenue, which includes Guest Entertainment, Hotel Services, System Sales and Related Services and Advertising Services, decreased $32.8 million or 7.4%, to $410.9 million in 2011 compared to $443.7 million in 2010.  Average monthly Hospitality and Advertising Services revenue per room was $21.36 for 2011, an increase of 0.3% as compared to $21.29 per room in the prior year.  Guest Entertainment revenue decreased $36.5 million or 14.1%, to $222.1 million in 2011 as compared to $258.6 million in 2010.  Monthly Guest Entertainment revenue for 2011 declined 7.0%, to $11.54 compared to $12.41 for 2010.  Hotel Services revenue decreased $1.3 million or 0.9%, to $134.8 million during 2011 versus $136.1 million in 2010.  System Sales and Related Services revenue for 2011 increased $4.9 million or 12.6%, to $44.0 million as compared to $39.1 million for 2010.  Advertising Services revenue increased $0.1 million or 0.9%, to $10.0 million during 2011 as compared to $9.9 million for 2010.

 

Healthcare revenue increased $1.8 million or 21.4%, to $10.3 million during 2011 as compared to $8.5 million for 2010.

 

Direct Costs (exclusive of operating expenses and depreciation and amortization discussed separately below).  Total direct costs decreased $16.7 million or 6.6%, to $237.3 million in 2011 as compared to $254.0 million in 2010.  Total direct costs were 56.3% of revenue for 2011 as compared to 56.2% for 2010.  The decrease in total direct costs was primarily related to lower royalties, hotel commissions, programming fees and connectivity costs.

 

Operating Expenses.  System operations expenses decreased $3.5 million or 8.3%, to $39.4 million in 2011 as compared to $42.9 million in 2010.  The decrease was driven by lower property taxes, system repair costs and labor from the workforce reductions initiated in the first quarter of 2011.  Selling, general and administrative (“SG&A”) expenses decreased $6.3 million or 12.9%, to $41.9 million in 2011 as compared to $48.2 million in 2010.  The decrease resulted from lower professional services and labor from the workforce reductions initiated in the first quarter of 2011, our first quarter expense mitigation initiative and debt issuance costs incurred during 2010.  Depreciation and amortization expenses were $72.2 million in 2011 as compared to $83.2 million in 2010.  We incurred costs of $1.9 million during 2011 related to workforce reduction activities, while we had workforce reduction costs of $0.4 million during 2010.

 

Operating Income.  As a result of the factors described above, operating income increased to $28.5 million in 2011 as compared to $23.4 million in the prior year.

 

Interest Expense.  Interest expense was $31.2 million in the 2011 versus $33.5 million in 2010.  The all-in weighted average interest rate was 8.4% for the 2011 versus 7.4% for 2010.  The outstanding balance of our debt under the Credit Facility decreased to $362.6 million at December 31, 2011 from $372.5 million at the end of the prior year.  Interest expense for 2011 included a net $1.5 million non-cash interest gain related to our interest rate swap position.  Interest expense for 2010 included $1.5 million of non-cash interest charges related to our interest rate swap position.

 

Loss on Early Retirement of Debt.  In 2011, we made an additional prepayment on the term loan of $2.0 million and, as result of this prepayment and the First Amendment to our Credit Facility, expensed $0.2 million of unamortized debt issuance costs.  During 2010, we made additional prepayments totaling $96.8 million on our term loan and expensed $1.1 million of unamortized debt issuance costs.

 

Taxes.  During 2011, we recorded a net tax benefit of $2.6 million, consisting of taxes incurred of $0.7 million, primarily for state franchise taxes and foreign income taxes, and a $3.3 million Canadian tax benefit.  For 2010, we incurred taxes of $0.8 million, primarily for state franchise taxes and foreign income taxes.

 

Net Loss.  As a result of the factors described above, net loss was $0.6 million for 2011 compared to a net loss of $11.7 million in the prior year.

 

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Critical Accounting Policies

 

Management’s discussion and analysis of financial condition and results of operations are based upon our financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America.  Our primary cost drivers are predetermined rates, such as hotel commissions; license fees paid for major motion pictures and other content or one-time fixed fees for independent films; and cable television programming costs.  However, the preparation of financial statements requires us to make estimates and assumptions which affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period.  We base our estimates on historical experience and on various other assumptions we believe to be reasonable based upon the available information.  The critical policies related to the more significant judgments and estimates used in the preparation of the financial statements are further discussed within the Notes of the financial statements as follows:

 

Ø              Revenue Recognition – footnote #2

Ø              Goodwill and Other Intangible Assets – footnote #6

Ø              Restructuring – footnote #14

 

Recent Accounting Developments

 

In December 2011, the FASB issued ASU No. 2011-11, “Disclosures about Offsetting Assets and Liabilities” (“ASU 2011-11”) and in January 2013 issued ASU No. 2013-01 “Clarifying the Scope of Disclosures About Offsetting Assets and Liabilities.” These standards retain the existing offsetting requirements and enhance the disclosure requirements to allow investors to better compare financial statements prepared under GAAP with those prepared under IFRS. This new guidance is to be applied retrospectively. ASU 2011-11 will be effective for the Company’s quarterly and annual financial statements beginning with the first quarter 2013 reporting. The Company believes that the adoption of ASU 2011-11 and ASU 2013-01 will not have a material impact on its consolidated financial statements.

 

In July 2012, the Financial Accounting Standards Board (“FASB”) issued FASB Accounting Standards Update (“ASU”) No. 2012-02, “Testing Indefinite-Lived Intangible Assets for Impairment,” which is now codified under FASB ASC Topic 350, “Intangibles – Goodwill and Other.”  This ASU allows an entity to first assess qualitative factors to evaluate if the existence of events or circumstances leads to a determination it is more likely than not the indefinite-lived intangible asset is impaired.  After assessing the totality of events or circumstances, if it is determined it is not more likely than not the indefinite-lived asset is impaired, the entity is not required to take further action.  Otherwise, the entity is required to determine the fair value of the indefinite-lived intangible asset and perform the quantitative impairment test by comparing the fair value with the carrying amount in accordance with Topic 350.  An entity has the option to bypass the qualitative assessment for any indefinite-lived intangible asset in any period and proceed directly to performing the quantitative impairment test, and then resume performing the qualitative assessment in any subsequent period.  FASB ASU No. 2012-02 is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted, including for annual and interim impairment test performed as of a date prior to July 27, 2012, provided the public entity’s financial statements for the most recent annual or interim period have not yet been issued.  We do not expect the adoption of this ASU to have an impact on our consolidated financial position, results of operations or cash flows.

 

In February 2013, the FASB issued FASB ASU No. 2013-02, “Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income,” which is now codified under FASB ASC Topic 220, “Comprehensive Income.”  This ASU will require entities to present, either in a note or parenthetically on the face of the financial statements, the effect of significant amounts reclassified from each component of accumulated other comprehensive income based on its source and the income statement line items effected by the reclassification.  If a component is not required to be reclassified, to net income in its entirety, a company would instead cross reference to the related footnote for additional information.  This guidance is effective for public companies for fiscal years, and interim periods within those years, beginning after December 15, 2012.  We are evaluating the disclosure options, and do not expect the adoption of this ASU to have an impact on our consolidated financial position, results of operations or cash flows.

 

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Table of Contents

 

Item 7A - Quantitative and Qualitative Disclosures About Market Risk

 

We are exposed to various market risks, including potential losses resulting from adverse changes in interest rates and foreign currency exchange rates.  We do not enter into derivatives or other financial instruments for trading or speculative purposes.

 

Interest.  At December 31, 2012, we had debt totaling $347.3 million as follows (dollar amounts in thousands):

 

 

 

Carrying

 

Fair

 

 

 

Amount

 

Value

 

Credit Facility:

 

 

 

 

 

Term loan

 

 $

325,407

 

 $

195,244

 

Revolving loan commitment

 

21,000

 

21,000

 

Capital leases

 

860

 

860

 

 

 

 $

347,267

 

 $

217,104

 

 

The fair value of our long-term debt is estimated based on current interest rates for similar debt of the same remaining maturities and quoted market prices, except for capital leases and our revolving loan commitment borrowings, which are reported at carrying value. For our capital leases and revolving loan commitment borrowings, the carrying value approximates the fair value.  In addition, the fair value of our long-term debt is strictly hypothetical and not indicative of what we are required to pay under the terms of our debt instruments.

 

The term loan interest rate as of December 31, 2012 was 8.5%, the revolving loan commitment rate was 9.25%, the capital lease interest rate was 3.4% and our weighted average interest rate for the year ended December 31, 2012 was 7.1%.  As of December 31, 2012, we had capital leases of $0.9 million and variable rate debt of $346.4 million.  For variable rate debt, interest rate fluctuations generally do not affect the fair market value but do impact future earnings and cash flows, assuming other factors are held constant. There would be no impact on earnings and cash flow for the next year resulting from a one percentage point increase to interest rates, assuming other variables remain constant, due to our LIBOR floor of 1.5%.

 

Economic Condition and Consumer Confidence.  Our results are generally connected to the performance of the lodging industry, where occupancy rates may fluctuate resulting from various factors.  Reduction in hotel occupancy and consumer buy rates, resulting from business, general economic or other events, such as a recession in the United States, significant international crises, acts of terrorism, war or public health issues, could adversely impact our business, financial condition and results of operations.  The overall travel industry and consumer buying pattern can be, and has been in the past, adversely affected by weaker general economic climates, geopolitical instability and concerns about public health.

 

Foreign Currency Transactions.  A portion of our revenue is derived from the sale of Guest Entertainment services in Canada and Mexico.  The results of operations and financial position of our operations in Canada and Mexico are measured in their local currencies and translated into U.S. dollars.  The effects of foreign currency fluctuations in Canada and Mexico are somewhat mitigated by the fact expenses and liabilities are generally incurred in the local currency.  The reported income of our Canadian and Mexican subsidiaries will be higher or lower depending on a weakening or strengthening of the U.S. dollar against the local currency. Additionally, a portion of our assets are based in Canada and Mexico and are translated into U.S. dollars at foreign currency exchange rates in effect as of the end of each period.  Accordingly, our consolidated assets will fluctuate depending on the weakening or strengthening of the U.S. dollar against the local currency.

 

Item 8 - Financial Statements and Supplementary Data

 

See “Item 15 – Exhibits and Financial Statement Schedules” for LodgeNet’s Consolidated Financial Statements, the Notes thereto and Schedules filed as a part of this report.

 

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Table of Contents

 

Item 9 - Changes In and Disagreements with Accountants on Accounting and Financial Disclosure

 

None.

 

Item 9A - Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures.  Based on their evaluation as of the end of the period covered by this Annual Report on Form 10-K, the Chief Executive Officer and Chief Financial Officer have concluded the disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) are effective to ensure information required to be disclosed by us in reports we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.  Additionally, our disclosure controls and procedures were also effective in ensuring information required to be disclosed in our Exchange Act reports is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosures.

 

Management’s report on internal control over financial reporting.  Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the Securities Exchange Act of 1934.  Our 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.  Our internal control over financial reporting includes those policies and procedures which (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of assets; (ii) provide reasonable assurance transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets, which could have a material effect on the financial statements.

 

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 controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.

 

Management has assessed our internal control over financial reporting in relation to criteria described in Internal Control — Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission.  Based on this assessment, using those criteria, we concluded that, as of December 31, 2012, our internal control over financial reporting was effective.

 

Changes in Internal Control over Financial Reporting.  There was no change in our internal control over financial reporting during the quarter ended December 31, 2012 which has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

Item 9B - Other Information

 

None.

 

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PART III

 

Item 10 – Directors, Executive Officers and Corporate Governance

 

Identification of Directors

 

The Company’s Certificate of Incorporation and Bylaws provide that the number of directors shall be determined from time to time by the Board of Directors but may not be less than three nor more than nine. The Board of Directors is currently composed of seven members. The Bylaws further provide for the division of the directors into three classes of approximately equal size, with directors in each class elected for a three-year term and approximately one third of the directors elected each year. We expect that all of the directors will resign as of the closing of the investment agreement with the Colony Syndicate.

 

The following table sets forth certain information, as of March 19, 2013, with respect to the directors of the Company.

 

Name

 

Age

 

Principal Occupation or Employment for the Past
Five Years and Principal Qualifications for Serving
as a Director of the Company

 

Year First
Became
Director/ Term
Expires

 

 

 

 

 

 

 

Marty Abbott

 

45

 

President, CEO and Partner/Member of AKF Consulting, LLC, a consulting firm specializing in high-growth Internet startups and high-tech public companies, May 2007 to present; Chief Operations Officer of QUIGO, an advertising technology firm, July 2005 to May 2007; Senior Vice President of Technology / Chief Technology Officer, Ebay, Inc., May 2003 to July 2005.   The principal qualifications that led to Mr. Abbott’s selection as a director include his extensive experience in the development and operation of scalable technical infrastructures, and the development of Internet-based business models.

 

2008/2012

 

 

 

 

 

 

 

R. Douglas Bradbury

 

62

 

Private investor; director of Level 3 Communications, Inc. (LVLT)* a telecommunications and information services company, 2009 to present; former Executive Vice President, RCN Corporation, a provider of digital cable, telephone and high-speed Internet services, October 2003 to March 2004; former Executive Vice President of LVLT, August 1997 to January 2003; former Vice Chairman of the Board of LVLT, February 2000 to January 2003; and former Chief Financial Officer of LVLT, 1997 to 2000.  The principal qualifications that led to Mr. Bradbury’s selection as a director were his extensive financial and operational experience in telecommunications companies.

 

1999/2012

 

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J. Scott Kirby

 

45

 

President, U.S. Airways Group, Inc. (NYSE:LCC)* a holding company whose business activity is the operation of a network of air carriers through its wholly owned subsidiaries, September 2006 to present; Executive Vice President, Sales and Marketing of U.S. Airways Group, Inc. and its wholly owned subsidiary, U.S. Airways, Inc. and its predecessor organization from September 2001 to September 2006;  served in various executive positions with America West Airlines, October 1995  to September 2001.  The principal qualifications that led to Mr. Kirby’s selection as a director include his extensive experience in the airline industry, which is affected by similar economic issues faced by the hospitality industry in which the Company operates.  Mr. Kirby’s qualifications include operational and financial experience relevant to the Company.

 

2008/2013

 

 

 

 

 

 

 

Thomas N. Matlack

 

48

 

Mr. Matlack, CFA is a private investor who has led several venture investments in the areas of media and technology, including Art technology Group, The Ladders, and Telephia.  Mr. Matlack was previously the founder and Managing Partner of Megunticook Management, a venture capital firm that started more than 30 companies.  Prior to Megunticook, he was Chief Financial Officer of The Providence Journal Company.  He serves on the boards of Game Empire Enterprises, Good Men media, and Seismic Games.  He is a graduate of Wesleyan University (BA) and Yale University (MBA).  The principal qualifications that led to Mr. Matlack’s selection as a director was his extensive financial experience and his experience in early-stage companies in the technology and new media space.

 

2010/2014

 

 

 

 

 

 

 

Scott C. Petersen

 

57

 

Former Chairman of the Board, President and Chief Executive Officer of the Company.  Mr. Petersen joined the Company in 1987 as Senior Vice President for Corporate and Legal Affairs, was appointed Executive Vice President and Chief Operating Officer in 1991, was appointed President and Chief Executive Officer in July 1998 and became Chairman of the Board in October 2000.  The principal qualifications that led to Mr. Petersen’s selection as a director include 23 years of experience as a senior officer of the Company, including 14 years as Chief Executive Officer.

 

1993/2013

 

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Vikki Pachera

 

53

 

Chief Executive Officer, The Pachera Group, an executive search firm, March 2007 to present; Chief Executive Officer, Elevation Recruiting, LLC, January 2010 to present; former Partner, Allen Austin Transearch, an executive search firm, July 2006 to March 2007; former Vice President, Global Alliances & Business Development, Hewlett-Packard Company, a technology solutions provider to consumers, businesses and institutions, May 2002 to December 2005; Vice President, Strategic Business Development, Compaq Computer Corporation, December 2000 to May 2002.  The principal qualifications that led to Ms. Pachera’s selection as a director include her extensive experience in business development of technology-based businesses as well as her significant expertise in talent management and compensation matters.

 

2005/2014

 

 

 

 

 

 

 

Scott H. Shlecter

 

60

 

Investment Advisor, Morton Capital Management, a registered investment advisor, August 2009 to present, Managing Director and Portfolio Manager of Kayne Anderson Capital Advisors LP, a registered investment advisor, February 2002 to June, 2009. The principal qualifications that led to Mr. Shlecter’s selection as a director include extensive experience in analyzing the financial performance of real estate investment companies and similar entities holding significant investments in hotels. Mr. Shlecter also has the financial expertise to serve as Audit Committee chairman.

 

2004/2013

 

 

*              Denotes public company.]

 

Committees

 

The Company has standing audit, governance and nominating, and compensation committees of the Board of Directors.  The Audit Committee of the Board of Directors is composed of three non-employee directors who are financially literate in financial and auditing matters and are “independent,” as such term is defined by the NASDAQ listing standards. The Audit Committee of the Board of Directors is composed of Messrs. Shlecter (Chair), Bradbury, and Matlack.  The Audit Committee provides assistance to the Board of Directors in satisfying its responsibilities relating to accounting, auditing, and financial reporting requirements of the Company. The Audit Committee also appoints the independent registered public accounting firm to conduct the annual audit of the Company’s financial statements, oversees the activities of the independent registered public accounting firm and confers with them prior to the release of quarterly earnings.  In addition, the Audit Committee annually evaluates the performance of the Company’s internal controls, and reviews the internal controls with management and the Company’s independent registered public accounting firm.  The Board of Directors has adopted a written charter for the Audit Committee, which is available at the Company’s website at http://www.lodgenet.com.  The Audit Committee met eleven times during 2012.  For further information regarding the Audit Committee, see “Report of the Audit Committee.”

 

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The Compensation Committee of the Board of Directors is composed of Ms. Pachera (Chair) and Messrs. Abbott, and Kirby.  Ms. Pachera and Messrs. Abbott and Kirby are “independent,” as such term is defined by the NASDAQ listing standards.  The Compensation Committee is responsible for establishing compensation policies and for setting compensation levels for the Company’s executive officers.  The Compensation Committee met seven times during 2012.  The Board of Directors has adopted a written charter for the Compensation Committee, which is available at the Company’s website at http://www.lodgenet.com.  For a description of the functions of the Compensation Committee, see “ELECTION OF DIRECTORS - Executive Compensation –Compensation Committee Report.”

 

The Governance and Nomination Committee (the “Governance Committee”) of the Board of Directors is composed of Mr. Bradbury (Chair), Mr. Shlecter and Ms. Pachera, each of whom is considered “independent”, as such term is defined by the NASDAQ listing standards. The Governance Committee oversees corporate governance and Board membership matters and provides assistance to the Board of Directors in any matter involving governance and Board membership issues. The Governance Committee also works with the Company and the Company’s compliance officer on issues concerning the Company’s Code of Business Conduct and Ethics and the Company’s Non-Retaliation Policy. The Governance Committee met two times during 2012.  The Board of Directors has adopted a written charter for the Governance Committee, which is available at the Company’s website at http://www.lodgenet.com.

 

Leadership Structure

 

In May 2012, the Company established the office of an independent chairman, and appointed Mr. Bradbury to serve as Chairman, replacing Mr. Petersen, who also served as President and Chief Executive Officer of the Company.  By appointing an independent chairman, the Company ended its prior practice of appointing a Lead Director, whose responsibilities were subsumed by the Chairman.  The Chairman is responsible for overseeing all aspects of the Board of Directors, including (a) setting the agenda for and leading meetings of the directors and executive sessions of the independent directors (which are held on a regular basis); (b) briefing the CEO on issues arising in the executive sessions; (c) establishing Board agendas in consultation with the officers of the Company and other directors; (d) facilitating discussion among the directors on key issues and concerns outside of Board Meetings; and (e) serving as a non-exclusive conduit to the CEO of views, concerns, and issues of the independent directors.

 

Risk Oversight

 

While the Board has overall responsibility for risk oversight, the charters of each Committee specify the areas of responsibility of the Committee with respect to risk oversight.  For example, the Audit Committee is charged with periodic review with management and the independent accountants of any significant business risks and exposures of the Company and management’s steps to mitigate them.  Similarly, the Compensation Committee is charged with considering whether any aspects of the Company’s compensation plans encourage or incentivize participants to take excessive risks, and the Governance Committee is responsible for oversight and administration of the Company’s Code of Business Conduct and Ethics, and also for periodically reviewing the role of the Board and of Committees in overseeing risk.

 

Section 16(a) Beneficial Ownership Reporting Compliance

 

Under Section 16(a) of the Exchange Act, the Company’s directors, executive officers and any persons holding 10% or more of the common stock are required to report their ownership of common stock and any changes in that ownership to the Securities and Exchange Commission (the “SEC”) and to furnish the Company with copies of such reports. Specific due dates for these reports have been established and the Company is required to report in this Proxy Statement any failure to file on a timely basis by such persons. To the Company’s knowledge, based solely upon a review of copies of such reports received by the Company which were filed with the SEC from January 1, 2012 through March 15, 2013, and upon written representations from such persons that no reports were required, the Company has been advised that all reports required to be filed under Section 16(a) have been timely filed with the SEC with the exception of Initial Reports on Form 3 with respect to executives who were appointed to their respective positions in June 2011, but the failure to file their respective Form 3 reports was not discovered until January 2012, when they received the equity grants following their appointment.

 

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We have adopted a written code of business conduct and ethics, which applies to all employees, including the principal executive officer, principal financial officer and accounting officer, controller or persons performing similar functions and all members of the Board of Directors.  The policies are found on our website, which is http://www.lodgenet.com.

 

The charters of our Audit Committee, Governance and Nominating Committee and Compensation Committee may also be found on our website.

 

Item 11 - Executive Compensation

 

The following table shows the compensation and expense reimbursement paid to each non-employee director during 2012:

 

 

 

2012 Director Compensation

 

Name

Fees
Earned
or
Paid in
Cash
($)

Stock
Awards
($)
(1)

Option
Awards
($)
(2)

Non-Equity
Incentive Plan
Compensation
($)

Change in Pension
Value and
Nonqualified Deferred
Compensation
Earnings
($)(3)

All Other
Compensation
($)

Total
($)

(a)

(b)

(c)

(d)

(e)

(f)

(g)

(h)

Abbott, Marty

20,800

49,910

-

-

-

-

70,710

Bradbury, R. Douglas

48,866

49,910

-

-

-

-

98,776

Haire, John E.(4)

1,200

-

-

-

-

-

1,200

Kirby, J. Scott

20,800

49,910

-

-

-

-

70,710

Matlack, Thomas (5)

16,600

49,910

-

-

-

-

66,510

Pachera, Vikki

28,400

49,910

-

-

-

-

78,310

Petersen, Scott(6)

8,000

49,910

-

-

-

-

57,910

Shapiro, Edward(7)

4,000

-

-

-

-

-

4,000

Shlecter, Scott

39,533

49,910

-

-

-

-

89,443

Spencer, Phillip(8)

13,200

48,205

-

-

-

-

61,405

 

(1)         The amounts in this column represent the aggregate grant date fair value of the restricted stock or restricted stock units granted to non-executive directors computed in accordance with FASB ASC Topic 718.  Each non-executive director (other than Messrs. Haire and Shapiro who retired from the Board on March 27, 2012 and May 10, 2012 respectively) received 32,200 shares of restricted stock or 32,200 restricted stock units in May 2012, one half of which vested on the date of the grant and one half of which will vest on the first anniversary of the grant.  Each award had an aggregate grant date fair value of $49,910 with the exception of the grant made to Mr. Spencer, which had a grant date value of $24,955.  Mr. Spencer also received an additional 15,000 shares of restricted stock in connection with his services as interim CEO, which shares had an aggregate grant date fair value of $23,250.  The detailed methodology for computing these amounts is set forth in Note 12 to the Company’s financial statements as of December 31, 2012.  Mr. Spencer forfeited 31,100 shares upon his resignation in August 2012. The aggregate number of outstanding restricted stock awards held by each non-employee director as of December 31, 2012 consisted of 16,100 shares of restricted stock or restricted stock units.

(2)         The Company did not grant options to its independent directors in 2012, nor were shares forfeited by the directors in 2012 with the exception of 5,000 shares that were forfeited by Mr. Shapiro at the time of his resignation. See note 7 below.  The aggregate number of outstanding option awards held by each non-employee director as of December 31, 2012 was as follows:  Mr. Abbott: 30,000; Mr. Bradbury:  71,000; Mr. Kirby: 30,000; Ms. Pachera: 59,000; Mr. Petersen: 310,000; and Mr. Shlecter: 71,000.

(3)         Represents fees deferred pursuant to the 2006 Non-Employee Directors Fee Plan.

(4)         Mr. Haire retired as a director as of March 27, 2012.

(5)         Mr. Matlack was appointed as a director on May 31, 2012.

(6)         Mr. Petersen resigned as the Company’s President and Chief Executive Officer on May 31, 2012, and after that date served as a non-executive director.

(7)         Mr. Shapiro resigned as a director on May 10, 2012.

(8)         Mr. Spencer was appointed as a director on February 28, 2012, and was appointed to serve as interim CEO from May 31, 2012 until the appointment of Richard L. Battista as President and CEO on September 11, 2012.  He resigned as a director on October 25, 2012.

 

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In May 2008, the Company adopted stock ownership guidelines for the Company’s non-employee directors pursuant to which each non-employee director is expected to acquire over the following five years, if not before, common stock of the Company with a value equal to four times the annual retainer paid to such director.  As a result of decreases on the value of the Company’s common stock, none of the directors met this requirement as of December 31, 2012.

 

Executive Officers

 

Set forth below is certain information concerning the Company’s executive officers, and their ages, as of the date of this Annual Report on Form 10-K:

 

Name and Position

 

Age

 

 

 

Scott C. Petersen, President and Chief Executive Officer

 

57

Phillip M. Spencer, Interim President and Chief executive Officer

 

50

Richard L. Battista, President and Chief Executive Officer

 

48

Frank P. Elsenbast, Senior Vice President, Chief Financial Officer and Interim Co-Chief Executive Officer

 

47

Mark G. Fetcenko, Senior Vice President, Senior Vice President, Technical Operations

 

53

James G. Naro, Senior Vice President, Legal and Human Resources/General Counsel and Interim Co-Chief Executive Officer

 

59

Derek S. White, Senior Vice President, President, Interactive and Media Networks

 

52

 

Scott C. Petersen served as the Company’s Chairman of the Board from January 1, 2012 until May 10, 2012 and as President and Chief Executive Officer from January 1, 2012 through May 31, 2012. Please see Mr. Petersen’s biographical information set forth above.

 

Phillip M. Spencer served as the Company’s Interim President and Chief Executive Officer from May 31, 2012 through September 11, 2012. Please see Mr. Spencer’s biographical information set forth above.

 

Richard L. Battista served as President and Chief Executive Officer of the Company from September 11, 2012 through January 16, 2013.  Prior to joining the Company, Mr. Battista formed Pontiac Digital Media through which he created and invested in media properties with a focus on the digital and content arenas.  Mr. Battista was employed for 20 years with the News Corp/Fox companies in which he held numerous senior management roles across a number of divisions of the company, most recently as Executive Vice President, News Corporation.  Mr. Battista served as Chief Executive Officer of Gemstar-TV Guide International, from 2004-2008.

 

Frank P. Elsenbast has served as the Company’s Chief Financial Officer since April 2010.  He was appointed Interim Co-Chief Executive Officer on January 16, 2013.  Previously, Mr. Elsenbast served as Chief Financial Officer of ValueVision Media, Inc., d/b/a ShopNBC, a multichannel electronic retailer, from 2004 to 2010.

 

Mark G. Fetcenko served as Senior Vice President, Technical Operations from June 1, 2012 to date.  From April 4, 2007 until May 31, 2012, he served as Vice President, Operations.

 

James G. Naro has served as the Company’s Senior Vice President, Legal and Human Resources, General Counsel since August 2008, prior to which he served as Senior Vice President, General Counsel since June 2006. He was appointed Interim Co-Chief Executive Officer on January 16, 2013.  Prior to joining the Company, Mr. Naro served as Vice President, General Counsel and Secretary of Digital Angel Corporation from March 2005 through June 2006. From 2001 to June 2004, Mr. Naro was Senior Vice President and, from 1995 to 2004, General Counsel and Secretary, of DirecTV Latin America, LLC, a provider of pay television services in Latin America and the Caribbean.

 

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Derek S. White has served as a Senior Vice President of the Company and as President of The Hotel Networks, a wholly owned subsidiary of the Company, since February 2008.  He was named President of the Company’s Interactive Media and Networks division in September 2010.  Prior to joining the Company, Mr. White served as Executive Vice President of Alloy, Inc., a NASDAQ-listed company providing targeted media and marketing services, from November, 2001 through February 2008.

 

 

Compensation Discussion and Analysis

 

Introduction

 

The Company recruits executive talent from a broad marketplace, competing with other companies for a variety of disciplines and experience. In order to be competitive for executives in the broad market, the Compensation Committee of the Board of Directors (the “Compensation Committee”) believes that the compensation programs for the Company’s executive officers need to be designed to attract, retain and motivate high-caliber executives.  More specifically, the Compensation Committee’s objectives are to:

 

·                  offer a total compensation opportunity, including base salary, annual incentive bonus and long-term equity, that takes into consideration the compensation practices of other media, technology and similarly-sized companies with which the Company competes for executive talent;

·                  provide an overall compensation opportunity sufficient to attract executives and to retain them;

·      consider whether any aspects of the Company’s compensation plans encourage or incentivize participants to take excessive risks; and

·      provide equity-based, long-term incentives to align the financial interests of the executive officers with those of our stockholders.

 

The specific compensation principles, components, and decisions designed to achieve these objectives are discussed in more detail below.

 

Oversight of Executive Compensation

 

The executive compensation program is administered by the Compensation Committee.  The role of the Compensation Committee is to discharge the Board’s responsibilities relating to compensation of our executive officers and employees.  The specific responsibilities of the Compensation Committee related to executive compensation include:

 

·                  Approving compensation plans for the CEO and executive officers, including

o                 base salary;

o                 annual incentive bonus target opportunities, goals, and payouts;

o                 equity compensation grants;

o                 employment agreements and severance provisions; and

o                 any other benefits or employment arrangements for executives.

·                  Reviewing this Compensation Discussion and Analysis and recommending its inclusion in the Company’s Form 10-K.

 

The Compensation Committee also recommends director compensation to the Board of Directors.

 

More information about the Committee’s structure, roles and responsibilities, and related matters can be found under Corporate Governance and Committees of the Board of Directors, above.

 

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Executive Compensation Philosophy and Core Principles

 

The Company’s compensation structure is designed to attract, retain and motivate high-performing executives.  The Company’s general compensation philosophy is that annual cash compensation should vary based on achievement of financial (such as net income, cash flow generation and new revenue growth) and non-financial (such as strategic and operational, team and individual) performance objectives, and that long-term incentive compensation should be closely aligned with stockholders’ interests through the use of equity awards tied to service and performance.  The Company’s compensation philosophy places a significant portion of compensation at risk based on the performance of the Company and the individual, increasing the portion at risk with the increasing responsibility level of the executive.

 

More specifically, the guiding principles of the Company’s compensation plan design and administration are as follows:

 

·                  Provide a total compensation package that is competitive with the market for talent.

·                  Make executive compensation dependent on Company performance with emphasis on incentive pay.

·                  Provide compensation that rewards superior individual performance, taking into consideration the overall performance and economic condition of the Company.

·                  Increase target bonus opportunities and equity grants as a percentage of total pay with increasing levels of responsibility in the organization.

·                  Ensure the total compensation package is aligned with the interest of our stockholders.

·                  Manage to clear guidelines on each compensation element (base pay, incentive pay and equity awards), but provide the Compensation Committee with the flexibility to make final decisions regarding the CEO and other executive officers based on factors such as experience, contribution to business success, retention needs and extraordinary extenuating circumstances.

·                  Align the compensation of each executive with both the near-term financial performance of the Company based on its annual budget as well as on its long-term shareholder value creation in a manner that does not encourage executives to engage in transactions involving excessive levels of risk.

 

Compensation Committee Process

 

When making individual executive compensation decisions, the Compensation Committee takes many factors into account, including market pay data as well as the geographic location of the Company or the geographic location of the relevant position, each individual’s skill, experience, and impact on the organization, and any retention or recruitment considerations.  The Compensation Committee takes into consideration the CEO’s input and recommendations when evaluating these factors relative to the executive officers other than the CEO.

 

All decisions relating to the CEO’s pay are made by the Compensation Committee in executive session, without management present. In assessing the CEO’s pay, the Compensation Committee considers the performance of the Company, the CEO’s contribution to that performance, and other factors as mentioned above in the same manner as for any other executive.  The Compensation Committee approves the CEO’s salary, payment of any applicable incentive plan compensation (consistent with the terms of the plan as described below) and long-term incentive awards.

 

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The Compensation Committee periodically evaluates the competitive market for pay for the Company’s executives with the assistance of outside professional services firms engaged by the Compensation Committee, as needed. However, while the Compensation Committee engaged Semler-Brossy, a compensation consultant, to assist it in designing an appropriate compensation package for Mr. Battista in 2012, the Company has not conducted a general  evaluation of executive compensation since 2008 because the Company has generally not adjusted the base compensation for any of its Named Executive Officers from the level established in 2008 in light of the Company’s operating results and general wage freeze during the economic recession of 2008 through 2011 with the exception of an increase for Mr. White in connection with his promotion to president of the Company’s Interactive and Media Networks division. Nevertheless, when making a new executive hire, the Compensation Committee informally obtains current market data and data regarding competitive offers to ensure that the Company is offering a compensation package sufficient to attract highly qualified and competent executives.  As each of the Company’s executives reports to the CEO, the CEO assists the Compensation Committee in considering changes to such executives’ compensation in order to take into consideration performance, changes to job responsibilities and other factors with which the CEO is most familiar.

 

Compensation Components

 

The four major components of the Company’s executive officer compensation are:

 

·                  Base salary;

·                  Performance-based annual bonus, which is paid in cash;

·                  Periodic grants of long-term equity-based incentives, and

·                  Other supplemental benefits.

 

Base Salary

 

The Company’s philosophy is that base salaries should meet the objective of attracting, recruiting and retaining the executive talent needed to run the business.  In late 2007, following the completion of the On Command transaction, Mercer was asked to review the base compensation of each Named Executive Officer in light of the transactions and as compared with the data from the peer group described above and the Mercer Compensation Database.  As a result of this analysis, Mercer concluded that the pre-acquisition base compensation of Mr. Petersen was significantly below that of chief executive officers of comparably sized companies and its peer group, and based on Mercer’s recommendation, Mr. Petersen’s base salary was increased in 2008 to the minimum base compensation paid by comparable companies.  Mercer also considered the compensation paid to each of the other executive officers of the Company and concluded that in each case, their compensation was in line with market comparables at that time.

 

The multiple of the CEO’s base compensation compared to the average base compensation of other senior executives of the Company in 2012 was approximately 2.2 times, which the Compensation Committee deemed to be reasonable. From 2008 through 2012, the multiple of the CEO’s base compensation compared to the base compensation of other senior executives of the Company ranged from 1.7 to 2.3 times the average base salary of the other senior executives.  For the purpose of the foregoing computation, the CEO’s base compensation was based on the annual base compensation payable to each of the three CEOs (Messrs. Petersen, Spencer and Battista) for the periods during which each served as CEO during 2012 or $649,370 per annum.

 

As part of a Company-wide plan to control operating expenses during the current economic downturn, none of the named executive officers of the Company appointed prior to 2012 (with the sole exception of Mr. White, who received a salary adjustment in connection with the assumption of additional responsibilities) received base salary adjustments for 2010, 2011 or 2012. Neither Mr. Battista nor Mr. Fetcenko, who were initially appointed to their respective positions in 2012, received salary increases beyond those in effect on the date of their respective appointments.  No decision has been made as of this date to adjust executive base compensation in 2013.

 

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Base salary adjustments can affect the value of other compensation elements.  For example, a higher base salary will result in a higher annual incentive award in dollar terms, assuming the same level of achievement against goals.  Base salaries also affect the level of severance and change in control benefits for all of the Named Executive Officers, as discussed below.

 

In January 2011, the Company implemented a program suspending vacation accruals for all employees.  The amount of accrued vacation ranged from three days for most employees to eight days for the Named Executive Officers other than the CEO and ten days for the CEO.  The purpose of this program was to reduce operating expenses during 2011 to assist the Company in meeting its operating expense targets while maintaining its compliance with the covenants contained in its bank credit facility.  In 2012, the Company implemented additional programs designed to reduce operating expenses, including a five day furlough, the suspension of certain employee benefits, and changes to the Company’s vacation accrual policies.

 

Bonus Plans

 

Recent Bonus History

 

2010 Incentive Compensation:

 

In light of the fact that employees received no base compensation adjustments in 2009 or 2010, and in light of the fact that no management bonuses were paid with respect to 2008 or 2009,  the Compensation Committee established a broad-based cash bonus opportunity for all employees for 2010, including the Named Executive Officers and other management-level employees.  The program established a minimum threshold of $125.5 million in adjusted operating cash flow (“AOCF”) for 2010, which was the target AOCF included in the Company’s 2010 operating plan.  AOCF is defined as operating income (prepared in accordance with GAAP), exclusive of depreciation, amortization, share-based compensation, impairment, restructuring, integration and reorganization expenses and the effects of insurance recoveries.  The Company’s AOCF for the year ended December 31, 2009 was $124.3 million.

 

As the Company did not achieve the minimum targeted AOCF, no payouts were made pursuant to this plan with respect to 2010.

 

2011 Incentive Compensation

 

For the fiscal year ended December 31, 2011, the Compensation Committee determined that no incentive compensation program would be funded unless the Company achieved a target of $104.0 million in Adjusted Operating Cash Flow for the year.  The target bonus for each of the Named Executive Officers was to be as follows:

 

Name

2011Target Incentive Compensation

Scott C. Petersen, CEO

70% of base compensation

Frank P. Elsenbast, CFO

45% of base compensation

James G. Naro

45% of base compensation

Steven R. Pofahl

45% of base compensation

Derek R. White

45% of base compensation

 

As Adjusted Operating Cash Flow for the year was $104.6 million excluding any accrual for incentive compensation, in February 2012 the Compensation Committee decided to award aggregate incentive compensation of $584,000.  The amounts of incentive compensation received in March 2012, with respect to the fiscal year ended December 31, 2011, by each of the Named Executive Officers were as follows:

 

Name

2011 Incentive Compensation

Scott C. Petersen, CEO

$167,895 or 28.7% of base compensation

Frank P. Elsenbast, CFO

$55,760 or 16.4% of base compensation

James G. Naro