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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

[  X  ]  Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended March 31, 2012

or

[       ]  Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from                          to                        

Commission File Number 0-22334

LodgeNet Interactive Corporation

(Exact name of registrant as specified in its charter)

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)

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  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 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.  (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes        No  X  

At May 3, 2012, there were 25,347,609 shares outstanding of the registrant’s common stock, $0.01 par value.

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LodgeNet Interactive Corporation and Subsidiaries

Index

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

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

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Part I — Financial Information

Item 1 — Financial Statements

LodgeNet Interactive Corporation and Subsidiaries

Consolidated Balance Sheets

(Dollar amounts in thousands, except share data)

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

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LodgeNet Interactive Corporation and Subsidiaries

Consolidated Statements of Operations (Unaudited)

(Dollar amounts in thousands, except share data)

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

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LodgeNet Interactive Corporation and Subsidiaries

Consolidated Statements of Comprehensive Income (Unaudited)

(Dollar amounts in thousands)

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

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LodgeNet Interactive Corporation and Subsidiaries

Consolidated Statements of Cash Flows (Unaudited)

(Dollar amounts in thousands)

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

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LodgeNet Interactive Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

Note 1 — Basis of Presentation

The accompanying consolidated financial statements as of March 31, 2012, and for the three month periods ended March 31, 2012 and 2011, have been prepared by us, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (the “Commission”).  The information furnished in the accompanying consolidated financial statements reflects all adjustments, consisting of normal recurring adjustments, which, in our opinion, are necessary for a fair statement of such financial statements.

Certain information and footnote disclosures, normally included in annual financial statements prepared in accordance with generally accepted accounting principles, have been condensed or omitted pursuant to the rules and regulations of the Commission.  Although we believe the disclosures are adequate to make the information presented herein not misleading, it is recommended these unaudited consolidated financial statements be read in conjunction with the more detailed information contained in our Annual Report on Form 10-K for 2011, as filed with the Commission.  The results of operations for the three month periods ended March 31, 2012 and 2011 are not necessarily indicative of the results of operations for the full year due to inherent seasonality within the business, among other factors.

The consolidated financial statements include the accounts of LodgeNet Interactive Corporation and its subsidiaries.  All significant inter-company accounts and transactions have been eliminated in consolidation.

Note 2 — Property and Equipment, Net

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

Note 3 — Goodwill and Other Intangible Assets

Goodwill represents the excess of cost over the fair value of net assets acquired.  In 2007, we recorded goodwill in connection with the acquisitions of StayOnline, On Command and The Hotel Networks.  The product lines of both StayOnline and On Command shared the same operating and economic characteristics as our pre-acquisition product lines, and were integrated into the Hospitality operating segment.

Effective January 1, 2012, we adopted Financial Accounting Standards Board (“FASB”) Accounting Standards Update (“ASU”) No. 2011-08, “Testing Goodwill for Impairment,” which is now codified under FASB Accounting Standards Codification (“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 necessary to perform the current two-step test.  After assessing the totality of events or circumstances, if it is determined it is more likely than not the fair value of a reporting unit is less than its carrying amount, then the two-step impairment test must be performed for that reporting unit or units.  An entity has the option to bypass the qualitative assessment for any reporting unit in any period and proceed directly to the two-step impairment test, and then resume performing the qualitative assessment in any subsequent period.

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Per FASB ASC Topic 350, our goodwill is not amortized; rather, it is tested for impairment annually or if there is a triggering event which indicates the carrying value may not be recoverable.  The goodwill impairment test is a two step test; the first step compares a reporting unit’s fair value to its carrying amount.  If the carrying amount is positive and does not exceed the reporting unit’s fair value, no impairment loss exists.  If the carrying amount exceeds the reporting unit’s fair value, the second step (Step 2) is to be performed.  Reporting units with zero or negative carrying amounts are required to perform Step 2 of the goodwill impairment test if it is more likely than not goodwill impairment exists.  In considering whether it is more likely than not that an impairment loss exists, we evaluate qualitative factors, including the same factors presented in existing guidance which would trigger an interim impairment test of goodwill.  Factors include a significant deterioration in market conditions, unanticipated competition, loss of key personnel or an anticipated sale of a reporting unit.  If an entity determines it is more likely than not that impairment exists, Step 2 of the impairment test must be performed for that reporting unit or units.  Step 2 involves allocating the fair value of the reporting unit to each asset and liability, with the excess being implied goodwill.  An impairment loss results if the amount of recorded goodwill exceeds the implied goodwill.

We perform our annual goodwill impairment test for each reporting unit during the fourth quarter.  During the first quarter of 2012, we did not encounter events or circumstances which could trigger an impairment of our goodwill or intangible assets, and the adoption of the additional provisions of FASB ASC Topic 350, as noted above, has not had an impact on our consolidated financial position, results of operations or cash flows.  The determination of fair value requires us to make significant estimates and assumptions.  These estimates may differ from actual results due to inherent uncertainty, such as deterioration in market conditions, prohibiting expected revenue recovery levels.  Our revenue is closely linked to the performance of products and services sold to business and leisure travelers.  A significant slow-down in economic activities impacting the travel and lodging industry, consumer conservatism and other market dynamics, including hotel room loss, a decline in Guest Entertainment revenue, new technologies and increased competition, could adversely impact our business, financial conditions, results of operations and cash flows.  Certain costs within the reporting units are fixed in nature; therefore, changes in revenue which exceed or fall below the fixed cost threshold would have an effect on cash flow and recoverability of goodwill.  Consequently, our goodwill may be impaired if the market conditions deteriorate, revenues and profits decline in a persistent fashion or the capital market erodes.

The carrying amount of goodwill by reportable segment was as follows (dollar amounts in thousands):

We have intangible assets consisting of certain acquired technology, patents, trademarks, hotel contracts, customer relationships, studio agreements and licensee fees.  These intangible assets have been deemed to have finite useful lives and are amortized over their current estimated useful lives, ranging from 2 to 20 years.  We review the intangible assets for impairment when triggering events occur or a change in circumstances, such as a significant deterioration in market conditions, warrant modifications to the carrying amount of the assets.

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We had the following intangible assets (dollar amounts in thousands):

We recorded amortization expense of $1.8 million and $2.0 million, respectively, for the three months ended March 31, 2012 and 2011.  We estimate total amortization expense for the nine months remaining in 2012 and the years ending December 31 as follows (dollar amounts in millions): 2012 - $5.0; 2013 - $6.6; 2014 - $6.4; 2015 - $6.3; 2016 - $6.2 and 2017 - $5.9.  Actual amounts may change from such estimated amounts due to additional intangible asset acquisitions, potential impairment, accelerated amortization or other events.

Note 4 — Earnings Per Share Computation

We follow FASB ASC Topic 260, “Earnings Per Share,” which requires the computation and disclosure of two earnings per share (“EPS”) amounts, basic and diluted.  Basic EPS is computed based on the weighted average number of common shares actually outstanding during the period.  Diluted EPS is computed based on the weighted average number of common shares outstanding plus all potentially dilutive common shares outstanding during the period.  Potential common shares which have an anti-dilutive effect are excluded from diluted earnings per share.  The provisions of FASB ASC Topic 260 also provide that unvested share-based payment awards which contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method.  We determined our outstanding shares of non-vested restricted stock are participating securities.

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The following table reflects the calculation of weighted average basic and fully diluted shares for the periods ended March 31.  Dollar amounts are in thousands, except share data:

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Note 5 — Accrued Expenses

Accrued expenses were comprised as follows (dollar amounts in thousands):

Note 6 — Long-term Debt and Credit Facilities

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

Bank Credit Facility ¾  In April 2007, we entered into a $675.0 million bank Credit Facility, comprised of a $625.0 million term loan, which matures in April 2014, and a $50.0 million revolving loan commitment, which matures 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 term loan is collateralized by substantially all of the assets of the Company.

Effective March 22, 2011, we entered into a First Amendment (the “Amendment”) to the bank Credit Facility.  The 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 current expiration in April 2014.  The restricted payment basket within the Amendment allows for dividend payments not to exceed $5,750,000 per year.  In 2011, the Company incurred $2.7 million of debt issuance costs related to certain fees and expenses in connection with this Amendment.

Under the Amendment, the $50.0 million revolving loan commitment was reduced to $25.0 million.  The Amendment also requires us to make quarterly term loan repayments of $2.5 million, which began 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 Amendment.

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The Amendment includes terms and conditions which require compliance with leverage and interest coverage covenants.  As of March 31, 2012, our consolidated leverage ratio was 3.67 compared to the maximum allowable ratio of 4.00 and our consolidated interest coverage ratio was 2.68 compared to the minimum allowable ratio of 2.25.  Per the Amendment, the maximum allowable consolidated leverage ratio will remain at 4.00 until September 30, 2012, when it will change to 3.75 for the quarters ending December 31, 2012 through June 30, 2013.  It will then drop to 3.50 for the quarter ending September 30, 2013 until maturity.  The minimum allowable consolidated interest coverage ratio will continue to be 2.25 until maturity.

The Credit Facility also requires we notify the agent upon the occurrence of a “Material Adverse Effect” prior to any draw on the Company’s revolving loan commitment, as such terms are defined and used within our bank Credit Facility.  However, under the Credit Facility, the provision of such a notice is not an event of default, but if such an event occurred, it could restrict the Company’s ability to obtain additional financing under the revolving loan commitment.  The original Credit Facility also stipulated we enter into hedge agreements to provide at least 50% of the outstanding term loan into a fixed interest rate for a period not less than two years.  Our fixed rate swap agreements expired in June 2011 (see Note 13).  The Amendment did not require us to enter into any hedge agreements.  The term loan interest rate as of March 31, 2012 was 6.5%.  The weighted average interest rate for the quarter ended March 31, 2012 was 6.6%.  As of March 31, 2012, we were in compliance with all financial covenants required by our bank Credit Facility.

Our ability to remain in compliance with those covenants will depend on our ability to generate sufficient Consolidated EBITDA (a term defined in the Amendment) and to manage our capital investment and debt levels.  We continue taking actions within our control to manage our debt level and remain in compliance with our debt covenants.  The actions within our control include our management of capital investment, working capital and operating costs and exploring other alternative financing.  Our ability to continue to comply with our current covenants is subject to the general economic climate and business conditions beyond our control.  The uncertainties impacting travel and lodging, in addition to the constraints in the credit markets, consumer conservatism and other market dynamics, including technological changes, may continue to negatively impact our planned results and required covenants.  If we are not able to remain in compliance with our current debt covenants and our lenders will not amend or waive covenants with which we are not in compliance, the debt would be due, we would not be able to satisfy our financial obligations and we would need to seek alternative financing.  If we were not able to secure alternative financing, this would have a substantial adverse impact on the Company and our ability to continue our operations.

During the first quarter of 2012, we made a prepayment of $15.0 million on the term loan, along with the required payment of $2.5 million.  We expensed $0.2 million of debt issuance costs related to the prepayment.

In the first quarter of 2011, we made our required quarterly payment of $1.0 million, prepaid $2.0 million on the term loan and expensed $0.2 million of debt issuance costs related to the prepayment and the Amendment described above.

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 Amendment, this amount was reduced to $7.5 million.  As of March 31, 2012, we had outstanding letters of credit totaling $350,000, which reduce amounts available under the revolving loan commitment.  During the first quarter of 2012, we borrowed $10.0 million under the revolving loan commitment and repaid the entire amount during the quarter.

Capital Leases — As of March 31, 2012, we had total capital lease obligations of $1.2 million.  We acquired approximately $0.6 million of equipment under capital lease arrangements during the three months ended March 31, 2012.  Our capital lease obligations consist primarily of vehicles used in our field service operations.

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As of March 31, 2012, long-term debt had the following scheduled maturities for the nine months remaining in 2012 and the full years ending December 31, 2013 and after (dollar amounts in thousands):

We do not utilize special purpose entities or off-balance sheet financial arrangements.

Note 7 ¾  Comprehensive Income

FASB ASC Topic 220, “Comprehensive Income,” provides standards for reporting and disclosure of comprehensive income and its components.  Comprehensive (loss) income reflects the changes in equity during a period from transactions related to foreign currency translation adjustments for the periods ended March 31, 2012 and 2011, and our interest rate swap arrangements for the period ended March 31, 2011.  Effective January 1, 2012, we adopted FASB ASU No. 2011-05, “Presentation of Comprehensive Income,” which is now codified under FASB ASC Topic 220.  This guidance gives entities two options for presenting the total of comprehensive income, the components of net income and the components of other comprehensive income.  We elected to present two separate, but consecutive statements, presenting: each component of and a total of net income; each component of and a total of other comprehensive income; and a total of comprehensive income.  Effective January 1, 2012, we also adopted FASB ASU No. 2011-12, “Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05,” which is now codified under FASB ASC Topic 220.  This ASU deferred certain aspects of FASB ASU No. 2011-05 while the FASB redeliberates the requirement to measure and present reclassification adjustments from accumulated other comprehensive income to net income by income statement line item in net income and also in other comprehensive income.

Accumulated other comprehensive income, as shown on our Consolidated Balance Sheets, consisted of foreign currency translation adjustments as of March 31, 2012 and December 31, 2011.

Note 8 ¾ Statements of Cash Flows

Cash is comprised of demand deposits.  Cash paid for interest was $6.0 million and $8.0 million, respectively, for the three months ended March 31, 2012 and 2011.  Cash paid for taxes was $57,000 and $93,000 for the three months ended March 31, 2012 and 2011, respectively.

Note 9 — Share-Based Compensation

We account for our stock option and incentive plans under the recognition and measurement provisions of FASB ASC Topic 718, “Compensation — Stock Compensation,” which require the measurement and recognition of compensation expense for all stock-based awards based on estimated fair values, net of estimated forfeitures.  Share-based compensation expense recognized in the three months ended March 31, 2012 and 2011 includes compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of this Topic.

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The following amounts were recognized in our Consolidated Statements of Operations for share-based compensation plans for the periods ended March 31 (dollar amounts in thousands):

For the three months ended March 31, 2012 and 2011, cash received from stock option exercises was $10,000 and $5,000, respectively.  Due to our net operating loss tax position, we did not recognize a tax benefit from options exercised under the share-based payment arrangements.  The amounts presented in the table above are included as non-cash compensation in our cash flow from operating activities.

Stock Options

For the three months ended March 31, 2012, we did not grant any stock options to non-employee directors of the Company; however, we did grant 217,500 stock options to certain officers and employees.  The valuation methodology used to determine the fair value of the options issued during the quarter was the Black-Scholes-Merton option-pricing model.  The Black-Scholes-Merton model requires the use of exercise behavior data and the use of a number of assumptions, including volatility of the stock price, the weighted average risk-free interest rate and the weighted average expected life of the options.  We do not pay dividends on our common stock; therefore, the dividend rate variable in the Black-Scholes-Merton model is zero.

Restricted Stock

For the three months ended March 31, 2012, we did not award any shares of time-based or performance-based restricted stock to our non-employee directors; however, we did award 60,000 shares of time-based restricted stock to certain officers pursuant to our 2003 Stock Option Incentive Plan.  The shares will vest over four years from the date of grant, with 50% vested at the end of year three and 50% vested at the end of year four.  The fair value of the restricted stock is equal to the fair market value, as defined by the terms of the 2003 Plan, on the date of grant and is amortized ratably over the vesting period.  In the first quarter of 2012, we did not issue any performance-based restricted stock to our officers.

Note 10 — Restructuring

In 2012, we implemented a reorganization initiative to gain operating efficiencies by reducing the number of service operation locations.  This initiative included a reduction in workforce and vacating leased warehouse/office facilities.  As a result of this action, we incurred $0.6 million of costs during the three months ended March 31, 2012, related to our Hospitality and Advertising Services businesses.  As a result of the 2011 initiative to gain operating efficiencies by reorganizing departments and reducing layers of management, we incurred $1.2 million of costs during the three months ended March 31, 2011.  All such costs are included in operating expenses on the Consolidated Statements of Operations. 

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Liabilities associated with our restructuring activities to date, along with charges to expense and cash payments, were as follows (dollar amounts in thousands):

Note 11 — Fair Value Measurements

We follow the fair value measurement and disclosure provisions of FASB ASC Topic 820, “Fair Value Measurements and Disclosures,” relating to financial and nonfinancial assets and liabilities.  The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for such asset or liability.  FASB ASC Topic 820 includes a fair value hierarchy, which is intended to increase consistency and comparability in fair value measurements and related disclosures.  The fair value hierarchy is based on inputs to valuation techniques, which are used to measure fair value and which are either observable or unobservable.  Observable inputs reflect assumptions market participants would use in pricing an asset or liability based on market data obtained from independent sources, while unobservable inputs reflect a reporting entity’s pricing based upon their own market assumptions.  The fair value hierarchy consists of the following three levels:

Level 1: Quoted market prices in active markets for identical assets or liabilities.

Level 2: Observable market-based inputs or unobservable inputs that are corroborated by market data.

Level 3: Unobservable inputs that are not corroborated by market data.

Effective January 1, 2012, we adopted FASB ASU No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs,” which is now codified under FASB ASC Topic 820.  This new guidance provides common requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. generally accepted accounting principles (“GAAP”) and International Financial Reporting Standards (“IFRSs”).  Certain fair value measurement principles were clarified or amended in this ASU, such as the application of the highest and best use and valuation premise concepts.  New and revised disclosure requirements include: quantitative information about significant unobservable inputs used for all Level 3 fair value measurements and a description of the valuation processes in place, as well as a qualitative discussion about the sensitivity of recurring Level 3 fair value measurements; public companies will need to disclose any transfers between Level 1 and Level 2 fair value measurements on a gross basis, including the reason(s) for those transfers; a requirement regarding disclosure on the highest and best use of a nonfinancial asset; and a requirement that all fair value measurements be categorized in the fair value hierarchy with disclosure of that categorization.

Financial Assets and Financial Liabilities ¾  The estimated carrying and fair values of our financial instruments in the financial statements were as follows (dollar amounts in thousands):

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The fair value of our long-term debt is classified as Level 2 and is estimated based on current interest rates for similar debt of the same remaining maturities and quoted market prices, except for capital leases, which are reported at carrying value.  For our capital leases, the carrying value approximates the fair value.  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.

Nonfinancial Assets and Nonfinancial Liabilities ¾  Certain assets and liabilities measured at fair value on a non-recurring basis could include nonfinancial assets and nonfinancial liabilities measured at fair value in the goodwill impairment tests and intangible assets and other nonfinancial long-lived assets measured at fair value for impairment assessment.  There was no triggering event which warranted an evaluation of impairment; therefore, there were no nonfinancial assets or liabilities measured at fair value on a non-recurring basis during the three months ended March 31, 2012.

Note 12 — Segment Information

We operate in three reportable segments, Hospitality, Advertising Services and Healthcare.  We organize and manage our segments based upon the products and services delivered and the nature of our customer base receiving those products and services.  The Hospitality business distributes entertainment, media and connectivity services to the hospitality industry.  Our Advertising Services business generates revenue from the sale of advertising-based media services within our hospitality customer base, utilizing the same server-based technology or by satellite transmission.  Our Healthcare business generates revenue from the sale of interactive system hardware, software licenses, installation services and related programming and support agreements to the healthcare market.

Our Hospitality and Advertising Services businesses provide a variety of interactive and media network services to hotels and/or the respective hotels’ guests.  The products can include interactive video-on-demand programming, music, games, cable television programming, Internet services or advertising services, and have an analogous consumer base.  All products and services are delivered through a proprietary system platform utilizing satellite delivery technology, and are geared towards the hotels and their guests.

The accounting policies of the segments are the same as those described in the summary of significant accounting policies, except certain expenses are not allocated to the segments.  These unallocated expenses are corporate overhead, depreciation and amortization expenses, restructuring charges, other operating income (expense), interest expense, loss on the early retirement of debt, other income (expense) and income tax expense.  We evaluate segment performance based upon operating profit and loss before the aforementioned expenses.

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Financial information related to our reportable segments for the three months ended March 31 was as follows (dollar amounts in thousands):

Note 13 — Derivative Information

We follow the provisions of FASB ASC Topic 815, “Derivatives and Hedging Activities,” which establish accounting and disclosure standards regarding a company’s derivative instruments and hedging activities.

We were required by our original Credit Facility to convert 50% of the outstanding term loan into a fixed interest rate for a period not less than two years.  Our objective of entering into hedge transactions (or interest rate swaps) using derivative financial instruments was to reduce the variability of cash flows associated with variable-rate loans and comply with the terms of our Credit Facility.  As changes in interest rates impact future interest payments, the hedges provided an offset to the rate changes.  The swap agreements expired in June 2011.  The Amendment to our Credit Facility did not require us to enter into any hedge agreements.

In April 2007, we entered into interest rate swap agreements with notional values of $312.5 million, at a fixed rate of 5.09%, and $125.0 million, at a fixed rate of 4.97%, both of which expired in June 2011.  These swap arrangements effectively changed the underlying debt from a variable interest rate to a fixed interest rate for the term of the swap agreements.  All of the swap agreements were issued by Credit Suisse International.  The swap agreements were designated as, and met the criteria for, cash flow hedges and were not considered speculative in nature.

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With our amended Credit Facility, our interest rate swaps ceased to be effective and hedge accounting was discontinued effective March 22, 2011 and going forward, primarily related to the LIBOR floor of 1.5% as established under the Amendment.  As a result, our deferred losses of $4,928,000 recorded in other comprehensive income were frozen and were amortized into earnings over the original remaining term of the hedged transaction.  All subsequent changes in the fair value of the swaps were recorded directly to interest expense.  For the three months ended March 31, 2011, we recorded a loss of $448,000 related to nine days of amortization of our deferred losses and a gain of $1,193,000 related to the change in fair value of the interest rate swaps.  The net amount of $745,000 is a non-cash gain and did not impact the amount of cash interest paid during the quarter.

A summary of the effect of cash flow hedges on our financial statements for the three months ended March 31, 2011 was as follows (dollar amounts in thousands):

Note 14 ¾ Perpetual Preferred Stock Dividend

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.  Dividend payments not to exceed $5,750,000 in any fiscal year are allowable under the restricted payment basket as defined within the Amendment to our Credit Facility.

Dividends were declared on the preferred stock by our Board of Directors.  We had $1.4 million of unpaid dividends as of March 31, 2012.  The dividends were recorded as a reduction to additional paid-in capital, due to our accumulated deficit balance.  These dividends were paid on April 16, 2012.

Note 15 ¾ Legal Proceedings

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

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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.  On April 5, 2012, the Texas action was dismissed, and a similar action was filed in the Central District of California.  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 our consolidated financial position, results of operations or cash flows.

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Item 2 — 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.

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 elsewhere in this Report and in Item 1A of our most recent Annual Report on Form 10-K for the year ended December 31, 2011 and filed on March 15, 2012, in any prospectus supplement or any report or document incorporated herein by reference, such factors include, among others, the following:

             the effects of general economic and financial conditions;

             the economic condition of the hospitality industry, which can be particularly affected by general economic and financial conditions, as well as by factors such as high gas prices, levels of unemployment, consumer confidence, acts or threats of terrorism and public health issues;

             decreases in hotel occupancy, whether related to economic conditions or other causes;

             competition from providers of similar services and from alternative sources;

             changes in demand for our products and services;

             programming costs, availability, timeliness and quality;

             technological developments by competitors;

             developmental costs, difficulties and delays;

             relationships with clients and property owners;

             the impact of covenants contained in our credit agreement, compliance with which could adversely affect capital available to finance growth, and the violation of which would constitute an event of default;

             changes to government laws and regulations and industry compliance standards;

             potential effects of litigation;

             risks of expansion into new markets and territories;

             risks related to the security of our data systems; and

             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.

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 March 31, 2012, we provided interactive media and connectivity services to approximately 1.6 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 March 31, 2012, our systems were installed in 72 healthcare facilities, representing approximately 16,700 beds.

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The Company experienced a 12.1% decrease in total revenue for the first quarter of 2012, to $94.7 million, a decrease of $13.0 million compared to the first quarter of 2011.  The decrease was primarily due to an 11.9% decline in the number of Guest Entertainment rooms served and also by a 1.5% decline in Hospitality and Advertising Services revenue per room.  Guest Entertainment revenue per room decreased 11.3% period over period, while revenue generated from non-Guest Entertainment services increased 10.8%.  Revenue generated from non-Guest Entertainment services comprised 51.4% of total revenue for the quarter.

Guest Entertainment revenue decreased $12.8 million or 21.8%.  The decrease in Guest Entertainment revenue resulted primarily from an 11.9% reduction in the average number of Guest Entertainment rooms served period over period and an 11.3% decline in Guest Entertainment revenue per room, which was primarily caused by a decline in revenue from Hollywood and non-theatrical movies.  The majority of room reductions were attributable to hotel customers who did not switch to a different interactive television provider, but chose to limit their media offering to only free television content.  The decline in revenue per room was due to several factors, including the top box office movies experiencing less popularity than the prior year, certain merchandising and promotional pricing initiatives which, in some cases, had a negative impact on revenue and reduced purchase frequency of mature content.  We are engaged in a comprehensive review of the issues impacting Guest Entertainment revenues.  This review includes all operating parameters impacting current performance, including recent marketing and pricing changes, modifications to the user interface and changes to content offerings, as well as general environmental factors.

Hotel Services revenue was $32.1 million in the current quarter, a decline of 7.6% versus the prior year period, primarily due to a 9.4% decline in the number of rooms receiving cable television programming services.  On a per-room basis, Hotel Services revenue increased 5.1% quarter over quarter, driven primarily by an increase in the number of rooms receiving high definition (“HD”) cable television programming service and the expiration of contracts with unfavorable terms.  System Sales and Related Services revenue per room improved 45.4%, related to professional services work, television programming system sales and service-related revenue and programming fees.  Our advertising services subsidiary generated revenue of $1.3 million, a decrease of 49.2% compared to the first quarter of 2011.  This decline was expected, due to the previously announced transition of our current analog Superblock platform to an expanded HD advertising platform, targeted to begin operation in early 2013.  Our Healthcare subsidiary generated $2.9 million of revenue during the first quarter of 2012, an increase of $1.0 million or 53.2%, driven by increased system installation revenue and a 31.5% increase in the number of beds receiving our recurring services.

Our total direct costs decreased $3.7 million or 6.1% period over period, to $56.6 million in the first quarter of 2012 as compared to $60.3 million in the first quarter of 2011.  The decrease in total direct costs was primarily due to lower sales volume in Guest Entertainment and Hotel Services, resulting in lower royalties, hotel commissions and programming fees.  Advertising Services direct costs were lower due to the transition to our new advertising platform.  Gross margins decreased to 40.2% for the first quarter of 2012, compared to 44.0% for the prior year period.

System operations expenses and selling, general and administrative (“SG&A”) expenses decreased $1.7 million or 8.3% quarter over quarter, to $18.1 million in the first quarter of 2012 compared to $19.8 million in the prior year quarter.  Factors driving the improvement period over period include reduced system repair costs, content distribution costs, professional services and facilities expenses and our first quarter expense reduction initiatives, which included the reduction of personnel and other payroll-related expenses with a first quarter benefit of $1.5 million.  These changes will result in modest expense reductions going forward.  Depreciation and amortization expenses decreased 22.5%, to $15.2 million in the first quarter of 2012 versus $19.6 million in the first quarter of 2011.  The improvement was due to assets becoming fully depreciated, lower cost systems being installed and the reduction in capital investment levels over the past three years.  As a result of the factors noted above, operating income was $4.2 million in the first quarter of 2012 compared to $6.9 million in the prior year quarter.

We generated $22.8 million of cash from operating activities, an 18.4% increase as compared to $19.2 million in the first quarter of 2011.  Cash used for capital investments was $9.2 million in the first quarter of 2012.  In March 2012, we made the required quarterly payment of $2.5 million on our term loan and prepaid $15.0 million.

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We continued to make progress on our strategic initiatives, such as Envision, and diversifying our business during the first quarter of 2012.  Hotel adoption of Envision, our cloud-connected interactive television system, continues to grow, which is driving the conversion of the room base to our higher revenue, HD platform and creating new subscription-based revenues.  As of March 31, 2012, our Envision platform was installed in over 43,000 rooms, with over 71,000 total rooms under contract.  Our LodgeNet Mobile App was launched during the quarter, expanding our relationship with the traveler beyond the guest room television.  The App is available in over 570,000 rooms as of March 31, 2012.  During the quarter, we upgraded or installed nearly 17,000 rooms with HD interactive systems.  These additional rooms brought us to over 326,000 HD rooms installed at the end of the first quarter, representing 22.5% of our Guest Entertainment room base.  Our HD platform continues to generate over 60% more revenue per room versus our analog base. In addition, the average cost to install a HD room has declined 24.7% quarter over quarter, to $140 per room, due to lower component and labor costs.

Hospitality and Advertising Services Businesses

Our Hospitality and Advertising Services businesses include television content sold to hotels and/or the respective hotels’ guests.  The products can include interactive video-on-demand (VOD), cable television programming, Internet services or advertising services, and have an analogous consumer base.  All products and services are delivered through a proprietary system platform having related satellite communication technology, and are geared towards the hotels and their guests.

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 48.6% of total revenue for the quarter ended March 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:

·      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.

·      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.

·      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:

·      The number of rooms equipped with our interactive high-definition television (“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 us to invest in HD televisions and equipment.  We are focused on accelerating the installation of our iHDTV systems as hotels increase their purchase of HD televisions.

·      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 our revenue and profitability.

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·      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.

·      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.

·      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 websites 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®.

·      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:

·      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;

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

·      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