10-K 1 a2043426z10-k.txt 10-K ================================================================================ 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, 2000 or ================================================================================ [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 Commission File Number: 0-22334 LODGENET ENTERTAINMENT 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 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment to this Form 10-K. [ ] As of March 23, 2001, the aggregate market value of the common stock held by non-affiliates of the Registrant was approximately $158,500,000 based on the March 23, 2001 closing price of $14.00. The number of shares of common stock of the Registrant outstanding as of March 23, 2001 was 12,212,439 shares. DOCUMENTS INCORPORATED BY REFERENCE - Portions of the Registrant's definitive proxy statement for the 2000 Annual Meeting of Stockholders, which will be filed within 120 days of the fiscal year ended December 31, 2000, are incorporated by reference in Part III of this Form 10-K. TABLE OF CONTENTS Item 1 - Business.........................................................................................1 Overview.........................................................................................1 Markets and Customers............................................................................2 Services and Products............................................................................2 Operations.......................................................................................4 Competition......................................................................................6 Business Strategy................................................................................7 Regulation.......................................................................................8 Employees........................................................................................9 Item 2 - Properties.......................................................................................9 Item 3 - Legal Proceedings................................................................................9 Item 4 - Submission of Matters to a Vote of Security Holders..............................................9 Item 5 - Market for Registrant's Common Equity and Related Stockholder Matters............................10 Dividends........................................................................................10 Stockholder Rights Plan..........................................................................10 Item 6 - Selected Financial Data..........................................................................12 Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations............14 Item 7A - Quantitative and Qualitative Disclosures About Market Risk......................................23 Item 8 - Financial Statements and Supplementary Data......................................................23 Item 9 - Changes In and Disagreements with Accountants on Accounting and Financial Disclosure.............23 Item 10 - Directors and Officers of the Registrant........................................................23 Item 11 - Executive Compensation..........................................................................24 Item 12 - Security Ownership of Certain Beneficial Owners and Management..................................24 Item 13 - Certain Relationships and Related Transactions..................................................24 Item 14 - Exhibits, Financial Statement Schedules and Reports on Form 8-K.................................24 ---------------------- As used herein (unless the context otherwise requires) "LodgeNet", the "Company" and/or the "Registrant" mean LodgeNet Entertainment Corporation and its consolidated subsidiaries. i PART I ITEM 1 - BUSINESS OVERVIEW LodgeNet is an interactive services provider specializing in the delivery of interactive television and Internet access services to the lodging industry. Utilizing broadband technology, the Company provides services throughout the United States, Canada and select international markets. These services include on-demand movies, music and music videos, Nintendo(R) video games, Internet-enhanced television, high-speed Internet access, and other interactive television services designed to serve the needs of the lodging industry and the traveling public. LodgeNet currently provides service to 806,100 rooms in more than 5,100 hotel properties. The Company has installed its interactive television system in more than 725,000 of those rooms, which host more than 250 million guests on an annual basis. The Company's interactive services are purchased by guests on a per-view, hourly, or daily basis and include on-demand movies, network-based Nintendo video games, music and music videos, Internet-enhanced television (which does not require a laptop for access), and high-speed Internet access services (referred to by the Company as Guest Pay interactive services). Service packages may also include satellite-delivered basic and premium cable television programming, and other interactive entertainment and information services that are paid for by the hotel and provided to guests at no charge (referred to by the Company as free-to-guest services). The Company provides its services to various corporate-managed hotel chains such as Hilton, Doubletree, Embassy Suites, Sheraton, Ritz-Carlton, Harrah's Casino Hotels, Omni, Delta Hotels and Resorts, Outrigger, La Quinta Inns, Wingate, Homewood Suites, Hampton Inns and Red Roof Inns, as well as many individual properties using the Marriott, Holiday Inn, Inter-Continental, Prince, Radisson, Westin and other trade names. The growth in revenue and operating cash flow that the Company has experienced over the past five years has primarily resulted from the rapid expansion of the number of rooms installed with the Company's services. During this period, the number of hotel rooms receiving the Company's Guest Pay services has grown from 400,000 at the end of 1996 to more than 725,000 as of December 31, 2000. The Company provides its services throughout the United States and Canada, and in other select countries through licensing arrangements with strategic partners. The Company's contracts are exclusive and typically have initial, non-cancelable terms of five to seven years. The exclusive nature of these contracts allows the Company to estimate (based on certain operating assumptions) future revenues, cash flows and rates of return related to the contracts prior to making a capital investment decision. The Company delivers its interactive television and Internet access services through a system which it has designed. The system, which it refers to as B-LAN(R), has the ability to transmit more information and images than was commonly possible just a few years ago, because it utilizes greater transmittal capacity, commonly referred to as bandwidth. The system is also referred to as a local area network because it ties together numerous hotel rooms to a server located in the hotel. Because the Company's system is based on the UNIX operating system, the Company can upgrade its software to support the introduction of new interactive services and integrate new technologies as they become commercially available and economically viable. The Company believes the flexibility of its system has enabled it to provide innovative and creative interactive offerings to the lodging industry, including: - being the first in its industry to offer on demand movies (as compared to scheduled movies that can only be watched at predetermined times) in 100% of guest rooms with Company provided services, - being the first in its industry to install and then widely deploy network-based video games, - being the first in its industry to utilize and then deploy in 100% of guest rooms with Company provided services, menus which use images rather than text to display movies, video games and other interactive services available to guests, - integrating technology that enables hotel guests to access and navigate the Internet and Internet-sourced entertainment and information through guest room televisions, and - integrating technology that allows the Company to cost-effectively provide high-speed Internet access (at up to 50 times the speed of conventional modems) to hotel guest rooms, hotel business conference rooms and other hotel meeting spaces. 1 The Company's predecessor commenced business in 1980 as Satellite Movie Company, incorporated as a South Dakota corporation in February 1983, and changed its name to LodgeNet Entertainment Corporation in September 1991. On October 13, 1993, LodgeNet Entertainment Corporation changed its state of incorporation from South Dakota to Delaware by merging with and into the Company, its newly-formed Delaware subsidiary, which then adopted the LodgeNet name. The Company's principal executive offices are located at 3900 West Innovation Street, Sioux Falls, South Dakota 57107, (605) 988-1000. MARKETS AND CUSTOMERS LARGE HOTEL MARKET. Historically, the Company's primary market for its services has been large hotels with over 150 rooms located in metropolitan areas in the U.S. and Canada. Based on industry sources, the Company estimates that this market segment contains approximately 1.7 million rooms. The Company currently provides its services to large hotels that are generally part of chains such as Hilton, Doubletree, Embassy Suites, Sheraton, Ritz-Carlton, Omni, Radisson, Harrah's Casino Hotels, Delta Hotels and Resorts, Outrigger, Holiday Inn, Inter-Continental, Prince, Westin and Marriott. No single contract represented greater than 10% of the Company's revenue for the year ended December 31, 2000. MID-SIZE HOTEL MARKET. In 1995, LodgeNet redesigned its interactive system, enabling the Company to deliver on-demand movies and network-based video games more cost-effectively to mid-size hotels. Since 1995, the Company has also been targeting mid-size hotels of 75 to 150 rooms as part of its marketing strategy and has added more than 198,000 rooms to its room base from mid-size hotels. Based on industry sources, the Company estimates that this market segment contains approximately 1.4 million rooms, and has historically been underserved by the Company's industry because smaller average property sizes generally lack economies of scale. The mid-size hotel segment represents a large and attractive market for the Company's services that generates financial returns that meet or exceed those achieved in larger hotels. FREE-TO-GUEST MARKET. Some form of free-to-guest television service is available to almost all of the approximately 3.9 million hotel rooms in the United States. Free-to-guest television service typically involves a package of basic and premium programming which the hotel purchases and provides at no charge to its guests. These services can be purchased on a stand-alone basis or as part of a package which includes Guest Pay interactive services. INTERNATIONAL MARKET. The Company also provides services in other select international countries, primarily countries located in Central and South America, through licensing arrangements with established entities in these countries. Under the arrangements, the Company does not provide any capital investment. Instead, the Company sells equipment and licenses its interactive architecture and technologies to the licensee and receives a royalty based on gross revenue. Financial information related to the Company's geographic operations is included in the Company's consolidated financial statements. SERVICES AND PRODUCTS GUEST PAY INTERACTIVE SERVICES. The Company's primary source of revenue is providing in-room, interactive television services to the lodging industry, for which the hotel guest pays on a per-view, per-play or per-day basis. The high-speed, two-way digital communications design of the Company's broadband system architecture enables the Company to provide sophisticated interactive features such as on-demand movies, network-based Nintendo video games, Internet-enhanced television and high-speed Internet access services. Guest Pay packages may also include satellite-delivered basic and premium cable television programming which are paid for by the hotel and provided to guests free of charge, and other interactive services such as review of room charges and video checkout, guest surveying, advertising and merchandising services. Guest Pay interactive services include in-room television viewing of recently released major motion pictures and independent films for which a hotel guest pays on a per-view basis. The Company's on-demand movie system allows guests to choose from an expanded menu of video selections and individually start the selected video at their convenience rather than restricting them to a predetermined start time. It has been the Company's experience that rooms having the on-demand format generate significantly greater movie revenues than comparable rooms having only the pre-scheduled format. As of December 31, 2000, the Company served over 725,000 Guest Pay rooms, of which 100% featured the Company's interactive on-demand system. The Company continuously monitors guests' entertainment selections and adjusts its programming to respond to viewing patterns. The system also enables hotel owners to broadcast informational and promotional messages. In May 1993, the Company entered into a non-exclusive license agreement with Nintendo to provide hotels with a network-based Nintendo video game playing system. In May 1998, this agreement was revised and extended for ten years. Pursuant to this extended agreement, Nintendo provides the Company with access to its Nintendo N64 video system and games. The Company uses its broadband system architecture to allow guests to play the video games over the hotel's master antenna television 2 system. Hotel guests are charged a fee based on the amount of time they play the video games. The Company had over 697,000 rooms installed with the Nintendo video game systems as of December 31, 2000. The revenues generated from Guest Pay interactive services at any given property are dependent upon a number of factors: (i) the occupancy rate at the property; (ii) the "buy rate" or percentage of occupied rooms that purchase a movie, video game, Internet access or other interactive service offered at the property; and (iii) the price of the movie, video game, Internet access or other interactive service purchased by the hotel guest. For example, a property installed with the Company's interactive system with a 68% occupancy rate, a buy rate of 10% and an $8.95 movie price will generate an average of approximately $18.50 of gross movie revenue per installed room per month, plus additional gross revenues of $4.00 per month from video games, free-to-guest and other interactive services, resulting in total gross revenue per room per month of $22.50, assuming an average of 30.4 days in the month. Occupancy rates vary by property based on the property's competitive position within its marketplace, over time based on seasonal 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. Buy rates generally reflect the hotel's guest mix profile, the popularity of the available programming and the guests' other entertainment alternatives. Buy rates also vary over time with general economic conditions. The price charged for each programming option is established by the Company and is set based on the guest mix profile at each property and overall economic conditions. Movie prices are set by the Company on a title by title basis and may be higher in some locations and for certain highly popular titles. The cost of installing the Company's interactive system in a hotel varies depending on the size of the hotel property and the configuration of the interactive system being installed. The average installed cost of an interactive system that includes on-demand movies, video games and general interactive services capabilities is currently approximately $360 per room. The installation of Internet access on television capabilities generally adds $60 to $80 more per room. Installation costs include equipment that is located in one location within the hotel and controls the overall operation of the Company's system in each room (referred to by the Company as a headend location), in-room equipment and labor and overhead costs. In addition to hotel commissions and royalties paid to movie studios and other interactive content providers, operating costs of the Guest Pay interactive systems include system maintenance, preview tapes or discs, tape duplication, taxes, freight, insurance, personal property taxes, data line and Internet connectivity costs. Upon contract renewal or significant contract extension the Company typically invests from $75 to $175 per room, depending on the length of the extended contract period and the upgrade services installed. FREE-TO-GUEST AND OTHER SERVICES. In addition to Guest Pay interactive services, the Company provides cable television programming for which the hotel, rather than its guests, pays the charges. Programming is delivered via satellite and distributed to guest rooms over the hotel's existing master antenna system. The hotel pays the Company a fixed monthly charge per room for each programming channel selected and provides these channels to its guests free of charge. Premium channels, such as HBO, Showtime and The Disney Channel, broadcast major motion pictures and specialty programming, while non-premium channels, such as CNN, ESPN and WTBS, broadcast news, sports and informational programs. Premium programming suppliers typically contract only with cable companies and other large volume subscribers, such as the Company, and will not generally provide programming directly to individual hotel properties. The Company successfully competes with local cable television operators by customizing packages of programming to provide only those channels desired by the hotel subscriber, which typically reduces the overall cost of the services provided. The Company also provides a variety of other services to its hotel customers including the sale of system equipment and service parts and labor. The Company believes that these services complement its goal of being a full-service provider of in-room entertainment and information services to the lodging industry. INNMEDIA, LLC. In October of 2000, the Company entered into an arrangement with Hilton Hotels Corporation to form and equally own a new broadband, interactive media company, InnMedia LLC, to offer hotel guests new and innovative interactive television content such as high speed Internet access through the television as well as customized hotel and guest information. Under this arrangement, InnMedia will supply Internet portal and interactive television content to the Company for distribution to Hilton and to other hotels installed with the Company's broadband, interactive system. InnMedia will report the operations of these activities and will pay LodgeNet a fee for use of LodgeNet's system. RESIDENTIAL SERVICES. In 1996 the Company formed ResNet Communications, Inc. to extend delivery of the Company's services to the multi-family dwelling market. In July 1998, the Company decided to merge ResNet into a larger, independent entity. Beginning on November 30, 1998, the closing date for the merger transaction, ResNet ceased to be a majority-owned subsidiary of the Company. The Company received an approximate 30% equity interest in Global Interactive Communications Corporation, the successor to ResNet, as a result of the merger. The Company is not actively involved in the business activities of Global. 3 OPERATIONS CONTRACTS. The Company provides its Guest Pay interactive services under contracts with lodging properties that generally run for a term of five to seven years. During the five years ended December 31, 2000, the average initial term of new guest pay contracts exceeded six years. The Company's contracts generally provide that the Company will be the exclusive provider of in-room, on-demand television entertainment services to the hotels, permit the Company to set prices, and allow the Company to terminate the contract and remove its systems if the results of operation of the Company's system installed at the hotel do not meet the Company's return on investment criteria. The contracts also typically grant the Company a right of first refusal regarding the provision of additional video related services to the hotel. Under these contracts, the Company installs its system into the hotel free of charge and retains ownership of all equipment utilized in providing its services. The terms contained in the contracts with corporate-managed hotels in any one chain generally are negotiated by that chain's corporate management, and the hotels subscribe at the direction of corporate management. In the case of franchised hotels, the contracts are generally negotiated separately with each hotel. Typically, the hotel provides and owns the television set installed in the guest room; however, the Company in some cases provides televisions incorporating the Company's integrated guest pay terminal units to hotels which meet certain economic criteria. For Guest Pay interactive services which are paid for by the hotel guest, the hotel collects such charges, coincident with the collection of room and other charges made by the hotel guest, and the hotel remits monthly to the Company. The hotels retain a commission from such charges, which varies depending on the size and profitability of the system and other factors. The Company generally seeks to extend and renew hotel contracts in advance of their expiration on substantially similar terms. The average remaining life of the Company's current Guest Pay interactive contracts is approximately four years with less than 11% of these contracts coming up for renewal before 2002. TECHNOLOGY, PRODUCT DEVELOPMENT AND PATENTS. The Company designs and develops high quality interactive, multimedia entertainment and information systems. Because such systems utilize an open architecture, UNIX-based platform incorporating industry standard interfaces, the Company can upgrade system software to support the introduction of new services or integrate new technologies as they become economically viable. The Company's interactive system incorporates the Company's scaleable proprietary broadband local area network system architecture with commercially manufactured, readily available electronic and computer components and hardware. The Company's broadband system architecture utilizes the Company's proprietary, two-way digital communications design to process and respond to input commands from the viewer very rapidly. This capability enables the Company to provide sophisticated interactive television services such as on-demand movies, network-based Nintendo video games, Internet-enhanced television, high-speed Internet access, and a variety of other interactive services such as review of room charges and video checkout, guest surveying, advertising and shopping services. The Company's Guest Pay interactive systems consist of equipment located within the guest room connected via a local-area cable distribution network to a headend located elsewhere in the hotel. Typical in-room equipment includes a terminal unit, a hand-held remote television control and a video game controller. In-room equipment may also include an infrared computer keyboard and a desktop device which provides a high-speed Internet connection. Movie programming originates from the system headend and is transmitted to individual rooms over the hotel's master antenna system. Video game programs are downloaded into dedicated video game processors also located within the headend. Keystrokes and other system commands and communications are transmitted from the room using the Company's proprietary high-speed communications infrastructure and the video and other signals are transmitted to the guest room over the hotel's master antenna system. The system computer controls the delivery of the Guest Pay interactive services to the guest room and also automatically records purchase transactions and billing data to the hotel's accounting system, which automatically posts the charge to the guest's bill. It is the Company's policy to apply for patents on those product designs which management believes may be of significance to the Company. The Company owns eight United States patents and has other applications for patents pending in the U.S. Patent and Trademark Office dealing with various aspects of the Company's interactive multimedia systems. The Company also licenses industry related technology from third parties. The Company uses a number of registered and unregistered trademarks for its products and services. The Company has applications for registration pending for certain of the unregistered trademarks, and those trademarks for which the Company has not sought registration are governed by common law and state unfair competition laws. Because the Company believes that these trademarks are significant to the Company's business, the Company has taken legal steps to protect its trademarks in the past and intends to actively protect these trademarks in the future. The Company believes that its trademarks are generally well recognized by consumers of its products and are associated with a high level of quality and value. 4 SALES AND MARKETING. The Company focuses its sales and marketing strategies on acquiring new contracts from hotels, extending and retaining existing contracts, and marketing the Company's Guest Pay interactive services to the hotel guest. The Company's sales and marketing organization includes national account representatives who develop relationships with national hotel franchise organizations and management groups, and regional sales representatives who maintain relationships primarily with regional hotel management and ownership organizations. The Company markets its services and products to hotels by advertising in industry trade publications, attending industry trade shows, direct marketing and telemarketing. Sales activities are coordinated from the Company's headquarters. The Company markets its services to hotel guests by means of an interactive, image-based menu and purchasing protocol using on-screen graphics and movie and video game promotion and programming information. The 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 the Company's system. INSTALLATION AND SERVICE OPERATIONS. The Company believes that high quality and consistent systems support and maintenance are essential to competitive success in its industry. The Company emphasizes the use of Company-employed installation and service personnel residing in 23 locations throughout the United States and Canada, but also uses Company-trained subcontractors in areas where there is not a sufficient concentration of Company-served hotels to warrant a Company-employed service representative. Currently, the Company's service organization has responsibility for approximately 87% of the Guest Pay interactive hotel rooms served by the Company. Service personnel are responsible for all preventive and corrective systems maintenance. The Company's installation personnel prepare engineering surveys at each particular hotel, install the Company's systems, train the hotel staff to operate the systems and perform quality control tests. The Company maintains a toll-free customer support hot line, "Tech-Connect," which is monitored 24 hours a day, 365 days a year by trained support technicians. The on-line diagnostic capability of the Company's systems enables the Company to identify and resolve a majority of reported system malfunctions from the Company's service control center without visiting the hotel property. When a service visit is required, the modular design of the Company's systems permits installation and service personnel to replace only those components which are defective at the hotel site. PROGRAMMING. The Company obtains non-exclusive rights to show recently released major motion pictures from motion picture studios pursuant to a master agreement with each studio. The license period and percentage fee for each movie are negotiated separately, with the studio receiving a percentage of the Company's gross revenue from the movie. For recently released motion pictures, the Company typically obtains rights to exhibit the picture while it is still in theatrical release, but prior to its release to the home video market or for exhibition on cable television. Generally, studios make master video tapes of their movies available for duplication sufficiently in advance of the release dates for the lodging industry so that all of the Company's hotels can offer the movies as of the first date they are available for exhibition. The Company obtains independent films, most of which are non-rated and intended for mature audiences, for a one-time flat fee that is nominal in relation to the licensing fees paid for major motion pictures and which permits the Company to duplicate the films as necessary to supply copies to its hotel sites. The Company obtains its selection of Nintendo video games pursuant to a ten year non-exclusive license agreement with Nintendo entered into in 1998. Under the terms of the agreement, the Company pays Nintendo a monthly fee based on the number of rooms offering Nintendo video game services. The Company continuously monitors guests' entertainment selections and adjusts its programming to respond to viewing patterns. The Company obtains its basic and premium cable television programming pursuant to multiyear license agreements generally containing automatic renewal provisions and pays its programming suppliers a fixed, monthly fee for each room or subscriber receiving the service. Management believes that relations with the programming suppliers are good and expects to renew these contracts as necessary on competitive terms. In January 2000, the Company entered into a multi-year agreement with DIRECTV, Inc. to make available DIRECTV(R) programming to the properties it services. 5 SYSTEMS PRODUCTION GROUP AND EQUIPMENT SUPPLIERS. The Company contracts directly with various electronics firms for the manufacture and assembly of certain of its systems hardware, the design of which is controlled by the Company. The Company has found these suppliers to be dependable and generally able to meet delivery schedules on time. The Company believes that, in the event of a termination of any of its sources, with proper notification from the supplier, alternate suppliers could be located without incurring significant costs or delays. Certain electronic component parts used within the Company's 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 the Company were to experience a shortage of any given electronic part, the Company believes that alternative parts could be obtained or system design changes implemented. In such event, the Company could experience a temporary reduction in the rate of new room installations and/or an increase in the cost of such installations. All other components of the Company's systems are standard commercial products, such as computers, video cassette players, modulators and amplifiers that are available from multiple sources. The Company believes its anticipated growth can be accommodated through existing suppliers. COMPETITION Based on the number of hotel rooms served, the Company is the second largest provider of interactive television services to the lodging industry, currently serving over 825,000 hotel rooms. The Company's largest competitor is On Command Corporation ("OCC"), the successor corporation resulting from the 1996 merger of SpectraVision, Inc. and On Command Video Corporation. Based upon publicly available information, the Company estimates that OCC currently serves approximately 977,000 hotel rooms. The Company also competes with Hospitality Networks, SeaChange, AOL Time Warner, Cox Cable and InRoomVideo among others. With regard to high-speed Internet connectivity, the Company also competes with CAIS Internet, STSN and many others. There are also a number of potential competitors that could use their existing infrastructure to provide in-room entertainment services to the lodging industry, including franchised and wireless cable operators, telecommunications companies, Internet service and digital broadcast service providers. Some of these potential competitors are already providing free-to-guest or Internet-related services to the lodging industry and have announced plans to offer guest pay services. Some of these companies may have substantially greater financial and other resources than the Company, and it is possible that such competitors may develop a technology that is more cost effective than the Company's broadband local area network system architecture. To respond to competition, the Company will need to continue to enhance its in-room entertainment systems, expand its operations and meet the increasing demands for competitive pricing, service quality and availability of value-added product offerings. Competition with respect to new hotel contracts centers on a variety of factors, depending upon the features important to a particular hotel. Among the more important factors are: (i) the features and benefits of the entertainment systems; (ii) the quality of the vendor's technical support and maintenance services; (iii) the financial terms and conditions of the proposed contract (including commissions to the hotel); and (iv) the ability to complete system installation in a timely and efficient manner. In addition, with respect to hotel properties already receiving in-room entertainment services, the incumbent provider may have certain informational and installation cost advantages as compared to outside competitors. The Company believes that its competitive advantages include: (i) its broadband local area network system architecture that enables the Company to deliver a broad range of interactive features and services such as on-demand movies, Internet-enhanced television, high speed Internet connectivity and network-based Nintendo video games; (ii) the flexible design of the Company's system which enables it to add enhancements or integrate new technologies and services as they become commercially available and economically viable; (iii) high quality customer support and field service operations; and (iv) an experienced management team and well-trained professional sales organization. The Company believes that its success in securing contracts reflects the strong competitive position of the Company's products and services. Because of the high level of penetration in the large hotel segment of the lodging industry already achieved by guest pay providers, most of the growth opportunities in this market segment have typically involved securing contracts to serve hotels that are served by a competing vendor. An incumbent provider may have certain information and installation cost advantages as compared to outside competitors. These circumstances have led to increasing competition for contract renewals, particularly at hotels operated by major hotel chains. Because free-to-guest service providers generally have substantially comparable access to the satellite delivered programming that comprises the free-to-guest services, competition in this segment has been based primarily on price and customer service. While the Company believes that its broadband local area network system architecture is comparable or superior to the systems currently being used by its competitors in the lodging industry, there can be no assurance that such competitors will not 6 develop a cost-effective system that is comparable or superior to the Company's system. In order to broaden its market opportunities, the Company over time has redesigned its system to permit the delivery of on-demand movies and network-based video games to mid-size hotels of 75 to 150 rooms, a market segment the Company believes has been historically under-served by guest pay providers. There can be no assurance that the Company will continue its current level of success in obtaining new contracts from hotels currently served by other vendors or previously unserved, or that the Company will be able to retain contracts with hotels it serves when those contracts expire. Although in the free-to-guest market, the local franchised cable operator in a hotel's market may have a substantial market presence, such operators typically offer the hotel owner only standard packages of programming typically developed for the residential market rather than the lodging market, and at a fixed price per room based on all the channels provided. The Company competes with the franchised cable operator for free-to-guest contracts by customizing packages of programming to provide only those channels desired by the hotel, typically reducing the overall cost per room to the hotel operator. Competitive pressures in the guest pay and free-to-guest segments could result in reduced market share for the Company, higher hotel commissions, lower margins and increased expenditures for marketing, product development and systems installation, each of which could adversely affect the Company's financial condition and operating results. BUSINESS STRATEGY CONTINUE TO EXPAND THE COMPANY'S ROOM BASE. Within the Company's target market of hotels with 75 or more rooms, the Company believes substantial opportunity exists for continued, selective growth in its Guest Pay interactive room base. The Company estimates that 350,000 rooms are presently not served by any guest pay vendor and fit its target economic profile. The Company believes that the cost-effective and flexible design of its scaleable interactive television system, together with its expertise in installation, programming, technical support and customer service, will allow the Company to continue to expand its interactive room base pursuant to long term contracts. Internationally, the Company intends to continue to expand into selected countries in Asia and Latin America and other regions through licensing agreements with established entities in these countries. INCREASE ROOM REVENUES THROUGH EXPANSION OF INTERACTIVE SERVICES. Having successfully transitioned 100% of its Guest Pay room base to its interactive television platform, the Company plans to continue to increase the revenue it realizes from each Guest Pay interactive room by expanding and enhancing the scope of its interactive television programming and, through its relationship with InnMedia LLC, adding Internet on television based services to its installed base. The Company intends to continue offering on-demand movies, Nintendo N64 video games and digital music services in all new Guest Pay interactive rooms. It also plans to upgrade selected existing systems to provide digital movies, digital music, N64 games and Interaction television services. In addition to its television-based Internet product development activities, the Company has also been focused on integrating technology into its interactive offering which would allow hotel guests with laptop computers to connect to the Internet (without changing their system configurations) at access speeds up to 50 times faster than conventional modems, while bypassing the hotel's telephone system. The high-speed Internet access service can be installed into a hotel's business conference rooms, other hotel meeting rooms and public space, as well as at the desktop within the guest room. The Company believes that this "managed connectivity" service may represent a significant opportunity to generate additional new interactive revenues from usage fees charged to guests who utilize the service or from hotels which want to provide the service as an amenity to their guests. The Company believes that its high-speed Internet services attractively complement its existing interactive service offerings. This 7 combination of Internet services and interactive television capabilities, coupled with its broad presence in the United States and Canada, makes the Company a convenient, single-source from which hotels can obtain the complete range of interactive television and Internet services. CONTINUE TO INCREASE OPERATING MARGINS. Complementing the Company's growth objective is its ongoing goal of increasing operating margins by reducing direct and overhead expenses, as measured on a percentage of revenue and on a per-installed unit basis. Over the past five years, the Company has reduced per-room operating costs as it spread its expenses related to corporate overhead and operating infrastructure over a larger base of installed rooms, as well as a broader range of revenue generating sources. The Company believes that further efficiencies can be achieved as it continues to expand the number of installed rooms and the scope of its interactive television and Internet access offerings. REGULATION TELECOMMUNICATIONS ACT OF 1996. The Telecommunications Act of 1996 (the "Act") is intended, in part, to promote substantial competition for telephone and video services and will alter federal, state and local laws and regulations regarding telecommunications providers and services. The Act generally removes previous restrictions preventing cable firms, telephone companies, long distance carriers and public utilities from entering into certain new markets, removes many cross-ownership restrictions and modifies rate regulations applicable to franchised cable operators. In particular, the Act authorizes local telephone companies to provide video programming directly to subscribers in their service areas and eliminates the requirement that "private cable" operators serve only buildings "under common ownership, management or control," but preserves the requirement that such operations not use closed transmission paths to cross public rights-of-way. It is anticipated that the Act will stimulate increased competition generally in the telecommunications and cable industries which may adversely impact the Company. No assurance can be given that changes in current or future laws or regulations adopted by the FCC or state or local regulatory authorities would not have a material adverse effect on the Company's business. As a result of the Act, the Company's business may be adversely affected by the entry of additional competitors in the multichannel video programming distribution market. In part, the Company's competitiveness also will depend upon the outcome of FCC rulemaking proceedings to interpret and implement the provisions of the Act. It is not possible at this time to predict the outcome of such rulemaking proceedings or their effect on the Company. 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, 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 that is designed to provide cable service which includes video programming and which is provided to multiple subscribers within a community, but the law exempts from that definition, among other facilities, a facility that serves subscribers without using any public rights-of-way. The Company constructs and operates separate headend systems at each hotel and those systems do not use public rights-of-way. Thus, with respect to its private guest services operations, the Company is not required to comply with many of the FCC's 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. As a multichannel video programming distributor, however, the Company is subject to various provisions of the Communications Act. These include laws and regulations that benefit the Company, such as provisions that ensure the Company access to programming on fair, reasonable and nondiscriminatory terms, as well as provisions that subject the Company to additional requirements, such as the requirement to obtain consent from broadcasters in order to retransmit their signals over the Company's systems. ELECTRIC UTILITY ENTRY INTO CABLE AND TELECOMMUNICATIONS. The Act provides that registered utility holding companies and subsidiaries may provide telecommunications services (including cable television) notwithstanding the Public Utility Holding Company Act. Electric utilities must establish separate subsidiaries, known as "exempt telecommunications companies" and must apply to the FCC for operating authority. Large utility holding companies may become significant competitors to both cable television and other telecommunications providers. The foregoing does not purport to describe all present and proposed federal, state and local regulations and legislation relating to the video programming industry. 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 that could change in 8 varying degrees, the manner in which private cable operators and other video programming distributors operate. The Company cannot estimate the outcome of these proceedings or their impact upon its operations at this time. EMPLOYEES As of December 31, 2000, the Company had 769 employees in the United States and Canada, none of which are covered by a collective bargaining agreement. The Company has not experienced any significant labor problems and believes that its relationship with its employees is good. ITEM 2 - PROPERTIES The Company leases 23 facilities, in various locations, from unaffiliated third parties. These facilities are combination warehouse/office facilities for installation and service operations and are located throughout the United States and include one location in Canada. Each of these facilities occupies less than 3,500 square feet. The Company's headquarters, including its distribution center and principal executive offices, is located in Sioux Falls, South Dakota. The facility occupies approximately 228,500 square feet including approximately 126,500 square feet for executive, administrative and support functions, approximately 60,000 square feet for assembly and distribution functions, and approximately 42,000 square feet for warehouse space. The opening of the facility in 1997 allowed the Company to consolidate all of its local operations into a single, multipurpose facility which is designed to enhance operational efficiency and to facilitate any necessary future expansion needs of the Company. The Company believes that its facility is sufficient to accommodate its foreseeable local operational space requirements. ITEM 3 - LEGAL PROCEEDINGS The Company is subject to litigation arising in the ordinary course of business. As of the date hereof, the Company believes the resolution of such litigation will not have a material adverse effect upon the Company's financial condition or results of operations. ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the quarter ended December 31, 2000. 9 PART II ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock currently trades on the NASDAQ National Market System ("NASDAQ NMS") under the symbol "LNET". The Company's Common Stock began trading on the NASDAQ NMS on October 14, 1993 upon the effectiveness of its initial public offering. As of March 23, 2001 there were outstanding 12,212,439 shares of the Company's Common Stock. The following table sets forth, for the fiscal quarters indicated, the range of high and low sales prices of the Company's Common Stock as reported by NASDAQ NMS.

Quarter Ended High Low ----------------------- ---------- ---------- March 31, 1999 $ 9.00 $ 6.25 June 30, 1999 13.93 5.75 September 30, 1999 14.75 10.50 December 31, 1999 25.12 12.00 March 31, 2000 26.75 18.56 June 30, 2000 27.25 17.50 September 30, 2000 29.25 21.13 December 31, 2000 29.00 11.88

On March 23, 2001, the closing price of the Company's Common Stock, as reported by NASDAQ NMS was $14.00. Stockholders are urged to obtain current market quotations for the Company's Common Stock. As of March 23, 2001 there were 133 stockholders of record of the Company with approximately 87% of the shares held in "street name". The Company estimates that as of March 23, 2001 there were more than 2,500 stockholders of the Company. DIVIDENDS No dividends have been paid to date on the Common Stock of the Company. Management of the Company does not intend to pay any cash dividends on Common Stock of the Company in the foreseeable future, rather, it is expected that the Company will retain earnings to finance its operations and growth. The terms and conditions of the Company's 10.25% Senior Notes and of the Company's bank credit facility both contain covenants which restrict and limit payments or distributions in respect of the Common Stock of the Company. STOCKHOLDER RIGHTS PLAN On February 28, 1997, the Company adopted a stockholder rights plan. The rights plan is intended to maximize stockholder value by providing flexibility to the Board of Directors in the event that an offer for the Company is received that is either inadequate or not in the best interest of all stockholders. Under the rights plan, the Board of Directors declared a dividend distribution of one right for each outstanding share of common stock to stockholders of record at the close of business on March 10, 1997. Each right, when exercisable, entitles the registered holder to purchase one one-thousandth of a share of a new series of Series A Participating Preferred Stock, at a price of $60.00. Initially, the rights are "attached" to the common stock and trade with the common stock. They separate from the common stock if a person or group acquires 15% or more of the outstanding shares of common stock or a public announcement of a tender offer or exchange offer is made which would result in someone becoming the owner of 15% or more of the outstanding common stock. Following a separation, the rights become exercisable, are separately tradable and the Company will mail separate rights certificates to stockholders. The rights expire on the earliest of February 28, 2007, the date of the consummation of a merger with a person who acquired common stock with the approval of the Board of Directors or the redemption of the rights by the Company. 10 The number of rights are adjusted to prevent dilution in the event of a stock split or stock dividend. The purchase price, and the number of shares of preferred stock issuable upon exercise of the rights, are also adjusted for stock splits and dividends, as well as for other events, including the issuance of preferred stock at less than the market price or the distribution of Company assets to preferred stockholders. If the Company is acquired without the approval of the directors who are neither officers of the Company nor related to the acquirer, the rights become exercisable for shares of common stock of the acquiring company with a market value of two times the exercise price. If there is merely an acquisition of at least 15% of the common stock of the Company without such approval, the rights become exercisable for common stock with a market value of two times the exercise price Prior to a 15% acquisition or the expiration of the rights, the Company may redeem the rights at a price of $.01 per right. The rights are also redeemable in connection with a merger or other similar transaction not involving a 15% acquirer or if the acquier has acquired less than 15% and there are no other acquirers. In addition, the Board of Directors may, after a 15% acquisition (but less than a 50% acquisition), exchange the rights for shares of common stock on a one for one basis or for cash or other assets or securities of the Company. If issued, the preferred stock will be nonredeemable and junior to any other series of preferred stock the Company may issue, but will have a preferential quarterly dividend equal to 1,000 times the dividend, if any, declared on each share of common stock, but not less than $25.00 and, in the event of liquidation of the Company, a preferred liquidation preference equal to the greater of $1,000 or 1,000 times the payment per share of common stock. Each share of preferred stock will have 1,000 votes and will vote together with the common stock. Until a right is exercised, the holder will have no rights as a stockholder of the Company. The Company and the rights agent have broad discretion to amend the Rights Agreement governing the rights; however, following a separation, no amendment may adversely affect the rights holders. 11 ITEM 6 - SELECTED FINANCIAL DATA The following is a summary of Selected Financial Data. The data should be read in conjunction with the Company's 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 for per share and per room amounts.

YEAR ENDED DECEMBER 31, ------------------------------------------------------------------------------------ 1996 1997 1998 1999 2000 -------------- -------------- -------------- -------------- -------------- STATEMENT OF OPERATIONS DATA: Revenues: Guest Pay $ 84,504 $ 116,276 $ 146,481 $ 169,850 $ 186,718 Other 13,217 19,434 19,870 11,422 10,099 -------------- -------------- -------------- -------------- -------------- Total revenue 97,721 135,710 166,351 181,272 196,817 Direct costs 44,379 58,512 74,008 78,490 82,450 -------------- -------------- -------------- -------------- -------------- Gross profit 53,342 77,198 92,343 102,782 114,367 Operating expenses 58,428 85,262 102,282 103,460 112,073 -------------- -------------- -------------- -------------- -------------- Operating income (loss) (5,086) (8,064) (9,939) (678) 2,294 Gain on sale of investments -- -- -- 14,739 -- Investment losses -- -- (6,550) (24,323) (13,593) Interest expense (8,551) (18,837) (23,261) (27,210) (27,809) Interest income 308 1,836 213 1,414 419 -------------- -------------- -------------- -------------- -------------- Loss before income taxes, extraordinary loss and cumulative effect of accounting change (13,329) (26,065) (39,537) (36,058) (38,689) Provision for income taxes (28) (344) (375) (370) (325) -------------- -------------- -------------- -------------- -------------- Loss before extraordinary loss and cumulative effect of accounting change (13,357) (25,409) (39,912) (36,428) (39,014) Extraordinary loss (1) (3,253) -- -- -- -- Cumulative effect of accounting change (2) -- (210) -- -- -- -------------- -------------- -------------- -------------- -------------- Net loss $ (16,610) $ (25,619) $ (39,912) $ (36,428) $ (39,014) ============== ============== ============== ============== ============== Per common share (basic and diluted): Loss before extraordinary loss and cumulative effect of accounting change $ (1.40) $ (2.25) $ (3.45) $ (3.05) $ (3.21) Extraordinary loss (.34) -- -- -- -- Cumulative effect of accounting change -- (.02) -- -- -- -------------- -------------- -------------- -------------- -------------- Net loss $ (1.74) $ (2.27) $ (3.45) $ (3.05) $ (3.21) ============== ============== ============== ============== ============== OTHER DATA: EBITDA (3) $ 24,729 $ 35,696 $ 48,576 $ 60,100 $ 67,764 EBITDA margin (3) 25.3% 26.3% 29.2% 33.2% 34.4% Capital expenditures (4) $ 84,256 $ 104,377 $ 69,660 $ 51,226 $ 60,195 Depreciation and amortization 29,815 43,760 55,215 60,778 65,470 Ratio of earnings to fixed charges (5) -- -- -- -- -- Ratio of total long-term debt to EBITDA (3) 7.27x 5.14x 5.52x 4.71x 4.29x Ratio of EBITDA to interest expense (3) 2.89x 1.90x 2.09x 2.21x 2.44x OPERATING DATA: Guest Pay rooms served (6) On-demand 358,842 484,070 581,893 661,691 725,075 Scheduled 41,403 27,781 14,913 -- -- -------------- -------------- -------------- -------------- -------------- Total Guest Pay rooms 400,245 511,851 596,806 661,691 725,075 ============== ============== ============== ============== ============== Rooms with Nintendo(R)game systems (6) 322,903 448,969 546,324 627,592 697,703 Rooms with Internet services (6) -- -- -- 10,152 31,502 Free-to-guest rooms served (6) 294,882 341,030 384,324 399,046 405,977 Total rooms served (6) (7) 516,348 613,407 703,325 761,509 806,112 Average monthly revenue per Guest Pay room: Movie revenue $ 18.38 $ 17.86 $ 18.44 $ 18.62 $18.19 Other interactive service revenue 2.93 3.28 3.62 3.85 4.27 -------------- -------------- -------------- -------------- -------------- Total $21.31 $ 21.14 $ 22.06 $ 22.47 $22.46 ============== ============== ============== ============== ==============

12

AS OF DECEMBER 31, --------------------------------------------------------- 1996 1997 1998 1999 2000 ---- ---- ---- ---- ---- BALANCE SHEET DATA: Cash and cash equivalents $ 86,177 $ 1,021 $ 5,240 $ 1,644 $ 4,059 Total assets 279,768 260,294 306,030 305,275 281,605 Total long-term debt 179,658 183,396 268,093 282,990 290,659 Total stockholders' equity (deficit) 75,552 49,579 11,774 (5,504) (36,426)

YEAR ENDED DECEMBER 31, --------------------------------------------------------- 1996 1997 1998 1999 2000 ---- ---- ---- ---- ---- STATEMENT OF CASH FLOWS DATA: Cash provided by operating activities $ 9,562 $ 16,653 $ 13,243 $ 40,782 $ 41,180 Cash used for investing activities (78,860) (104,377) (77,578) (55,445) (50,248) Cash provided by financing activities 153,129 2,610 68,608 11,030 11,510

(1) Loss on early redemption of debt. (2) Represents a charge for the effect of adopting EITF Issue 97-13 related to accounting for certain business reengineering costs. (3) EBITDA consists of earnings before interest, income taxes, depreciation, amortization and other non-operating income or expenses. EBITDA is not intended to represent an alternative to net income or cash flows from operating, financing or investing activities (as determined in accordance with generally accepted accounting principles) as a measure of performance, and is not representative of funds available for discretionary use due to the Company's financing obligations. EBITDA, as defined by the Company, may not be calculated consistently among other companies reporting similarly titled measures. EBITDA is included herein because it is a widely accepted financial indicator used by certain investors and financial analysts to assess and compare companies on the basis of operating performance. Management believes that EBITDA provides an important additional perspective on the Company's operating results and the Company's ability to service its long-term debt and to fund the Company's continuing growth. (4) Presented as cash used for property and equipment additions and business acquisitions as reported in the Statement of Cash Flows. (5) Earnings is defined as net loss before income taxes, extraordinary items and fixed charges, except where capitalized. Fixed charges is defined as the portion of rental expense under operating leases representing interest, and interest, including amortization of debt expense, whether expensed or capitalized. Earnings were insufficient to cover fixed charges for the years ended December 31 by: 1996 -- $(13,329); 1997 -- $(25,065); 1998 -- $(38,799); 1999 -- $(36,058); and 2000 -- $(38,689). (6) At end of year. (7) Total rooms served include those rooms receiving one or more of the Company's services, including rooms served by international licensees. 13 SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS CERTAIN STATEMENTS IN THIS ANNUAL REPORT ON FORM 10-K, INCLUDING, WITHOUT LIMITATION, STATEMENTS IN ITEM 1, INCLUDING CERTAIN STATEMENTS UNDER THE HEADINGS "OVERVIEW", "BUSINESS STRATEGY", "STRATEGIC INITIATIVES", "SERVICES AND PRODUCTS", "OPERATIONS", "COMPETITION" AND "REGULATION", IN ITEM 3 UNDER THE HEADING "LEGAL PROCEEDINGS", AND IN ITEM 7 UNDER THE HEADING "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS," CONSTITUTE "FORWARD-LOOKING STATEMENTS". WHEN USED IN THIS ANNUAL REPORT, THE WORDS "EXPECTS," "ANTICIPATES," "ESTIMATES," "BELIEVES," "NO ASSURANCE" AND SIMILAR EXPRESSIONS AND STATEMENTS WHICH ARE MADE IN THE FUTURE TENSE, ARE INTENDED TO IDENTIFY SUCH FORWARD-LOOKING STATEMENTS. SUCH FORWARD-LOOKING STATEMENTS INVOLVE KNOWN AND UNKNOWN RISKS, UNCERTAINTIES AND OTHER FACTORS, WHICH MAY CAUSE THE COMPANY'S ACTUAL RESULTS, PERFORMANCE OR ACHIEVEMENTS TO BE MATERIALLY DIFFERENT FROM ANY FUTURE RESULTS, PERFORMANCE OR ACHIEVEMENTS EXPRESSED OR IMPLIED BY SUCH FORWARD-LOOKING STATEMENTS. IN ADDITION TO THE RISKS AND UNCERTAINTIES DISCUSSED IN THE FOREGOING SECTIONS, SUCH FACTORS INCLUDE, AMONG OTHERS, THE FOLLOWING: THE IMPACT OF COMPETITION AND CHANGES TO THE COMPETITIVE ENVIRONMENT FOR THE COMPANY'S PRODUCTS AND SERVICES, CHANGES IN TECHNOLOGY, RELIANCE ON STRATEGIC PARTNERS, UNCERTAINTY OF LITIGATION, CHANGES IN GOVERNMENT REGULATION AND OTHER FACTORS DETAILED, FROM TIME TO TIME, IN THE COMPANY'S FILINGS WITH THE SECURITIES AND EXCHANGE COMMISSION. THESE FORWARD-LOOKING STATEMENTS SPEAK ONLY AS OF THE DATE OF THIS ANNUAL REPORT. THE COMPANY EXPRESSLY DISCLAIMS ANY OBLIGATION OR UNDERTAKING TO RELEASE PUBLICLY ANY UPDATES OR REVISIONS TO ANY FORWARD-LOOKING STATEMENTS CONTAINED HEREIN TO REFLECT ANY CHANGE IN THE COMPANY'S EXPECTATIONS WITH REGARD THERETO OR ANY CHANGE IN EVENTS, CONDITIONS OR CIRCUMSTANCES ON WHICH ANY SUCH STATEMENT IS BASED. ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE CONSOLIDATED FINANCIAL STATEMENTS OF THE COMPANY, INCLUDING THE NOTES THERETO, APPEARING ELSEWHERE HEREIN. OVERVIEW LodgeNet is a broadband, interactive services provider specializing in the delivery of interactive television and Internet access services to the lodging industry throughout the United States, Canada and select international markets. These services include on-demand movies, Nintendo video games, Internet-enhanced television, high-speed Internet access, and other interactive television services designed to serve the needs of the lodging industry and the traveling public. GUEST PAY INTERACTIVE SERVICES. Guest Pay interactive services are purchased by guests on a per-view, hourly, or daily basis and include on-demand movies, network-based Nintendo(R) video games, Internet enhanced television, and high-speed Internet access services. Guest Pay packages may also include additional services such as satellite-delivered basic and premium cable television programming, and other interactive entertainment and information services that are paid for by the hotel and provided to guests at no charge. The growth that the Company has experienced has principally resulted from its rapid expansion of Guest Pay interactive services. The Company's Guest Pay interactive revenues depend on a number of factors, including the number of rooms equipped with the Company's systems, hotel occupancy rates and guest demographics, and the popularity, pricing, and availability of programming. The primary direct costs of providing Guest Pay interactive services are (i) license fees paid to studios for non-exclusive distribution rights to recently-released major motion pictures, (ii) nominal one-time license fees paid for independent films, (iii) license fees for other interactive services, (iv) Internet connectivity costs, and (v) the commission retained by the hotel. Guest Pay operating expenses include costs of system maintenance and support, in-room marketing, programming delivery and distribution, data retrieval, insurance and personal property taxes. The Company installed its systems in the following number of rooms, net of de-installations, during the years ended December 31:

1998 1999 2000 ------------ ------------ ------------ Guest Pay interactive rooms 84,955 64,885 63,384 Nintendo video game rooms 97,355 81,268 70,111 Internet services rooms -- 10,152 21,350

14 The net room installations represent increases of 16.6%, 10.9%, and 9.6%, respectively for Guest Pay interactive rooms and 21.7%, 14.9%, and 11.2%, respectively, for Nintendo video game rooms. De-installation activity is generally less than 2% of the installed number of rooms. The Company's base of installed rooms was comprised as follows at December 31:

1998 1999 2000 ----------------------- ----------------------- ------------------------ ROOMS % ROOMS % ----------- ------- ----------- ------- ----------- -------- Guest Pay rooms: Scheduled 14,913 2.5 -- -- -- -- On-demand 581,893 97.5 661,691 100.0 725,075 100.0 ----------- ------- ----------- ------- ----------- -------- 596,806 100.0 661,691 100.0 725,075 100.0 Nintendo video game rooms 546,324 627,592 697,703 Internet services rooms -- 10,152 31,502

Total rooms served, representing rooms receiving one or more of the Company's services, including rooms served by international licensees, were as follows at December 31:

1998 1999 2000 ------------ ------------ ------------ Total rooms served 703,325 761,509 806,112 ============ ============ ============

FREE-TO-GUEST AND OTHER SERVICES. In addition to Guest Pay interactive services, the Company provides cable television programming for which the hotel, rather than its guests, pays the charges. Free-to-guest services include the satellite delivery of various programming channels through a satellite earth station, which generally is owned or leased by the hotel. The hotel pays the Company a fixed monthly charge per room for each programming channel provided. The Company obtains its free-to-guest programming pursuant to multi-year agreements and pays a monthly fee per room which varies depending on incentive programs in effect from time to time. To meet the needs of its hotel customers related to the Company's service offerings, the Company provides a variety of other services to its hotel customers including the sale of system equipment and service parts and labor. Results from these services and free-to-guest services delivered to rooms not receiving Guest Pay interactive services are included in the "other" components of revenues and direct costs in the statements of operations. RESIDENTIAL SERVICES. Effective November 30, 1998, the operations of the Company's majority-owned subsidiary, ResNet Communications, LLC, were merged with two non-affiliated entities to form Global Interactive Communications Corporation ("GICC"). GICC's business consists of providing cable television programming and telecommunications services to the multi-family dwelling unit market. The Company contributed net assets totaling $31.3 million in exchange for a 30% equity interest in GICC and notes receivable totaling $10.8 million. The ResNet business had sales of $5.4 million in 1998 and $2.7 million in 1997, which were included in the "other" component of revenues in the statements of operations. INNMEDIA LLC. During the fourth quarter of 2000, the Company entered into an arrangement with Hilton Hotels Corporation to form a new broadband, interactive media company, InnMedia LLC, to offer hotel guests new and innovative interactive television content such as high speed Internet access through the television as well as customized hotel and guest information. Under this arrangement, InnMedia will supply Internet portal and interactive television content to Hilton and other hotels using LodgeNet's broadband, interactive system. InnMedia will report the operations of these activities, of which LodgeNet and Hilton will equally share, and will pay LodgeNet a fee for use of LodgeNet's system. The arrangement includes $5 million financing commitments from both LodgeNet and Hilton to fund start-up and near-term operational costs. InnMedia is expected to begin delivery of content and services during the third quarter of 2001. 15 RESULTS OF OPERATIONS -- YEARS ENDED DECEMBER 31, 2000 AND 1999 REVENUE ANALYSIS The Company's total revenue for 2000 increased 8.6%, or $15.5 million, in comparison to 1999. The following table sets forth the components of the Company's revenue (in thousands) for the years ended December 31:

1999 2000 --------------------------- --------------------------- PERCENT PERCENT OF TOTAL OF TOTAL AMOUNT REVENUES AMOUNT REVENUES ------------ ----------- ----------- ----------- Revenues: Guest Pay $169,850 93.7 $186,718 94.9 Other 11,422 6.3 10,099 5.1 ------------ ----------- ----------- ----------- Total $181,272 100.0 $196,817 100.0 ============ =========== =========== ===========

GUEST PAY INTERACTIVE SERVICES. Guest Pay interactive service revenue increased 9.9%, or $16.9 million, in 2000 as compared to 1999. This increase is primarily due to a 10.0% increase in the average number of installed Guest Pay rooms. The following table sets forth information with respect to revenue per Guest Pay room for the years ended December 31:

1999 2000 ----------- ------------ Average monthly revenue per room: Movie revenue $ 18.62 $ 18.19 Other interactive service revenue 3.85 4.27 ----------- ------------ Total per Guest Pay room $ 22.47 $ 22.46 =========== ============

Average movie revenue per room decreased 2.3% from 1999 due to a relatively less popular selection of major motion pictures during 2000 compared to the prior year. This factor contributed to a decline in the average buy rate of movies by hotel guests, which was partially offset by higher prices charged for movies and slightly higher hotel occupancy levels. Average other interactive service revenue per room increased 10.9% from the prior year. This increase was primarily due to (i) increased per room revenue from Internet services resulting from increased penetration of Internet services into Guest Pay rooms, an expanded selection of revenue generating Internet services, and increasing interest in Internet services from hotel guests; and (ii) increased revenue from cable television programming services resulting from decreased incentive credits granted to hotels and increases in the number of cable television programming channels supplied by hotels to their guests. OTHER. Revenue from other sources includes revenue from free-to-guest services provided to hotels not receiving Guest Pay services and sales of system equipment and service parts and labor. The 11.6%, or $1.3 million, decrease in other revenue is primarily due to a $1.1 million decrease in revenue from free-to-guest services provided to hotels not receiving Guest Pay services. This was the result of a decline in the number of rooms receiving such services as the Company has chosen to not pursue the renewal of certain contracts as they expire, in certain cases where a technology upgrade (which would result in additional capital investment by the Company) is needed. 16 EXPENSE ANALYSIS DIRECT COSTS. The following table sets forth information regarding the Company's direct costs (in thousands) and gross profit margin for the years ended December 31:

1999 2000 ------------ ----------- Direct costs: Guest Pay $ 70,632 $ 76,586 Other 7,858 5,864 ------------ ----------- $ 78,490 $ 82,450 ============ ===========

Gross profit margin: Guest Pay 58.4% 59.0% Other 31.2% 41.9% Composite 56.7% 58.1% Guest Pay interactive direct costs increased 8.4% to $76.6 million in 2000 from $70.6 million in the prior year. Since Guest Pay direct costs (primarily movie license fees, license fees for other interactive services, Internet connectivity fees, and the commission retained by the hotel) are primarily based on related revenue, such costs generally vary directly with revenue. As a percentage of Guest Pay interactive service revenue, direct costs decreased from 41.6% in 1999 to 41.0% in 2000. The resulting increase in the gross profit margin from 58.4% to 59.0% is primarily the result of: (i) decreased license fees relative to movie revenue due to an increase in sales of independent movies versus major motion pictures as the license fees for independent movies are significantly less than those charged for major motion pictures; (ii) decreased video game license fees as the structure for license fees with Nintendo is such that incremental rooms are incurring license fees at lower rates resulting in an overall lower rate as the Company adds rooms; (iii) decreased commissions paid to the hotel on video game sales as commission rates on the newer N64 game offering have been lower than those on the Super Nintendo product; (iv) decreased programming costs relative to cable television programming revenue due to more favorable programming rates resulting from the Company's conversion to DIRECTV from PRIMESTAR during 2000. These factors were partially offset by a shift in the mix of Guest Pay revenue from the higher margin revenue source of movies to the lower margin revenue source of cable television programming services. Direct costs associated with other revenue decreased $2.0 million or 25.4% in 2000 from the year earlier period, primarily due to the decrease in free-to-guest services provided to hotels not receiving Guest Pay services as described in the revenue analysis above. As a percentage of related revenues, other direct costs decreased to 58.1% of other revenue in 2000 versus 68.8% in 1999. The resulting increase in gross profit margin from 31.2% in 1999 to 41.9% in 2000 is due to (i) the benefit of one-time incentives of $800,000 earned from a vendor and (ii) a shift in the mix of other revenue to higher margin sources from the lower margin source of free-to-guest services. The Company's overall gross profit increased 11.3% in 2000 to $114.4 million on an 8.6% increase in revenue compared to 1999. The overall gross profit margin increased to 58.1% in 2000 from 56.7% in the prior year, reflecting the improved margin for both Guest Pay and other revenue as described above, and due to a shift in sales toward the more profitable Guest Pay interactive services (94.9% of total sales in 2000 compared to 93.7% in 1999) from other revenue sources. 17 OPERATING EXPENSES. The following table sets forth information in regard to the Company's operating expenses (in thousands) for the years ended December 31:

1999 2000 --------------------------- --------------------------- PERCENT PERCENT OF TOTAL OF TOTAL AMOUNT REVENUES AMOUNT REVENUES ------------ ----------- ----------- ----------- Operating expenses: Guest Pay operations $ 24,908 13.7 $ 27,356 13.9 Selling, general and administrative 17,774 9.8 19,247 9.8 Depreciation and amortization 60,778 33.6 65,470 33.3 ------------ ----------- ----------- ----------- Total operating expenses $103,460 57.1 $112,073 56.9 ============ =========== =========== ===========

Guest Pay operations expenses, consisting of costs directly related to the operation of systems at hotel sites, increased 9.8%, or $2.4 million, in 2000 from the prior year. This increase is primarily attributable to the 10.0% increase in average installed Guest Pay rooms in 2000 as compared to 1999. Per average installed Guest Pay room, such expenses were $3.29 per month in 2000 compared to $3.30 per month in 1999. Selling, general and administrative expenses increased 8.3% to $19.2 million in 2000 from $17.8 million in 1999. This increase is primarily due to increased payroll and related expenses such as training, and increased advertising and facilities costs. As a percentage of revenue, SG&A expenses were 9.8% in 2000 and 1999. Depreciation and amortization expenses increased 7.7% to $65.5 million in 2000 from $60.8 million in the prior year. This increase is primarily attributable to the increase in the number of installed Guest Pay interactive rooms previously described, as well as the associated software costs and other capitalized costs such as service vans, equipment and computers that are related to the increased number of rooms in service since the prior year. As a percentage of revenue, depreciation and amortization expenses decreased to 33.3% in 2000 from 33.5% in 1999. OPERATING INCOME (LOSS). The Company generated operating income of $2.3 million compared to an operating loss of $678,000 in 1999, primarily due to increased revenue from Guest Pay interactive services and increased gross profit margin, as described above. GAIN ON SALES OF INVESTMENTS. During the third quarter of 1999, the Company sold its interest in Across Media Networks, Inc. ("AMN"), a creator and distributor of digitally produced on-screen content for television and the Internet, for approximately $9.0 million. The transaction resulted in a $7.1 million gain. In November 1999, the Company sold its interest in 1stUp.com, a provider of free Internet services, to CMGI, Inc. ("CMGI") in a stock-for-stock exchange. Pursuant to the transaction, the Company received 234,332 shares of CMGI common stock which were subject to certain sale and escrow restrictions. The aggregate market value of the shares was $9.8 million at the time the sales agreement was reached. After consideration of a discount to reflect the restrictions placed on the CMGI stock, the Company recorded a gain of $7.6 million during the fourth quarter of 1999. INVESTMENT LOSSES. Global Interactive Communications Corporation - as previously described, the merger of ResNet with two other entities effective November 30, 1998 to form GICC resulted in the Company obtaining a 30% equity interest in GICC. The Company's portion of GICC's net loss for 1998 was $738,000. For the first six months of 1999, the Company recorded equity losses totaling $3.2 million. Beginning with the third quarter of 1999, the Company began using the cost method of accounting for its investment in GICC to reflect its temporary condition resulting from the commencement of a plan by GICC management to sell its assets. The Company periodically reviews its remaining investment in GICC for realization and recognizes write-downs if estimated proceeds from GICC's asset sales are not expected to exceed the Company's recorded investment balance. During 1999, write-downs totaling $18.8 million were recorded to write-down the investment in GICC to estimated fair value. During the fourth quarter of 2000, a $4.2 million write-down was recorded to reduce the investment to its estimated fair value of $3.5 million. Across Media Networks - Prior to the sale of AMN as described above, the Company recorded equity losses of $2.2 million in 1999 related to this investment. Marketable Securities - During the fourth quarter of 2000, the Company recorded losses on its investment in CMGI common stock (described above related to the sale of 1stUp.com) of $6.4 million reflecting a market value decline in the 18 securities, which was deemed to be permanent. The recorded value of this investment was $1.4 million as of December 31, 2000. InnMedia LLC - As previously described, InnMedia was formed by LodgeNet and Hilton during the fourth quarter of 2000. The Company has a 50% equity interest in InnMedia and recorded losses under the equity method of accounting for an investment of $3.0 million during the fourth quarter. A significant portion of these losses represent one-time start-up and organizational-type costs. INTEREST EXPENSE. Interest expense increased to $27.8 million in 2000 from $27.2 million in 1999 due to increases in long-term debt to fund the Company's continuing expansion of its business. The average principal amount of long-term debt outstanding during 2000 was approximately $282 million (at a weighted average interest rate of approximately 9.9%) as compared to an average principal amount outstanding of approximately $273 million (at a weighted average interest rate of approximately 10.0%) during 1999. INTEREST INCOME. Interest income decreased to $419,000 in 2000 from $1.4 million in 1999 due to decreased loans to unconsolidated affiliates. EBITDA. EBITDA (defined by the Company as earnings before interest, income taxes, depreciation, amortization and other non-operating income or expenses) increased 12.8% to $67.8 million in 2000 as compared to $60.1 million in 1999. This increase is primarily due to a 10.0% increase in the average number of installed rooms receiving Guest Pay interactive services and the related increase in Guest Pay revenue, as well as increased gross profit earned on Guest Pay revenue and other revenue as described above. As a percentage of total revenue, EBITDA increased to 34.4% in 2000 as compared to 33.2% in 1999. EBITDA is not intended to represent an alternative to net income or cash flows from operating, financing or investing activities (as determined in accordance with generally accepted accounting principles) as a measure of performance, and is not representative of funds available for discretionary use due to the Company's financing obligations. EBITDA, as defined by the Company, may not be calculated consistently among other companies reporting similarly titled measures. EBITDA is included herein because it is a widely accepted financial indicator used by certain investors and financial analysts to assess and compare companies on the basis of operating performance. Management believes that EBITDA provides an important additional perspective on the Company's operating results and the Company's ability to service its long-term debt and to fund the Company's continuing growth. 19 RESULTS OF OPERATIONS -- YEARS ENDED DECEMBER 31, 1999 AND 1998 REVENUE ANALYSIS The Company's total revenue for 1999 increased 9.0%, or $14.9 million, in comparison to 1998. The following table sets forth the components of the Company's revenue (in thousands) for the years ended December 31:

1998 1999 --------------------------- --------------------------- PERCENT PERCENT OF TOTAL OF TOTAL AMOUNT REVENUES AMOUNT REVENUES ------------ ----------- ----------- ----------- Revenues: Guest Pay $146,481 88.1 $169,850 93.7 Other 19,870 11.9 11,422 6.3 ------------ ----------- ----------- ----------- Total $166,351 100.0 $181,272 100.0 ============ =========== =========== ===========

GUEST PAY INTERACTIVE SERVICES. Guest Pay interactive service revenue increased 16.0%, or $23.4 million, in 1999 as compared to 1998. This increase is attributable to a 13.8% increase in the average number of installed Guest Pay rooms and to a 1.9% increase in average monthly revenue per Guest Pay room. The following table sets forth information with respect to revenue per Guest Pay room for the years ended December 31:

1998 1999 ----------- ------------ Average monthly revenue per room: Movie revenue $ 18.44 $ 18.62 Other interactive service revenue 3.62 3.85 ----------- ------------ Total per Guest Pay room $ 22.06 $ 22.47 =========== ============

Average movie revenue per room increased 1.0% from 1998. This increase was due to higher average movie prices, partially offset by lower average buy rates and hotel occupancy levels. Average other interactive service revenue per room increased 6.4% from the prior year. This increase was primarily due to increased revenue from cable television programming services, partially offset by a decrease in average monthly video game revenue per room. OTHER. The decrease in other revenue in 1999 from the prior year of $8.5 million, or 42.5%, is primarily due to the $5.4 million of revenue generated by ResNet in 1998. In addition, sales declines were experienced with free-to-guest services and sales of system equipment and service parts. EXPENSE ANALYSIS DIRECT COSTS. The following table sets forth information regarding the Company's direct costs (in thousands) and gross profit margin for the years ended December 31:

1998 1999 ------------ ----------- Direct costs: Guest Pay $ 60,538 $ 70,632 Other 13,470 7,858 ------------ ----------- $ 74,008 $ 78,490 ============ =========== Gross profit margin: Guest Pay 58.7% 58.4% Other 32.2% 31.2% Composite 55.5% 56.7%

Guest Pay interactive direct costs increased 16.7% to $70.6 million in 1999 from $60.5 million in the prior year. Since Guest Pay direct costs (primarily movie license fees, license fees for other interactive services, Internet connectivity fees, and the commission retained by the hotel) are primarily based on related revenue, such costs generally vary directly with revenue. As a 20 percentage of Guest Pay interactive service revenue, direct costs increased from 41.3% in 1998 to 41.6% in 1999. The resulting decrease in the gross profit margin from 58.7% to 58.4% is primarily the result of slightly higher license fees for movies and video games. Direct costs associated with other revenue decreased $5.6 million or 41.7% in 1999 from the year earlier period. This decrease is primarily due to $2.4 million of direct costs incurred by ResNet in 1998 and the lower volume of sales of free-to-guest services and sales of system equipment and service parts, as previously described. The Company's overall gross profit increased 11.3% in 1999 to $102.8 million on a 9.0% increase in revenues compared to 1998. The overall gross profit margin increased to 56.7% in 1999 from 55.5% in the prior year, reflecting a shift in sales toward the more profitable Guest Pay interactive services (93.7% of total sales in 1999 compared to 88.1% in 1998) from other sources of revenue. OPERATING EXPENSES. The following table sets forth information in regard to the Company's operating expenses (in thousands) for the years ended December 31:

1998 1999 --------------------------- --------------------------- PERCENT PERCENT OF TOTAL OF TOTAL AMOUNT REVENUES AMOUNT REVENUES ------------ ----------- ----------- ----------- Operating expenses: Guest Pay operations $ 25,167 15.1 $ 24,908 13.7 Selling, general and administrative 18,600 11.2 17,774 9.8 Restructuring and other charge 3,300 2.0 -- -- Depreciation and amortization 55,215 33.2 60,778 33.6 ------------ ----------- ----------- ----------- Total operating expenses $102,282 61.5 $103,460 57.1 ============ =========== =========== ===========

Guest Pay operations expenses consist of costs directly related to the operation of systems at hotel sites. Additionally, prior to the ResNet merger, costs incurred to operate the ResNet systems were included in Guest Pay operations. Such costs totaled $2.9 million in 1998. Excluding the expenses incurred to operate the systems at residential sites, expenses related to Guest Pay operations increased 12.0%, or $2.7 million, in 1999 from $22.2 million in the previous year. This increase is primarily attributable to the 13.8% increase in average installed Guest Pay rooms in 1999 as compared to 1998, partially offset by lower average operating and service expenses incurred on a per room basis. Per average installed Guest Pay room, such expenses were $3.30 per month in 1999 compared to $3.35 per month in 1998. Selling, general and administrative ("SG&A") expenses decreased 4.4% to $17.8 million in 1999 from $18.6 million in 1998. Excluding ResNet SG&A expenses incurred during 1998 of $1.8 million, SG&A expenses increased $955,000 or 5.7%. As a percentage of revenue, excluding ResNet results in 1998, SG&A expenses decreased to 9.8% of revenue in 1999 compared to 10.4% in 1998. The $3.3 million restructuring and other charge recorded in 1998 represents costs incurred related to the Company's merger of its ResNet business as previously described. Such costs include professional services fees, employee costs, and the write-off of certain capitalized software development costs. Depreciation and amortization expenses increased 10.1% to $60.8 million in 1999 from $55.2 million in the prior year. Excluding ResNet depreciation and amortization expenses incurred during 1998 of $3.6 million, depreciation and amortization expense increased $9.2 million or 17.8%. This increase is primarily attributable to the increase in the number of installed Guest Pay interactive rooms previously described, as well as the associated software costs and other capitalized costs such as service vans, equipment and computers that are related to the increased number of rooms in service since the prior year. Additionally, increases in administrative and facility related assets contributed to the increased depreciation and amortization. As a percentage of revenue, excluding ResNet results in 1998, depreciation and amortization expenses increased to 33.6% from 32.1% in 1998. OPERATING LOSS. The Company's operating loss decreased to $678,000 in 1999 from $9.9 million in 1998. This is due to increased revenue from Guest Pay interactive services, improved gross profit margin, and lower Guest Pay operating and SG&A expenses, as described above. GAIN ON SALE OF INVESTMENTS. During the third quarter of 1999, the Company sold its interest in Across Media Networks, Inc. ("AMN") for approximately $9.0 million. The transaction resulted in a $7.1 million gain. 21 In November 1999, the Company sold its interest in 1stUp.com, a provider of free Internet services, to CMGI, Inc. ("CMGI") in a stock-for-stock exchange. Pursuant to the transaction, the Company received 234,332 shares of CMGI common stock which are subject to certain sale and escrow restrictions. The aggregate market value of the shares was $9.8 million at the time the sales agreement was reached. After consideration of a discount to reflect the restrictions placed on the CMGI stock, the Company recorded a gain of $7.6 million during the fourth quarter of 1999. INVESTMENT LOSSES. Prior to the sale of AMN as described above, the Company recorded equity losses of $5.8 million in 1998 and $2.2 million in 1999 related to this investment. Additionally, as previously described, the merger of ResNet with two other entities effective November 30, 1998 to form GICC resulted in the Company obtaining a 30% equity interest in GICC. The Company's portion of GICC's net loss for 1998 was $738,000. For the first six months of 1999, the Company recorded equity losses totaling $3.2 million. In addition, the Company recorded a $16.8 million charge in the second quarter of 1999 to write-down its investment in GICC to estimated fair value. Beginning with the third quarter of 1999, the Company is using the cost method of accounting for its investment in GICC to reflect its temporary condition resulting from the commencement of a plan by GICC management to sell its assets. During the fourth quarter of 1999, a $2.1 million charge was recorded to further write-down the investment in GICC to its current estimated fair value. INTEREST EXPENSE. Interest expense increased to $27.2 million in 1999 from $23.3 million in 1998 due to increases in long-term debt to fund the Company's continuing expansion of its business. The average principal amount of long-term debt outstanding during 1999 was approximately $273 million (at a weighted average interest rate of approximately 10.0%) as compared to an average principal amount outstanding of approximately $226 million (at a weighted average interest rate of approximately 10.3%) during 1998. INTEREST INCOME. Interest income, earned on loans to unconsolidated affiliates, increased to $1.4 million in 1999 from $213,000 in 1998. EBITDA. EBITDA (defined by the Company as earnings before interest, income taxes, depreciation, amortization and other non-operating income or expenses) increased 23.7% to $60.1 million in 1999 as compared to $48.6 million in 1998. This increase is primarily due to a 13.8% increase in the average number of installed rooms receiving Guest Pay interactive services and the related increase in Guest Pay revenue, as well as increased gross profit and lower Guest Pay operations and SG&A expenses, as described above. As a percentage of total revenue, EBITDA increased to 33.2% in 1999 as compared to 29.2% in 1998. SEASONALITY The Company's quarterly operating results are subject to fluctuation depending upon hotel occupancy rates and other factors. Typically, occupancy rates are higher during the second and third quarters due to seasonal travel patterns. LIQUIDITY AND CAPITAL RESOURCES Historically, the growth of the Company's business has required substantial amounts of capital. The Company has incurred operating and net losses due in large part to the depreciation, amortization and interest expenses related to the capital required to expand its business. Historically, cash flow from operations has not been sufficient to fund the cost of expanding the Company's business and to service existing indebtedness. For 1999, capital expenditures were $51.2 million and net cash provided by operating activities was $40.8 million. For 2000, capital expenditures were $60.2 million and net cash provided by operating activities was $41.2 million. Depending on the rate of growth of its business and other factors, the Company expects to incur capital expenditures between $70 to $80 million in 2001, as contemplated under its 2001 business plan. The Company's cash requirements for 2001 are expected to include $21.6 million of payments for principal maturities of long-term debt. In addition, the Company has committed up to $5 million of financing to InnMedia LLC, of which the Company funded $1 million in the fourth quarter of 2000. The Company also has a $13.3 million net working capital deficit as of December 31, 2000. As of December 31, 2000, the Company has $41 million available for borrowing under its $75 million revolving credit facility. The Company believes that its operating cash flows and borrowings available under the revolving credit facility will be sufficient to fund the Company's future growth and financing obligations for approximately nine months, as contemplated under its 2001 business plan. The Company may increase the revolving credit facility to $100 million, subject to certain conditions. The Company is presently analyzing various sources to obtain additional long-term financing in addition to the revolving credit facility, and believes that such amounts will be obtained to support the Company's growth objectives. There can be no assurance that the Company will be able to obtain financing, or, if such financing is available, that the Company will be able to 22 obtain it on acceptable terms. Failure to obtain additional financing could result in the delay or abandonment of some or all of the Company's expansion plans, which would reduce the level of capital expenditures anticipated for 2001 as described above. The actual amount and timing of the Company's capital expenditures will vary (and such variations could be material) depending upon the number of new contracts for services entered into by the Company, the costs of installations and other factors. ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is exposed to various market risks, including potential losses resulting from adverse changes in interest rates and foreign currency exchange rates. The Company does not enter into derivatives or other financial instruments for trading or speculative purposes. INTEREST. At December 31, 2000, the Company had debt totaling $290.7 million. The Company has interest rate swap arrangements covering debt with a notional amount of $109 million to effectively change the underlying debt from a variable interest rate to a fixed interest rate for the term of the swap agreements. After giving effect to the interest rate swap arrangements the Company had fixed rate debt of $281.7 million and variable rate debt of $9.0 million at December 31, 2000. For fixed rate debt, interest rate changes affect the fair market value but do not impact earnings or cash flows. Conversely, for variable rate debt, interest rate changes generally do not affect the fair market value but do impact future earnings and cash flows, assuming other factors are held constant. Assuming other variables remain constant (such as debt levels), a one percentage point increase in interest rates would decrease the unrealized fair market value of the fixed rate debt by an estimated $26.6 million. The impact on earnings and cash flow for the next year resulting from a one percentage point increase in interest rates would be approximately $90,000 assuming other variables remain constant. FOREIGN CURRENCY TRANSACTIONS. A portion of the Company's revenues are derived from the sale of Guest Pay services in Canada. The results of operations and financial position of the Company's operations in Canada are measured in Canadian dollars and translated into U.S. dollars. The effects of foreign currency fluctuations in Canada are somewhat mitigated by the fact that expenses and liabilities are generally incurred in Canadian dollars. The reported income of the Company's Canadian subsidiary will be higher or lower depending on a weakening or strengthening of the U.S. dollar against the Canadian dollar. In addition, a portion of the Company's assets are based in Canada and are translated into U.S. dollars at foreign currency exchange rates in effect as of the end of each period. Accordingly, the Company's consolidated assets will fluctuate depending on the weakening or strengthening of the U.S. dollar against the Canadian dollar. No significant foreign currency fluctuations occurred during 2000 to materially impact consolidated results of operations or financial condition. ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See "Item 14 - Exhibits, Financial Statement Schedules and Reports on Form 8-K" for the Company's Consolidated Financial Statements, the Notes thereto and Schedules filed as a part of this report. ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Except as hereinafter noted, the information concerning directors and executive officers of the Company is incorporated by reference from the sections entitled "Executive Officers", "Election of Directors - Board of Directors and Nominees" and "Compliance with Reporting Requirements of Section 16 of the Exchange Act" of the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year. 23 ITEM 11 - EXECUTIVE COMPENSATION Information concerning executive remuneration and transactions is incorporated by reference from the section entitled "Beneficial Ownership of Principal Stockholders and Management" of the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year. ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information concerning security ownership of certain beneficial owners and management is incorporated by reference from the section entitled "Beneficial Ownership of Principal Stockholders and Management" of the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A within 120 days after the end of the last fiscal year. ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information concerning certain relationships and related transactions with management is incorporated by reference from the section entitled "Certain Transactions with Management and Others" of the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A within 120 days after the end of the fiscal year. PART IV ITEM 14 -- EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES -- Reference is made to the "Index to Consolidated Financial Statements" of LodgeNet Entertainment Corporation, located at page F - 1 of this PART IV, for a list of the financial statements and schedules for the year ended December 31, 2000 included herein. (b) REPORTS ON FORM 8-K -- On October 18, 2000, the Company filed a Form 8-K reporting on the Company's agreement with Hilton Hotels Corporation. (c) EXHIBITS -- Following is a list of Exhibits filed with this report. Exhibits 10.1, 10.2, 10.30 and 10.31 constitute management contracts. Exhibits 10.3, 10.7, 10.8, 10.9, 10.10, 10.11, and 10.12 constitute compensatory plans. EXHIBIT NO. 3.1 Certificate of Incorporation of the Company (1) 3.2 By-Laws of the Registrant (1) 4.1 Registration Rights Agreement dated as of December 16, 1996, between LodgeNet Entertainment Corporation and Morgan Stanley & Co. Incorporated, NatWest Capital Markets Limited and Montgomery Securities (8) 4.2 Indenture dated as of December 19, 1996, between LodgeNet Entertainment Corporation and Marine Midland Bank, as trustee, including the form of Senior Note (8) 4.3 Form of Senior Notes (included in Exhibit 4.2) 4.4 First Supplemental Indenture dated October 15, 1998, among LodgeNet Entertainment Corporation and Marine Midland Bank, as trustee, to the Indenture dated December 19, 1996 (see Exhibit 4.2) 10.1 Form of Employment Agreement between the Company and each of Tim C. Flynn and Scott C. Petersen (1) 10.2 Form of Agreement between the Company and each of David M. Bankers, John M. O'Haugherty and Steven D. Truckenmiller (1) 10.3 LodgeNet Entertainment Corporation Stock Option Plan (as amended and restated effective August 15, 1996)(8) 10.6 License Agreement dated May 2, 1993 between Nintendo of America, Inc. and LodgeNet Entertainment Corporation (2) 24 10.7 Stock Option Agreements dated as of February 29, 1988 between the Company and Tim C. Flynn, as extended by Extension Agreement dated as of July 15, 1991 (2) 10.8 Stock Option Agreements dated as of February 29, 1988 between the Company and Scott C. Petersen, as extended by Extension Agreement dated as of July 15, 1991 (2) 10.9 Stock Option Agreement dated as of December 31, 1992 between the Company and John M. O'Haugherty (2) 10.10 Stock Option Agreement dated as of December 31, 1992 between the Company and David M. Bankers (2) 10.11 Form of Stock Option Agreement for Non-Employee Directors (3) 10.12 Form of Incentive Stock Option Agreement for Key Employees (3) 10.13 Securities Purchase Agreement, by and between LodgeNet Entertainment Corporation, John Hancock Mutual Life Insurance Company, Allstate Life Insurance Company, Connecticut Mutual Life Insurance and CMA Life Insurance Company, dated as of August 9, 1995 (4) 10.14 Amendment to Securities Purchase Agreement, dated as of December 19, 1996 (8) 10.15 Form of Executive Severance Agreement between the Company and each of Tim C. Flynn, Scott C. Petersen, Jeffrey T. Weisner, John M. O'Haugherty, David M. Bankers and Steven D. Truckenmiller; all dated of July 25, 1995 (5) 10.16 Video Services Agreement by and among GE Capital-ResCom L.P. and ResNet Communications, Inc. and LodgeNet Entertainment Corporation dated as of February 9, 1996 (6)+ 10.17 Amended and Restated Loan Agreement by and among LodgeNet Entertainment Corporation, the Banks Signatory thereto, National Westminster Bank Plc, as Agent for such Banks, and National Westminster bank of Canada, as an Issuing bank, dated December 19, 1996 (8) 10.18 Equipment Sales Agreement between ResNet Communications, Inc. and TCI Satellite Entertainment, Inc., dated as of October 21, 1996 (7) 10.19 Subordinated Convertible Term Loan Agreement between ResNet Communications, Inc. and TCI Satellite Entertainment, Inc., dated as of October 21, 1996 (7) 10.20 Option Agreement between ResNet Communications, Inc. and TCI Satellite Entertainment, Inc., dated as of October 21, 1996 (7) 10.21 Standstill Agreement between LodgeNet Entertainment Corporation and TCI Satellite Entertainment, Inc., dated as of October 21, 1996 (7) 10.22 Stockholders' Agreement between LodgeNet Entertainment Corporation and TCI Satellite Entertainment, Inc., dated as of October 21, 1996 (7) 10.23 Subscription Agreement between ResNet Communications, Inc. and TCI Satellite Entertainment, Inc., dated as of October 21, 1996 (7) 10.24 First Amendment, dated October 17, 1996, to License Agreement between Nintendo of America, Inc. and LodgeNet Entertainment Corporation (8) 10.25 Exchange Agreement, dated November 30, 1998, among Shared Technologies Communications Corporation, Interactive Cable Systems, Inc., ResNet Communications, LLC, ResNet Communications, Inc. and Global Interactive Technologies Corporation (9) 25 10.26 Stockholders Agreement dated November 30, 1998, by and among Global Interactive Technologies Corporation, Shared Technologies Communications Corporation, Interactive Cable Systems, Inc. and ResNet Communications, LLC (9) 10.27 Consent and Restructuring Agreement dated November 6, 1998, by and among ResNet Communications, LLC, ResNet Communications, Inc., and PrimeStar MDU (10) 10.28 Second Amended and Restated Credit Agreement dated as of February 25, 1999, by and among LodgeNet Entertainment Corporation, National Westminster Bank Plc, BankBoston, N.A., Morgan Stanley Senior Funding, Inc. and the Lenders Named Therein (10) 10.29 Confidential License Agreement for Use of Nintendo Video Game Systems with Hotel Entertainment System, dated May 12, 1998, between LodgeNet Entertainment Corporation and Nintendo of America Inc. + (10) 10.30 Form of Employment Agreement between the Company and Scott C. Petersen (11) 10.31 Form of Employment Agreement between the Company and each of David M. Bankers, John M. O'Haugherty and Jeffrey T. Weisner (11) 10.32 Master Services Agreement between Hilton Hotels Corporation and LodgeNet Entertainment Corporation dated October 9, 2000 + (12) 10.33 Warrant to Purchase Common Stock of LodgeNet Entertainment Corporation dated October 9, 2000(12) 10.34 InnMedia LLC Operating Agreement effective as of October 9, 2000(12) 12.1 Statement of computation of ratios 21.1 Subsidiaries of the Company (13) 23.1 Consent of Independent Public Accountants ----------------------- +Confidential Treatment has been requested with respect to certain portions of these agreements. (1) Incorporated by Reference to the Company's Amendment No. 1 to Registration Statement on Form S-1, as filed with the Securities and Exchange Commission, September 24, 1993. (2) Incorporated by Reference to the Company's Amendment No. 2 to Registration Statement on Form S-1, as filed with the Securities and Exchange Commission, October 13, 1993. (3) Incorporated by Reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1993, as filed with the Securities and Exchange Commission, March 25, 1994. (4) Incorporated by Reference to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1995, as filed with the Securities and Exchange Commission, August 14, 1995. (5) Incorporated by Reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1995, as filed with the Securities and Exchange Commission, November 14, 1995. (6) Incorporated by Reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1995, as filed with the Securities and Exchange Commission, April 1, 1996. (7) Incorporated by Reference to TCI Satellite Entertainment, Inc.'s Amendment No. 1 to Registration Statement on the Company's Form 10 as filed with the Securities and Exchange Commission, October 29, 1996. (8) Incorporated by Reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1996, as filed with the Securities and Exchange Commission, March 17, 1997. 26 (9) Incorporated by Reference to the Company's Form 8-K as filed with the Securities and Exchange Commission, December 15, 1998. (10) Incorporated by Reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1998, as filed with the Securities and Exchange Commission, March 25, 1999. (11) Incorporated by Reference to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1999, as filed with the Securities and Exchange Commission, August 13, 1999. (12) Incorporated by Reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2000, as filed with the Securities and Exchange Commission, November 14, 2000. (13) Incorporated by Reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1997, as filed with the Securities and Exchange Commission, March 25, 1998. 27 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized in the City of Sioux Falls, State of South Dakota, on March 29, 2001. LodgeNet Entertainment Corporation By: /s/ Scott C. Petersen, --------------------------------------- Scott C. Petersen, President, Chief Executive Officer and Chairman of the Board of Directors Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, and in the capacities indicated, on March 29, 2001.

SIGNATURE TITLE DATE --------- ----- ---- /s/ Scott C. Petersen President, Chief Executive Officer March 29, 2001 ----------------------------- and Chairman of the Board of Scott C. Petersen Directors (Principal Executive Officer) /s/ Gary H. Ritondaro Senior Vice President March 29, 2001 ----------------------------- Chief Financial Officer Gary H. Ritondaro (Principal Financial Officer) /s/ Ronald W. Pierce Vice President and Corporate March 29, 2001 ----------------------------- Controller (Principal Ronald W. Pierce Accounting Officer) /s/ R. Douglas Bradbury Director March 29, 2001 ----------------------------- R. Douglas Bradbury /s/ Lawrence Flinn, Jr. Director March 29, 2001 ----------------------------- Lawrence Flinn, Jr. /s/ Richard R. Hylland Director March 29, 2001 ----------------------------- Richard R. Hylland /s/ R. F. Leyendecker Director March 29, 2001 ----------------------------- R. F. Leyendecker

28 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS LODGENET ENTERTAINMENT CORPORATION AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Page Report of Independent Public Accountants.................................................................. F - 2 Consolidated Balance Sheets as of December 31, 1999 and 2000.............................................. F - 3 Consolidated Statements of Operations -- Three Years Ended December 31, 2000...............................F - 4 Consolidated Statements of Stockholders' Equity (Deficit) -- Three Years Ended December 31, 2000...........F - 5 Consolidated Statements of Cash Flows -- Three Years Ended December 31, 2000...............................F - 6 Notes to Consolidated Financial Statements ................................................................F - 7 INDEX TO FINANCIAL SCHEDULES Report of Independent Public Accountants on Schedule.......................................................F - 19 Schedule II -- Valuation and Qualifying Accounts...........................................................F - 20

F-1 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To LodgeNet Entertainment Corporation: We have audited the accompanying consolidated balance sheets of LodgeNet Entertainment Corporation (a Delaware corporation) and Subsidiaries as of December 31, 1999 and 2000, and the related consolidated statements of operations, stockholders' equity (deficit) and cash flows for each of the three years in the period ended December 31, 2000. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of LodgeNet Entertainment Corporation and Subsidiaries as of December 31, 1999 and 2000, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2000, in conformity with accounting principles generally accepted in the United States. ARTHUR ANDERSEN LLP Minneapolis, Minnesota February 9, 2001 F-2 LODGENET ENTERTAINMENT CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollar amounts in thousands)

DECEMBER 31, ------------------------------- 1999 2000 ------------- ------------- Assets Current assets: Cash and cash equivalents $ 1,644 $ 4,059 Marketable securities 25,952 1,398 Accounts receivable, net 29,620 26,553 Note receivable 7,060 -- Prepaid expenses and other 2,413 3,610 ------------- ------------- Total current assets 66,689 35,620 Property and equipment, net 204,334 224,927 Investments in and advances to unconsolidated affiliates 11,434 3,500 Debt issuance costs, net 8,710 7,121 Other assets, net 14,108 10,437 ------------- ------------- $ 305,275 $ 281,605 ============= ============= Liabilities and Stockholders' Deficit Current liabilities: Accounts payable $ 14,610 $ 12,671 Current maturities of long-term debt 5,915 21,563 Accrued expenses and other 10,643 11,988 Deferred revenue 2,536 2,713 ------------- ------------- Total current liabilities 33,704 48,935 Long-term debt 277,075 269,096 ------------- ------------- Total liabilities 310,779 318,031 ------------- ------------- Commitments and contingencies (Note 9) Stockholders' deficit: Common stock, $.01 par value, 20,000,000 shares authorized; 11,970,852 and 12,212,039 shares outstanding at December 31, 1999 and 2000, respectively 120 122 Additional paid-in capital 124,021 150,663 Accumulated deficit (146,967) (185,981) Accumulated other comprehensive income (loss) 17,322 (1,230) ------------- ------------- Total stockholders' deficit (5,504) (36,426) ------------- ------------- $ 305,275 $ 281,605 ============= =============

The accompanying notes are an integral part of these consolidated financial statements. F-3 LODGENET ENTERTAINMENT CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Dollar amounts, except per share amounts, in thousands)

YEARS ENDED DECEMBER 31, ------------------------------------------------- 1998 1999 2000 -------------- ------------- ------------- Revenues: Guest Pay $ 146,481 $ 169,850 $ 186,718 Other 19,870 11,422 10,099 -------------- ------------- ------------- Total revenues 166,351 181,272 196,817 -------------- ------------- ------------- Direct costs: Guest Pay 60,538 70,632 76,586 Other 13,470 7,858 5,864 -------------- ------------- ------------- Total direct costs 74,008 78,490 82,450 -------------- ------------- ------------- Gross profit 92,343 102,782 114,367 -------------- ------------- ------------- Operating expenses: Guest Pay operations 25,167 24,908 27,356 Selling, general and administrative 18,600 17,774 19,247 Restructuring and other charges (Note 3) 3,300 -- -- Depreciation and amortization 55,215 60,778 65,470 -------------- ------------- ------------- Total operating expenses 102,282 103,460 112,073 -------------- ------------- ------------- Operating income (loss) (9,939) (678) 2,294 Gain on sales of investments -- 14,739 -- Investment losses (6,550) (24,323) (13,593) Interest expense (23,261) (27,210) (27,809) Interest income 213 1,414 419 -------------- ------------- ------------- Loss before income taxes (39,537) (36,058) (38,689) Provision for income taxes (375) (370) (325) -------------- ------------- ------------- Net loss $ (39,912) $ (36,428) $ (39,014) ============== ============= ============= Per common share (basic and diluted): Net loss $ (3.45) $ (3.05) $ (3.21) ============== ============= ============= Weighted average shares outstanding (basic and diluted) 11,579,457 11,948,660 12,145,109 ============== ============= =============

The accompanying notes are an integral part of these consolidated financial statements. F-4 LODGENET ENTERTAINMENT CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) (Dollar amounts in thousands)

ACCUMULATED COMMON STOCK ADDITIONAL OTHER ---------------------------- PAID-IN ACCUMULATED COMPREHENSIVE SHARES AMOUNT CAPITAL DEFICIT INCOME/(LOSS) TOTAL ------------ ------------ ------------ -------------- ------------- ----------- Balance, December 31, 1997 11,322,058 $ 113 $ 120,792 $ (70,627) $ (699) $ 49,579 Common stock option activity 350,000 3 3,081 -- -- 3,084 Issuance of common stock 270,329 3 253 -- -- 256 Comprehensive loss: Net loss -- -- -- (39,912) -- Foreign currency translation adjustment -- -- -- -- (813) Comprehensive loss (40,725) Change of interest in subsidiary -- -- (420) -- -- (420) ------------ ------------ ------------ -------------- ------------- ----------- Balance, December 31, 1998 11,942,387 119 123,706 (110,539) (1,512) 11,774 Issuance of common stock 12,141 -- 158 -- -- 158 Common stock option activity 16,324 1 157 -- -- 158 Comprehensive loss: Net loss -- -- -- (36,428) -- Foreign currency translation adjustment -- -- -- -- 706 Unrealized gain on marketable securities -- -- -- -- 18,128 Comprehensive loss (17,594) ------------ ------------ ------------ -------------- ------------- ----------- Balance, December 31, 1999 11,970,852 120 124,021 (146,967) 17,322 (5,504) Common stock option activity 241,187 2 2,326 -- -- 2,328 Short-swing profits (Note 10) -- -- 2,468 -- -- 2,468 Warrants issued (Note 12) -- -- 21,848 -- -- 21,848 Comprehensive loss: Net loss -- -- -- (39,014) -- Foreign currency translation adjustment -- -- -- -- (424) Unrealized loss on marketable securities -- -- -- -- (18,128) Comprehensive loss (57,566) ------------ ------------ ------------ -------------- ------------- ----------- Balance, December 31, 2000 12,212,039 $ 122 $ 150,663 $ (185,981) $ (1,230) $ (36,426) ============ ============ ============ ============== ============= ===========

The accompanying notes are an integral part of these consolidated financial statements. F-5 LODGENET ENTERTAINMENT CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollar amounts in thousands)

YEARS ENDED DECEMBER 31, ------------------------------------------------- 1998 1999 2000 -------------- ------------- ------------- Operating activities: Net loss $ (39,912) $ (36,428) $ (39,014) Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation and amortization 55,215 60,778 65,470 Gain on sale of property and equipment (309) -- -- Gain on sales of investments -- (14,739) -- Investment losses 6,550 24,323 13,593 Non-cash portion of restructuring charge 840 -- -- Change in operating assets and liabilities: Accounts receivable (6,157) (1,366) 3,011 Prepaid expenses and other (2,659) 3,811 (1,948) Accounts payable (2,770) 886 (1,926) Accrued expenses and deferred revenue 1,677 1,294 296 Other 768 2,223 1,698 -------------- ------------- ------------- Net cash provided by operating activities 13,243 40,782 41,180 -------------- ------------- ------------- Investing activities: Property and equipment additions (68,733) (51,226) (60,195) Proceeds from (investment in) affiliates (8,330) (4,219) 2,747 Proceeds from sale of investment -- -- 7,200 Proceeds from sale of property and equipment 412 -- -- Business acquisitions (927) -- -- -------------- ------------- ------------- Net cash used for investing activities (77,578) (55,445) (50,248) -------------- ------------- ------------- Financing activities: Proceeds from long-term debt 1,000 75,000 -- Repayment of long-term debt (28) (38) (39) Payment of license rights liability (5,461) (4,954) (5,294) Payment of capital lease obligations (659) (577) (453) Borrowings under revolving credit facility 73,500 35,500 23,000 Repayments of revolving credit facility -- (90,500) (10,500) Debt issuance costs -- (3,559) -- Stock option activity 256 158 2,328 Short-swing profits (Note 10) -- -- 2,468 -------------- ------------- ------------- Net cash provided by financing activities 68,608 11,030 11,510 -------------- ------------- ------------- Effect of exchange rates on cash (54) 37 (27) -------------- ------------- ------------- Increase (decrease) in cash and cash equivalents 4,219 (3,596) 2,415 Cash and cash equivalents at beginning of period 1,021 5,240 1,644 -------------- ------------- ------------- Cash and cash equivalents at end of period $ 5,240 $ 1,644 $ 4,059 ============== ============= =============

The accompanying notes are an integral part of these consolidated financial statements. F-6 LODGENET ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 -- THE COMPANY LodgeNet is a broadband, interactive services provider specializing in the delivery of interactive television and Internet access services to the lodging industry throughout the United States, Canada and select international markets. These services include on-demand movies, Nintendo video games, Internet-enhanced television, high-speed Internet access, and other interactive television services designed to serve the needs of the lodging industry and the traveling public. The Company's operating performance and outlook are strongly influenced by such factors as hotel occupancy levels and economic conditions in the lodging industry, the number of lodging rooms equipped with the Company's interactive systems, hotel guest demographics, the number and type of product offerings, the popularity and availability of programming, and competitive factors. The rapid growth of the Company's business has and is expected to continue to require capital resources in excess of operating cash flows. The Company believes that its operating cash flows and borrowings available under its revolving credit facility will be sufficient to fund the Company's growth plans, as contemplated under its current business plan, for approximately nine months. The Company is currently seeking additional capital to support its growth plans in subsequent periods. Failure to obtain additional capital could result in the delay or abandonment of some or all of the Company's growth plans. NOTE 2 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION -- The consolidated financial statements include the accounts of the Company and its wholly owned Canadian subsidiary. Investments in affiliates in which the Company has significant influence, but not effective control (generally represented by common stock ownership of at least 20% but not more than 50%), are accounted for using the equity method of accounting for an investment. All significant intercompany accounts and transactions have been eliminated in consolidation. FOREIGN CURRENCY TRANSLATION -- The assets and liabilities of the Company's Canadian subsidiary were translated at year-end exchange rates. Income statement items were translated at average exchange rates during the periods. USE OF ESTIMATES -- The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions about certain matters and items. These estimates and assumptions affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues, expenses and costs during the reporting periods. The ultimate outcome of the matters and items may be different from the estimates and assumptions. LONG-LIVED ASSETS -- The Company reviews the carrying value of long-lived assets such as property and equipment and intangible assets whenever events or circumstances indicate that the carrying value of an asset may not be recoverable from the estimated future cash flows expected to result from its use and eventual disposition. In cases where undiscounted expected future cash flows are less than the carrying value, an impairment loss is recognized to reduce the carrying value of the asset to its estimated fair value. F-7 PROPERTY AND EQUIPMENT -- Property and equipment is stated at cost, net of accumulated depreciation and amortization. Installed Guest Pay and free-to-guest systems consist of equipment and related costs of installation, including certain payroll costs. Maintenance costs, which do not significantly extend the useful lives of the respective assets, and repairs are charged to operations as incurred. Depreciation of Guest Pay and free-to-guest systems begins when such systems are installed and activated. Depreciation of other equipment begins when such equipment is placed in service. The Company attributes no salvage value to equipment. Depreciation and amortization is computed using the straight-line method over the following useful lives:

YEARS ------------ Buildings 30 Guest Pay systems: System components 5 - 7 In-room equipment 2 - 5 Other equipment 3 - 10

SOFTWARE DEVELOPMENT -- The Company has capitalized certain costs of developing software for its Guest Pay systems in accordance with AICPA Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use". Capitalized costs are reported at the lower of unamortized cost or net realizable value, and are amortized over the system's estimated useful life, not to exceed five years. Guest Pay system development costs capitalized were $2,405,000, $1,554,000 and $2,818,000 during the years ended December 31, 1998, 1999 and 2000, respectively, and amortization of such costs was $1,138,000, $1,178,000 and $1,445,000, respectively. The Company charged $252,000, $704,000, and $507,000 to operations for each of the years presented related to research and development activities. REVENUE RECOGNITION -- In December 1999, the SEC staff released Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101"). SAB 101 provides interpretive guidance on the recognition, presentation and disclosures of revenue in the financial statements effective for all transactions beginning January 1, 2000. Adoption of SAB 101 did not materially impact the Company's revenue recognition policies. Revenue from the sale of interactive television services is recognized in the period the services are provided. Revenue from the sale of system equipment and service parts and labor is recognized when the equipment is delivered or the service has been provided. Deferred revenue consists of advance billings for certain interactive television services that are recognized in the periods that services are provided. CONCENTRATION OF CREDIT RISKS AND CUSTOMER DATA -- The Company derives virtually all of its revenue from entities in the lodging industry; however, no individual customer accounted for 10% or more of total revenue in any period presented in the accompanying consolidated statements of operations. The allowance for doubtful accounts was $800,000 at December 31, 1999 and 2000. The provision for doubtful accounts was $848,000 in 1998, $441,000 in 1999, and $340,000 in 2000. DERIVATIVE FINANCIAL INSTRUMENTS -- The Company has entered into interest rate swap arrangements to manage certain exposures to fluctuations in interest rates. The Company does not utilize these instruments for speculative or trading purposes. Interest rate swaps generally involve the exchange of fixed and variable rate interest payments without the exchange of the underlying principal. Net amounts paid or received are reflected as adjustments to interest expense. INCOME TAXES -- The Company accounts for income taxes under the liability method, in accordance with the requirements of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes". Deferred income tax assets and liabilities are computed annually for differences between the financial statement and tax basis of assets and liabilities. Measurement is based on enacted tax rates applicable to the periods in which such differences are expected to reverse. COMPREHENSIVE INCOME -- During 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income," which requires companies to report all changes in equity during a period, except those resulting from investments by F-8 owners and distributions to owners, in a financial statement for the period in which they are recognized. The Company has chosen to disclose comprehensive income, which is comprised of net loss, foreign currency translation adjustments, and unrealized gains (losses) on marketable securities available for sale, in the consolidated statement of stockholders' equity. EARNINGS PER SHARE COMPUTATION -- The Company follows SFAS No. 128, "Earnings Per Share" which requires the computation and disclosure of two EPS amounts, basic and diluted. Basic EPS is computed based only on the weighted average number of common shares actually outstanding during the period. Diluted EPS is computed based on the weighted average number of common shares outstanding plus all potentially dilutive common shares outstanding during the period. Weighted average options on 1,736,333, 1,710,796, and 1,912,991 shares of common stock and warrants on 480,000, 480,000, and 823,000 shares of common stock were not included in computing diluted EPS because their effects were antidilutive for each of the years presented. STOCK-BASED COMPENSATION -- The Company measures compensation costs associated with its stock option plans in accordance with the provisions of Accounting Principles Board Opinion No. 25, as permitted by SFAS No. 123. The effect of fair value based measurement of such costs on net loss and net loss per share, in accordance with SFAS No. 123, is disclosed on a pro forma basis in Note 11. STATEMENTS OF CASH FLOWS -- Cash equivalents are comprised of demand deposits and temporary investments in highly liquid securities having original maturities of 90 days or less. Cash paid for interest was $21,633,000, $27,081,000, and $27,879,000 during the years ended December 31, 1998, 1999, and 2000, respectively. Equipment acquired under capital lease arrangements totaled $885,000, $461,000, and $957,000 during the years ended December 31, 1998, 1999, and 2000, respectively. During 1998, non-cash activities included the acquisition of license rights valued at $15,709,000 in exchange for notes payable issued by the Company (see Note 9) and the issuance of 350,000 common shares valued at $3,084,000 as part of an acquisition completed during the year (see Note 3). During 2000, the Company issued 2.1 million stock purchase warrants valued at $21,848,000 to Hilton Hotels Corporation (Hilton) (see Note 12) to acquire rights to deliver interactive television services in Hilton hotels. EFFECT OF RECENTLY ISSUED ACCOUNTING STANDARDS -- In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". SFAS No. 133 establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. The statement requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item and requires that a company must formally document, designate and assess the effectiveness of transactions that receive hedge accounting. SFAS No. 133 will impact the Company, beginning January 1, 2001, by requiring that its interest rate swap agreements be recorded on the balance sheet as an asset or liability measured at fair value. The effective portion of the resulting gain or loss will be reported as a component of other comprehensive income and reclassified into earnings in the same period during which the hedged interest payments affect earnings. If SFAS No. 133 was required to be applied to the interest rate swap arrangements in place at December 31, 2000, changes in the fair value of the contract would increase liabilities by approximately $1.3 million with an offsetting amount recorded in accumulated other comprehensive income. RECLASSIFICATIONS -- Certain items in the consolidated financial statements have been reclassified to conform to 2000 classifications. Such reclassifications had no effect on previously reported net loss or stockholders' deficit. F-9 NOTE 3 -- INVESTMENT ACTIVITIES RESNET MERGER/GICC INVESTMENT - Effective November 30, 1998, the operations of the Company's majority-owned subsidiary, ResNet Communications, LLC ("ResNet"), were merged with two non-affiliated entities to form Global Interactive Communications Corporation ("GICC"). GICC's business consists of providing cable television programming and telecommunications services to the multi-family dwelling unit market. The Company contributed net assets totaling $31.3 million in exchange for a 30% equity interest in GICC and notes receivable totaling $10.8 million. In connection with this transaction, the Company incurred $3.3 million of costs during the fourth quarter of 1998 including professional services fees, employee costs, and the write-off of certain capitalized software development costs. These costs are reported as restructuring and other charges in the 1998 consolidated statement of operations. The ResNet business contributed sales of $5.4 million in 1998. Prior to the third quarter of 1999, the Company accounted for its investment in GICC using the equity method of accounting for an investment. The Company's portion of GICC's net loss for 1998 was $738,000 and for the first six months of 1999, the Company recorded equity losses totaling $3.2 million. During the second quarter of 1999, GICC defaulted on its notes payable to the Company. The Company recorded a $16.8 million charge in the second quarter of 1999 to write down its investment in GICC to estimated fair value. Beginning with the third quarter of 1999, the Company is using the cost method of accounting for its investment in GICC to reflect its temporary condition resulting from the commencement of a plan by GICC management to sell its assets. During 1999 and 2000, the Company advanced $2.1 million to GICC under terms of secured note agreements to assist GICC in meeting its operating cash needs while GICC's assets were being sold. Subsequent write-downs to estimated fair value of $2.1 million in the fourth quarter of 1999 and $4.2 million in the fourth quarter of 2000 were recorded. During 2000, the Company received cash distributions totaling $4.1 million related to GICC's asset sales. ACROSS MEDIA NETWORKS - In February 1998, the Company acquired an equity interest in Across Media Networks, Inc. ("AMN"), a creator and distributor of digitally produced on-screen content for television and the Internet. During the third quarter of 1999, the Company sold its interest in AMN in exchange for notes receivable of approximately $9.0 million, consisting of a $7.0 million note from the buyer which was paid in 2000 and a $2.0 million note from AMN due August 31, 2002. The transaction resulted in a $7.1 million gain. Prior to the sale of AMN, the Company recorded equity losses related to this investment of $2.2 million in 1999. 1STUP.COM/CMGI MARKETABLE SECURITIES - In November 1999, the Company sold its interest in 1stUp.com, a provider of free Internet services, to CMGI, Inc. ("CMGI") in a stock-for-stock exchange. Pursuant to the transaction, the Company received 234,332 shares of CMGI common stock subject to certain sale and escrow restrictions. The aggregate market value of the shares was $9.8 million at the time the sales agreement was reached. After consideration of a discount to reflect the restrictions placed on the CMGI stock, the Company recorded a gain on this transaction of $7.6 million during the fourth quarter of 1999. The CMGI marketable securities are classified as available for sale and recorded at current market value. Net unrealized gains and losses on marketable securities available for sale are credited or charged to other comprehensive income. During 1999, the unrealized gain on these securities was $18.1 million. In 2000, market value declines in these securities resulted in unrealized losses that offset the unrealized gain from 1999 and, in the fourth quarter of 2000, the Company recorded a charge to the income statement of $6.4 million to consider the market value decline as permanent. CONNECT GROUP - In October 1998, the Company completed the acquisition of Connect Group Corporation ("CGC"), in exchange for consideration of approximately $4.0 million, including acquisition costs, consisting of $927,000 and 350,000 shares of LodgeNet common stock. CGC developed technology that the Company is using to facilitate high speed Internet access to hotel guests and operators. The acquisition was accounted for as a purchase and the excess of the initial consideration over the fair value of CGC's net assets of approximately $4.0 million was recorded as an intangible asset and is being amortized on a straight-line basis over ten years. The pro forma results for 1998, assuming the transaction had been made as of the beginning of the year, would not be materially different from reported results. F-10 INNMEDIA LLC - During the fourth quarter of 2000, the Company entered into an arrangement with Hilton to form a new broadband, interactive media company, InnMedia LLC, to offer hotel guests new and innovative interactive television content such as high speed Internet access through the television as well as customized hotel and guest information. Under this arrangement, InnMedia will supply Internet portal and interactive television content to Hilton and other hotels using LodgeNet's broadband, interactive system. InnMedia will report the operations of these activities, of which LodgeNet and Hilton will equally share, and will pay LodgeNet a fee for use of LodgeNet's system. The arrangement includes $5 million financing commitments from both LodgeNet and Hilton to fund start-up and near-term operational costs. InnMedia is expected to begin delivery of content and services during the third quarter of 2001. The Company recorded losses under the equity method of accounting for an investment of $3.0 million during the fourth quarter. A significant portion of these losses represent one-time start-up and organizational-type costs. NOTE 4 -- FAIR VALUE OF FINANCIAL INSTRUMENTS Estimated fair values and carrying amounts in the financial statements are as follows at December 31 (in thousands of dollars):

1999 2000 --------------------------- --------------------------- CARRYING FAIR CARRYING FAIR AMOUNT VALUE AMOUNT VALUE ------------ ----------- ----------- ----------- Assets (Liabilities): Marketable securities $ 25,952 $ 25,952 $ 1,398 $ 1,398 Notes receivable 7,060 7,060 -- -- Interest rate swaps -- 2,005 -- (1,287) Long-term debt (282,990) (285,294) (290,659) (286,868)

Fair values were determined under the following methods: marketable securities - quoted market prices; notes receivable present value of projected cash flows using current interest rates and considering credit risks and other related business factors; long-term debt - quoted market prices (if available) or interest rates currently available to the Company for debt with similar terms and maturities; interest rate swaps - quoted amount the Company would receive (pay) to terminate the swap agreements, considering current interest rates. For certain of the Company's financial instruments including cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses, the carrying amounts approximate fair value due to their short maturities. NOTE 5 -- PROPERTY AND EQUIPMENT Property and equipment was comprised as follows at December 31 (in thousands of dollars):

1999 2000 ------------- ------------- Land, building and equipment $ 55,899 $ 62,432 Free-to-guest systems 18,111 20,175 Guest Pay systems: Installed 292,939 349,313 System components 22,551 24,565 Software costs 9,998 12,816 ------------- ------------- Total 399,498 469,301 Less - Depreciation and amortization (195,164) (244,374) ------------- ------------- Property and equipment, net $ 204,334 $ 224,927 ============= =============

F-11 NOTE 6 -- DEBT ISSUANCE COSTS Costs associated with the issuance of debt securities and with obtaining credit facilities are capitalized and amortized over the term of the related borrowing or facility. In conjunction with the amendment and restatement of the Company's bank credit facility described in Note 8, the Company capitalized $3,559,000 of additional debt issuance costs during the year ended December 31, 1999. No debt issuance costs were incurred in 2000. Amortization of such costs was $1,004,000 in 1998, $1,486,000 in 1999, and $1,589,000 in 2000. The components of the debt issuance costs recorded in the balance sheets are as follows at December 31 (in thousands of dollars):

1999 2000 ------------ ------------ Debt issuance costs $ 12,519 $ 12,519 Accumulated amortization (3,809) (5,398) ------------ ------------ $ 8,710 $ 7,121 ============ ============

NOTE 7 -- ACCRUED EXPENSES Accrued expenses were comprised as follows at December 31 (in thousands of dollars):

1999 2000 ------------ ------------ Accrued taxes $ 1,749 $ 2,294 Accrued compensation 2,525 2,396 Accrued interest 3,818 3,748 Other 2,551 3,550 ------------ ------------ $ 10,643 $ 11,988 ============ ============

NOTE 8 -- LONG-TERM DEBT AND CREDIT FACILITIES Long-term debt was comprised as follows at December 31 (in thousands of dollars):

1999 2000 ------------- ------------- Bank Credit Facility: Bank term loan $ 75,000 $ 75,000 Revolving credit facility 21,500 34,000 10.25% senior notes 150,000 150,000 11.50% senior notes 30,000 30,000 Less unamortized discount (739) (523) Capital leases 1,000 1,287 Other 6,229 895 ------------- ------------- 282,990 290,659 Less current maturities (5,915) (21,563) ------------- ------------- $ 277,075 $ 269,096 ============= =============

BANK CREDIT FACILITY -- In February 1999, the Company amended and restated its bank credit facility, increasing the size of the facility to $150 million, comprised of a $75 million term loan and a $75 million revolving credit facility (which may be increased to $100 million, subject to certain limitations). Quarterly repayments on the term loan begin in February 2001. The revolving credit facility matures in February 2005. Loans bear interest, payable quarterly, at the Company's option of (1) the bank's base rate (as defined) plus a margin of from 1.00% to 1.75%, depending on leverage as defined, or (2) the eurodollar rate plus a margin of from 2.00% to 2.75%, depending on leverage as defined. The margins applicable to the bank's base rate and/or the eurodollar rate loans are subject to quarterly adjustment as defined in the agreement. Weighted average interest rates as of December 31, 2000 were 8.81% for the term loan and 8.67% for the revolving credit facility. The loans are secured by a first priority security interest in all of the Company's assets. The facility provides for the issuance of letters of credit up to $12 million, subject to customary terms and conditions. As of December 31, 2000, the Company had outstanding letters of credit totaling $2.0 million. F-12 The facility includes terms and conditions which require the maintenance of certain financial ratios and place limitations on capital expenditures, additional indebtedness, liens, investments, guarantees and certain payments or distributions in respect of the common stock. As of December 31, 2000, the Company was in compliance with all covenants, terms and conditions of the bank credit facility. 10.25% SENIOR NOTES -- In December 1996, the Company issued $150 million of unsecured 10.25% senior notes (the "10.25% Notes"), due December 15, 2006. The 10.25% Notes are unsecured, rank PARI PASSU in right of payment with future unsubordinated unsecured indebtedness and rank senior in right of payment to all subordinated indebtedness of the Company. The 10.25% Notes require semi-annual interest payments and contain certain restrictive covenants. As of December 31, 2000, the Company was in compliance with all covenants, terms, and conditions of the 10.25% Notes. The 10.25% Notes are redeemable at the option of the Company, in whole or in part, on or after December 15, 2001, initially at 105.125% of their principal amount (plus accrued and unpaid interest) declining ratably to 100% of their principal amount (plus accrued and unpaid interest) on or after December 15, 2003. 11.50% SENIOR NOTES -- During 1995, the Company issued $30 million principal amount of unsecured 11.50% senior notes (the "11.50% Notes"). Mandatory annual principal payments of $6 million commence in July 2001 continuing through July 2005. Semi-annual interest payments are required. The Company issued a total of 480,000 warrants (see Note 12) to purchase common stock of the Company in connection with the issuance of the 11.50% Notes and the value of the warrants, $1.68 million, was recorded as additional paid-in capital and shown as a discount on the 11.50% Notes. As part of the refinancing transaction in which the 10.25% Notes were issued, the holders of the 11.50% Notes adopted the covenants and ranking of the 10.25% Notes. Long-term debt has the following scheduled principal maturities for the years ended December 31 (in thousands of dollars): 2001 -- $21,563; 2002 -- $25,161; 2003 -- $25,805; 2004 -- $28,652; 2005 -- $40,000; thereafter -- $149,478. NOTE 9 -- COMMITMENTS AND CONTINGENCIES PROGRAMMING AGREEMENTS -- The Company, through programming agreements, provides Guest Pay and free-to-guest programming services to the lodging industry. These agreements provide that the Company receives monthly revenue for such services. Such agreements contain various restrictions, including default and termination procedures, and generally range from five to seven years in duration. The Company has also entered into agreements with certain networks and studios which provide their programs for redistribution. Under these agreements, the Company pays fees which are based on revenue generated, or on rate schedules based on the number of sites under license by the Company. The agreements contain various restrictions, including default and termination procedures, and generally range from three to seven years in duration. PURCHASE COMMITMENTS -- The Company has purchase commitments in the ordinary course of business, none of which are expected to result in losses. OPERATING LEASES -- The Company has entered into certain operating leases, which at December 31, 2000, require future minimum lease payments, as follows: 2001 -- $325,000; 2002 -- $267,000; 2003 -- $161,000; 2004 -- $73,000; 2005 -- $24,000; thereafter -- $16,000. The leases expire at dates ranging from 2001 to 2006. Rental expense under all operating leases was $358,000, $436,000, and $474,000 for the years ended December 31, 1998, 1999, and 2000, respectively. LICENSE AGREEMENT -- During the third quarter of 1998, the Company entered into an agreement with On Command Corporation ("On Command") to settle all matters of pending litigation between the companies and enter into cross licensing arrangements regarding the use of each of the companies' patented technologies. The cross licensing arrangements, in consideration of the relative fair value of the patents involved, provided for the Company to make cash payments to On Command totaling approximately $16 million plus interest, payable in three annual installments which commenced in 1998 and ended in 2000. The Company has capitalized the present value of the obligation to F-13 On Command based on the fair value of the license rights acquired. This value is being amortized over the remaining average lives of the underlying patents, which as of December 31, 2000, range from six to nine years. LEGAL PROCEEDINGS -- The Company is subject to legal proceedings and claims arising in the ordinary course of its businesses. As of the date hereof, in the opinion of management, the resolution of such matters is not expected to have a material adverse effect on the Company's financial position or results of operations. NOTE 10 -- STOCKHOLDERS' EQUITY PREFERRED STOCK -- There are 5,000,000 shares of preferred stock, $.01 par value, authorized by the Company's certificate of incorporation, of which none were outstanding at December 31, 1999 and 2000. The Board of Directors may authorize the issuance of preferred stock, $.01 par value, in one or more series and with rights and privileges for each issue as determined by the Board of Directors. STOCKHOLDER RIGHTS PLAN -- On February 28, 1997, the Board of Directors of the Company authorized and adopted a Stockholder Rights Plan. Pursuant to the rights plan, the Board of Directors declared a dividend distribution of one right for each outstanding share of common stock of the Company to stockholders of record at the close of business on March 10, 1997. Initially, the rights will be attached to all common stock certificates and no separate rights certificates will be distributed. The rights will separate from the common stock and be distributed upon the occasion of (i) a public announcement that a person, group or entity has acquired or obtained the right to acquire 15% or more of the common stock of the Company or (ii) ten days following the commencement of, or an announcement of the intention to make, a tender or exchange offer which would result in a person, group or entity becoming the holder of 15% or more of the Company's common stock. The rights are not exercisable until distributed. In general, each right, when exercisable, initially entitles the registered holder to purchase from the Company one-thousandth of a share of a new series of preferred stock, designated as Series A Participating Preferred Stock, par value $.01, at a price of $60.00 per share. In certain other events, after the rights have become exercisable, each right entitles the holder to purchase for $60.00 an amount of common stock of the Company, or in certain circumstances securities of the acquirer, having a then-current market value of two times the exercise price of the right. The rights include anti-dilution provisions in the event of a stock dividend, split-up or reclassification of the common stock. The preferred stock purchasable upon exercise of the rights will be non-redeemable and junior to any other issue of preferred stock the Company might issue, and will include dividend and liquidation preferences. No stockholder privileges attach to the rights until exercised. SHORT-SWING PROFITS -- During 2000, the Company received approximately $2.5 million from a shareholder in settlement of a potential short-swing profit liability under section 16(b) of the Securities Exchange Act of 1934, resulting from certain trading activity of the Company's common stock by the shareholder. This amount was recorded as paid-in capital in stockholders' equity. F-14 NOTE 11 -- STOCK OPTION PLANS The Company has stock options plans which provide for the granting of up to 2,726,792 non-qualified or incentive stock options on the Company's common stock. Certain officers, directors and key employees have been granted options to purchase common stock of the Company under these plans. Options become exercisable in accordance with vesting schedules determined by a committee of the Board of Directors, and generally expire ten years after the date of grant. No options had expired as of December 31, 2000, and outstanding options expire beginning in 2001 through 2008. The following is a summary of the stock option activity for the years ending December 31:

WEIGHTED AVERAGE OPTIONS EXERCISE OUTSTANDING PRICE ------------- ------------ Balance at December 31, 1997 1,505,813 $ 7.91 Options granted 634,656 12.72 Options exercised (270,329) .81 Options forfeited/canceled (108,000) 12.84 ------------- Balance at December 31, 1998 1,762,140 10.45 Options granted 103,486 10.74 Options exercised (16,661) 9.64 Options forfeited/canceled (142,600) 11.53 ------------- Balance at December 31, 1999 1,706,365 9.68 Options granted 830,624 19.73 Options exercised (241,187) 9.67 Options forfeited/canceled (21,800) 18.35 ------------- Balance at December 31, 2000 2,274,002 $ 13.32 =============

The following is a summary of stock options outstanding as of December 31, 2000:

OUTSTANDING OPTIONS EXERCISABLE OPTIONS -------------------------------------------------- ----------------------------- WEIGHTED AVERAGE WEIGHTED WEIGHTED REMAINING AVERAGE AVERAGE EXERCISE TERM EXERCISE EXERCISE PRICE RANGE NUMBER IN YEARS PRICE NUMBER PRICE ----------------------- ------------- -------------- ------------- ------------- ------------- $0.23 to $0.46 83,303 2.8 $ .23 83,303 $ .23 $2.77 to $3.23 203,022 2.6 2.87 203,022 2.87 $6.46 to $9.79 252,477 5.9 8.79 205,527 8.86 $10.38 to $13.77 753,250 6.7 11.41 581,750 11.37 $14.00 to $24.89 981,950 5.1 19.21 186,300 17.90 ------------- ------------- 2,274,002 5.4 $ 13.32 1,259,902 $ 9.82 ============= =============

The weighted average fair value of options granted during the year ended December 31 was as follows:

1998 1999 2000 ---------- ---------- ----------- Weighted average fair value per option granted $ 4.36 $ 5.43 $ 10.71 ========== ========== ===========

The fair value of each option granted was estimated as of the grant date using the Black-Scholes option valuation model under the following assumptions: (i) dividend yield - none, (ii) weighted average risk-free interest rate - 5.15% in 1998, 5.54% in 1999, and 6.15% in 2000; (iii) weighted average expected life - 5.0 years, and (iv) weighted average expected volatility - 45.3% in 1998, 50.7% in 1999, and 54.6% in 2000. F-15 The Company accounts for its stock option compensation plans in accordance with the provisions of Accounting Principles Board Opinion No. 25. Accordingly, because the Company's stock option plans are fixed plans and options are issued at market value, no compensation cost has been charged to operations for any period presented. Had compensation cost been determined in accordance with SFAS No. 123, net loss and loss per share would have increased, and the effect of such increases, reflected on those items on a pro forma basis, would have been as follows for the years ended December 31 (in thousands of dollars, except per share amounts):

1998 1999 2000 ------------- ------------- ------------- Net loss As reported $ (39,912) $ (36,428) $ (39,014) Pro forma (42,677) (36,990) (47,592) Loss per share As reported $ (3.45) $ (3.05) $ (3.21) Pro forma (3.69) (3.10) (3.92)

NOTE 12 -- WARRANTS In connection with the 1995 issuance of the 11.50% Senior Notes (see Note 8), the Company issued 480,000 warrants to purchase common stock of the Company. Each warrant entitles the holder to purchase one share of common stock at an exercise price of $7.00 per share. The warrants include demand registration rights and anti-dilution provisions and expire on July 15, 2005. The portion of the proceeds from the 1995 debt issuance deemed attributable to the warrants was recorded as additional paid-in capital. On October 9, 2000, the Company entered into an agreement with Hilton to provide LodgeNet's interactive television services into Hilton's owned, leased and joint venture hotels in the United States. Under terms of the agreement, Hilton was issued a warrant granting it the right to purchase up to 2.1 million shares of LodgeNet common stock over the next seven years at a price of $20.44 per share. 1.5 million warrant shares relate to hotels owned or operated by Hilton and vested immediately. The remaining 600,000 warrant shares relate to hotels franchised through Hilton and will vest on a per room basis as LodgeNet obtains contracts for delivery of services to these hotels. The Company followed EITF 96-18 to account for the warrants issued. The fair value of the 1.5 million warrant shares was estimated at $21.8 million using the Black-Sholes valuation method and was recorded as contract acquisition costs within fixed assets and credited to additional paid-in capital. The 600,000 warrant shares will be measured and similarly accounted for upon delivery of the related room contracts. NOTE 13 -- EMPLOYEE BENEFIT PLANS The Company sponsors defined contribution plans covering eligible employees. The plans provide for employer contributions based primarily on the level of employee participation. Contribution expense for the Company was $558,000, $567,000, and $635,000 in 1998, 1999, and 2000, respectively. NOTE 14 -- INCOME TAXES Loss before income taxes was as follows for the years ended December 31 (in thousands of dollars):

1998 1999 2000 ------------- ------------ ------------- Domestic $ (38,825) $ (35,572) $ (38,669) Foreign (712) (486) (20) ------------- ------------ ------------- Total $ (39,537) $ (36,058) $ (38,689) ============= ============ ============

The provisions for income taxes of $375,000 in 1998, $370,000 in 1999, and $325,000 in 2000 consist of current state taxes. Such amounts differ from that which would be obtained by applying the statutory federal income tax rate to loss before income taxes due primarily to changes in the valuation allowance reflecting changes in net deferred tax assets. F-16 Deferred income taxes reflect the impact of temporary differences between the amounts of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. Significant components of the Company's deferred tax assets and liabilities were as follows at December 31(in thousands of dollars):

1999 2000 ------------- ------------- Deferred tax liabilities: Unrealized gain on marketable securities $ (6,164) $ -- ------------- ------------- Deferred tax assets: Net operating loss carryforwards 34,920 37,481 Losses of unconsolidated affiliates 7,907 10,345 Reserves and accruals 2,297 2,282 Deferred credits 914 922 Book over tax depreciation 1,275 7,419 Unrealized loss on marketable securities -- 2,185 Gain on sale of investment 665 665 ------------- ------------- 47,978 61,299 ------------- ------------- Net deferred tax assets 41,814 61,299 Valuation allowance (41,814) (61,299) ------------- ------------- Net deferred taxes $ -- $ -- ============= =============

The Company has net operating loss carryforwards of approximately $110 million for federal income tax purposes. Such carryforwards expire beginning in 2002 through 2015, and federal tax regulations limit the availability and timing of usage of carryforwards. The Company established the valuation allowance for deferred tax assets after considering its historical financial performance, existing deferred tax liabilities, and certain information about future years. NOTE 15 -- RELATED PARTY TRANSACTIONS The Company has advanced $1.2 million to a former officer as of December 31, 2000, under the terms of a promissory note providing for total advances of $1.5 million. Interest is payable monthly at the rate applicable to the Company under its revolving credit facility. The notes are secured by shares of the Company's stock held by the officer. NOTE 16 -- SEGMENT INFORMATION Effective with the ResNet merger transaction described in Note 3, the Company operates in one business segment, the distribution of entertainment and information services to the lodging industry. The following table presents revenues by country based on the location of the customer for the year ended December 31 (in thousands of dollars):

1998 1999 2000 -------------- -------------- -------------- United States $ 157,654 $ 171,828 $ 185,721 Canada 7,420 8,806 9,800 Other 1,277 638 1,296 ============== ============== ============== Total $ 166,351 $ 181,272 $ 196,817 ============== ============== ==============

Long-lived assets by country based on the location of the asset were as follows at December 31 (in thousands of dollars):

1998 1999 2000 -------------- -------------- -------------- United States $ 199,067 $ 192,827 $ 213,933 Canada 10,370 11,507 10,994 ============== ============== ============== Total $ 209,437 $ 204,334 $ 224,927 ============== ============== ==============

F-17 NOTE 17 -- SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) The following selected quarterly financial data are in thousands of dollars, except per share data:

QUARTER QUARTER QUARTER QUARTER ENDING ENDING ENDING ENDING MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31, ------------- ------------- ----------------- ---------------- 1999: Revenues $ 41,965 $ 44,269 $ 49,640 $ 45,398 Gross profit 23,717 25,264 27,751 26,050 Net income (loss) (1) (11,027) (24,826) 2,309 (2,884) Per common share (2) $ (0.92) $ (2.08) $ .19 $ (0.24) 2000: Revenues $ 47,733 $ 48,129 $ 52,894 $ 48,061 Gross profit 27,377 27,966 31,460 27,564 Net loss (1) (7,682) (6,539) (4,144) (20,649) Per common share (2): $ (.64) $ (.54) $ (.34) $ (1.69)

(1) Net loss for the quarter ended June 30, 1999 includes a $16.8 million charge to write-down the investment in GICC. Net income for the quarter ended September 30, 1999 includes a $7.1 million gain from the sale of AMN. Net loss for the quarter ended December 31, 1999 includes a $7.6 million gain from the sale of 1stUp.com and a $2.1 million charge to write-down the investment in GICC. Net loss for the quarter ended December 31, 2000 includes a $4.2 million charge to write-down the investment in GICC, equity losses of $3.0 million from InnMedia and losses on CMGI common stock totaling $6.4 million. (2) Per share amounts represent both basic and diluted earnings per share and are computed independently for each of the quarters presented. Therefore, the sum of such amounts may not equal the total for the year. F-18 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULE To LodgeNet Entertainment Corporation: We have audited, in accordance with auditing standards generally accepted in the United States, the consolidated financial statements included in this annual report on Form 10-K, and have issued our report thereon dated February 9, 2001. Our audit was made for the purpose of forming an opinion on those financial statements taken as a whole. The following schedule is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN LLP Minneapolis, Minnesota February 9, 2001 F-19 LODGENET ENTERTAINMENT CORPORATION AND SUBSIDIARIES SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTs (Dollar amounts in thousands)

COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E ------------------------------------------- ------------- -------------- -------------- ------------ ADDITIONS BALANCE CHARGED TO BALANCE BEGINNING COSTS AND DEDUCTIONS END OF DESCRIPTION OF PERIOD EXPENSES (NOTE 1) PERIOD ------------------------------------------- ------------- -------------- -------------- ------------ Allowances deducted from related balance sheet accounts: Year Ended December 31, 1998: Allowance for Doubtful Accounts $ 800 $ 848 $ 848 $ 800 Year Ended December 31, 1999: Allowance for Doubtful Accounts $ 800 $ 441 $ 441 $ 800 Year Ended December 31, 2000: Allowance for Doubtful Accounts $ 800 $ 336 $ 336 $ 800

(1) All deductions from reserves were for the purposes for which such reserves were created except for the 1998 activity, which includes a $45,000 reduction to the reserve resulting from the ResNet merger described in Note 3. F-20