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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2002

Commission File Number 0-22334

LodgeNet Entertainment Corporation

3900 West Innovation Street, Sioux Falls, South Dakota 57107

(605) 988-1000

     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 o.

     At October 24, 2002, there were 12,416,049 shares outstanding of the Registrant’s common stock, $0.01 par value.

This report contains a total of 27 pages

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LodgeNet Entertainment Corporation

Index

     As used herein (unless the context otherwise requires) “LodgeNet”, “the Company” and/or “the Registrant” means LodgeNet Entertainment Corporation and its majority-owned subsidiaries.

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Part I — Financial Information

Item 1 — Financial Statements

LodgeNet Entertainment Corporation
Consolidated Balance Sheets (Unaudited)
(Dollar amounts in thousands, except share data)

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

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LodgeNet Entertainment Corporation
Consolidated Statements of Operations (Unaudited)
(Dollar amounts, except per share amounts, in thousands)

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

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LodgeNet Entertainment Corporation
Consolidated Statements of Cash Flows (Unaudited)
(Dollar amounts in thousands)

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

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LodgeNet Entertainment Corporation
Notes to Consolidated Financial Statements (Unaudited)

Note 1 — Basis of Presentation

The accompanying consolidated financial statements as of September 30, 2002, and for the three and nine month periods ended September 30, 2002 and 2001, have been prepared by LodgeNet Entertainment Corporation (the “Company”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (the “Commission”). The information furnished in the accompanying consolidated financial statements reflects all adjustments, consisting of normal recurring adjustments, which, in the opinion of management, are necessary for a fair presentation of such financial statements.

Certain information and footnote disclosures, normally included in financial statements prepared in accordance with generally accepted accounting principles, have been condensed or omitted pursuant to the rules and regulations of the Commission. Although the Company believes that the disclosures are adequate to make the information presented herein not misleading, it is recommended that these unaudited consolidated financial statements be read in conjunction with the more detailed information contained in the Company’s Annual Report on Form 10-K for 2001, as filed with the Commission. The results of operations for the three and nine month periods ended September 30, 2002 and 2001 are not necessarily indicative of the results of operations for the full year due to inherent seasonality within the business among other factors.

The consolidated financial statements include the accounts of LodgeNet Entertainment Corporation and its majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

Note 2 — Property and Equipment, Net

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

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Note 3 — Loss Per Common Share

Basic earnings per share is computed based on the weighted average number of common shares actually outstanding during the period. Diluted earnings per share is computed based on the weighted average number of common shares outstanding plus all potentially dilutive common shares outstanding during the period. Potential common shares that have an anti-dilutive effect are excluded from diluted earnings per share.

The loss per common share for the three months ended September 30, 2002 and 2001 and for the nine months ended September 30, 2002, and 2001 is based on 12,406,919, 12,265,897, 12,363,428, and 12,236,310 weighted average shares outstanding during the respective periods. Potential common shares were not included in the computation of diluted earnings per share because their inclusion would be anti-dilutive. As of September 30, 2002 and 2001, the number of potential common shares was approximately 4,729,000 and 4,187,000, respectively. Such potential dilutive common shares consist of stock options and warrants. The foregoing potential common share amounts do not take into account the assumed number of shares that would be repurchased by the Company upon the exercise of stock options or warrants.

Note 4 — Long-term Debt and Credit Facilities

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

Bank Credit Facility — On August 29, 2001, the Company entered into a $225 million bank credit facility, comprised of a $150 million term loan and a $75 million revolving credit facility which may be increased to $100 million, subject to certain limitations. The term loan matures in June 2006 and quarterly repayments began in December 2001. The term loan bears interest at the Company’s option of (1) the bank’s base rate plus a margin of 2.75% or (2) LIBOR plus a margin of 4.00%. The term loan interest rate as of September 30, 2002 was 5.8%. The revolving credit facility matures in June 2006, and loans bear interest at the Company’s option of (1) the bank’s base rate plus a margin of 1.00% to 1.75%, or (2) LIBOR plus a margin of 2.25% to 3.00%. The weighted average interest rate for the revolving credit facility as of September 30, 2002 was 4.8%. Loans under the credit facility are collateralized 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 $10 million, subject to customary terms and conditions. As of September 30, 2002, the Company had outstanding letters of credit totaling $2.0 million.

The facility includes terms and conditions which require compliance in accordance with a material adverse effect covenant as well as the maintenance of certain financial ratios and place limitations on capital expenditures, additional indebtedness, liens, investments, guarantees, asset sales and certain payments or distributions in respect of the common stock. In August 2002, the Company received unanimous consent from its lenders to amend its existing bank credit facility. The amendment modified the covenants for leverage and interest coverage by generally deferring the scheduled step-downs in covenant terms that were to be effective as of December 31, 2002. (See Liquidity and Capital Resources) As of September 30, 2002, the Company was in compliance with all covenants, terms and conditions of the bank credit facility.

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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 September 30, 2002, 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 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”). Annual principal payments of $6 million commenced in July 2001 and continue through July 2005. Semi-annual interest payments are required. The Company issued a total of 480,000 warrants 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 financing 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 12 month periods ended September 30 (in thousands of dollars): 2003 — $9,134; 2004 — $8,237; 2005 — $7,783; 2006 — $167,221; 2007 — $150,001.

The Company does not utilize special purpose entities or off-balance sheet financial arrangements.

Note 5 — Accounting for Derivative Instruments and Hedging Activities

In March 2002, the Company entered into a $50 million interest rate swap agreement, which expires in March 2006. In addition, the Company had existing interest rate swap agreements on $100 million of long-term debt, of which $50 million expire in March 2003 and $50 million expire in December 2005. The Company is required by its bank credit facility to have in place a minimum of $100 million swap agreements that convert variable rate interest debt into fixed interest rate loans. The swap agreements have been designated as, and meet the criteria for, cash flow hedges and are not considered speculative in nature.

Note 6 — Comprehensive Loss

Comprehensive loss reflects the changes in equity during a period from transactions and other events and circumstances from non-owner sources. The Company’s comprehensive loss was as follows for the periods ended September 30 (in thousands):

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Note 7 — Effect of Recently Issued Accounting Standards

In June 2001, the Financial Accounting Standards Board issued SFAS No. 142, “Goodwill and Other Intangible Assets” which eliminates the current requirement to amortize goodwill and indefinite-lived intangible assets, addresses the amortization of intangible assets with a defined life and addresses the impairment testing and recognition for goodwill and intangible assets. Effective January 1, 2002, the Company adopted the provisions of this statement, which had no impact on its consolidated financial statements.

In June 2001, the Financial Accounting Standards Board issued SFAS No. 143, “Accounting for Obligations Associated with the Retirement of Long-Lived Assets”. SFAS No. 143 primarily establishes accounting standards for the recognition and measurement of an asset retirement obligation and its associated asset retirement costs. The provisions of SFAS No. 143 will be effective for fiscal years beginning after June 15, 2002. The Company has determined the adoption of this statement will not significantly impact its consolidated financial statements.

In October 2001, the Financial Accounting Standards Board issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. SFAS No. 144 supercedes SFAS 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of”. SFAS No. 144 primarily addresses significant issues relating to the implementation of SFAS No. 121 and develops a single accounting model for long-lived assets to be disposed of, whether previously held and used or newly acquired. Effective January 1, 2002, the Company adopted the provisions of SFAS No. 144, which had no impact on its consolidated financial statements.

In November 2001, the FASB Emerging Issues Task Force issued EITF 01-9, “Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Products”. The EITF concluded that certain consideration from a vendor to a customer is to be reported as a reduction of revenue. Effective January 1, 2002, the Company adopted the provisions of EITF 01-9, which had no impact on its consolidated financial statements.

In April 2002, the Financial Accounting Standards Board issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections”, effective for fiscal years beginning after June 15, 2002. SFAS No. 145 will require gains and losses on extinguishments of debt to be classified as income or loss from continuing operations rather than as extraordinary items as previously required under SFAS No. 4. Extraordinary treatment will be required for certain extinguishments as provided in APB Opinion No. 30. SFAS No. 145 also amends SFAS No. 13 to require certain modifications to capital leases be treated as a sale-leaseback and modifies the accounting for sub-leases when the original lessee remains a secondary obligor (or guarantor). In addition, the FASB rescinded SFAS No. 44, which addressed the accounting for intangible assets of motor carriers and made numerous technical corrections. The provisions of SFAS No. 145 will be effective for fiscal years beginning after May 15, 2002. The Company has determined the adoption of this statement will not significantly impact its consolidated financial statements.

In June 2002, the Financial Accounting Standards Board issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities”, which addresses financial accounting and reporting for costs associated with exit or disposal activities and supersedes EITF Issue 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)”. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. A liability for an exit cost as defined in EITF 94-3 is recognized at the date of an entity’s commitment to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. The Company will adopt the provisions of SFAS No. 146 for exit or disposal activities that are initiated after December 31, 2002. Adoption of this standard will not have a material effect on the Company’s consolidated financial statements.

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In October 2002, the FASB Emerging Issues Task Force reached a tentative conclusion on EITF 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” The EITF addresses how to account for multiple-deliverable revenue arrangements and focuses on when a revenue arrangement should be separated into different revenue-generating deliverables or “units of accounting” and if so, how the arrangement considerations should be allocated to the different deliverables or units of accounting. The provisions of EITF 00-21 will be effective for fiscal years beginning after December 15, 2002. The Company is currently evaluating the effect of the adoption of the EITF, however the Company does not believe that it will have an impact on its consolidated financial statements.

Note 8 — InnMedia LLC

Effective July 31, 2002, the Company and InnMedia’s co-owner, Hilton Hotels Corporation (“Hilton”), mutually agreed to dissolve InnMedia. InnMedia and the Company mutually released their claims against each other, and the lawsuit filed by InnMedia against the Company was dismissed with prejudice on August 7, 2002. During the third quarter of 2002, the Company contributed $252,000 for its share of pre-dissolution operating costs. The $252,000 was recorded as an equity loss in the same period.

Note 9 — Hilton Agreement

Effective July 31, 2002, the Company expanded its Master Services Agreement with Hilton Hotels Corporation. The Company acquired the right to provide television-based Internet access and time-shifted TV programming services to participating hotels and the right to independently pursue and further develop interactive television content throughout the Company’s entire room base. As consideration, the Company agreed to pay Hilton $8.0 million over a five year period. The present value of these payments, approximately $5.8 million, has been capitalized within other assets on the Company’s consolidated balance sheet and is being amortized on a straight-line basis over its estimated useful life. Additionally, the Company paid Hilton $1.0 million for a six months extension of the existing seven-year contracts with certain installed Hilton-owned properties, encompassing approximately 24,000 rooms.

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

The following discussion and analysis provides information concerning our results of operations and financial condition. This discussion should be read in conjunction with the accompanying consolidated financial statements and the notes thereto.

Special Note Regarding Forward-Looking Statements

Except for the historical statements contained herein, all statements made in this presentation are “forward-looking statements” within the meaning of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, and are subject to risks, uncertainties, and other factors that could cause actual results, performance or achievements of the Company to be materially different from those expressed or implied by such forward-looking statements. Such factors include, among others, the impact of competition and changes to the competitive environment for the Company’s products and services, changes in demand for the Company’s products and services, changes in technology, changes in the Company’s relationships with its 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. The Company does not undertake any obligation to update or revise any forward- looking statements, whether as a result of new information, future events or otherwise.

Overview –

LodgeNet, the world’s largest provider of television-based broadband services to the hospitality industry, specializes in the delivery of interactive television and television-based Internet access services to the lodging industry throughout the United States, Canada and select international markets. As of September 30, 2002, the Company provided interactive and television services to approximately 5,600 hotel properties, more properties than any other broadband service provider in the world. The Company’s services are designed to serve the needs of the lodging industry and the traveling public and include on-demand movies, music and music videos, Nintendo® video games, Internet-enhanced television, which does not require a laptop for access, high-speed Internet access, and other interactive services, all of which are referred to as Guest Pay interactive services. The Company has installed its interactive television system in more than 863,000 of its rooms, which host more than 260 million guests on an annual basis.

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, music and music videos, network-based video games, Internet-enhanced television, and high-speed Internet access services. Guest Pay packages may also include video review of room charges, video checkout, guest surveying, and merchandising services that are paid for by the hotel and provided to guests at no charge.

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, 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) one-time license fees paid for independent films; (iii) license fees for other interactive services; (iv) Internet connectivity costs; and (v) the commission paid to the hotel. Guest Pay operating expenses include costs of system maintenance and support, programming delivery and distribution, data retrieval, insurance, and personal property taxes.

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The room installations for the twelve months ended September 30, 2002 represent an increase of 8.7% for Guest Pay interactive rooms as compared to September 30, 2001. Additionally, Digital services rooms, as described below, increased 170.2% over the number of installed rooms at September 30, 2001. De-installation activity for 2002 has been less than 2% of the installed number of rooms.

The Company’s base of installed rooms was comprised as follows at September 30:

(1)  – 100% of Guest Pay interactive rooms are served by the Company’s on-demand movie system (as compared to a scheduled movie system that shows movies at predetermined times).

(2)  – Digital services rooms are equipped with the interactive digital systems where on-demand movies and music content are updated and delivered via satellite to the Company’s systems within respective hotels. Digital rooms are included with the total Guest Pay interactive rooms and represent more than 26% of the Guest Pay interactive rooms served.

(3)  – Total rooms served represent rooms receiving one or more of the Company’s services, including rooms served by international licensees.

Free-to-Guest and Other Services. In addition to Guest Pay interactive services, the Company provides 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, all of which are referred to as free-to-guest services. 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 other 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.

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InnMedia LLC. In October of 2000, the Company created a joint venture with Hilton Hotels Corporation, named InnMedia LLC, to provide interactive television and television-based Internet access services for distribution to the lodging industry. At that time the Company entered into various agreements with InnMedia pursuant to which the Company agreed to obtain interactive television and television-based Internet access services exclusively from InnMedia and to provide InnMedia with the services necessary to distribute such content. InnMedia and Hilton also entered into an agreement whereby InnMedia became the exclusive provider of interactive television content and Internet access services to various Hilton hotels. At that time, the Company also entered into a Master Services Agreement with Hilton pursuant to which the Company was named the exclusive guest-pay provider to Hilton owned hotels and the preferred guest pay provider to various Hilton managed and franchised hotels of movies, games and music content.

Effective July 31, 2002, the Company and InnMedia’s co-owner, Hilton Hotels Corporation (“Hilton”), mutually agreed to dissolve InnMedia. At that time, InnMedia and the Company mutually released their claims against each other, and the lawsuit filed by InnMedia against the Company has been dismissed with prejudice. During the third quarter of 2002, the Company contributed $252,000 for its share of pre-dissolution operating costs. The $252,000 was recorded as an equity loss in the same period.

Critical Accounting Policies

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, not to exceed the life of a contract:

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.

Revenue Recognition — 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.

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Discussion and Analysis of Results of Operations
Three Months Ended September 30, 2002 and 2001

Revenue Analysis. The Company’s total revenue for the third quarter of 2002 increased 10.4%, or $6.0 million, in comparison to the third quarter of 2001. The following table sets forth the components of revenue (in thousands) for the quarter ended September 30:

Guest Pay interactive revenue increased 12.5% or $6.8 million, in the third quarter of 2002 as compared to the third quarter of 2001. This increase was attributable to a 9.7% increase in the average number of installed Guest Pay interactive rooms, and a 2.6% increase in average monthly revenue per interactive Guest Pay room. The following table sets forth information in regard to average monthly Guest Pay interactive revenue per room for the quarter ended September 30:

Average movie revenue per room increased 3.0% due to higher movie prices, partially offset by declines in buy rate (30 basis points) and occupancy (40 basis points) versus the third quarter of 2001. Other interactive service revenue per room increased by 1.2% primarily driven by the New Media business, which is comprised of Internet-enhanced television and time-shifted television programming. The new media revenue recognized during the third quarter totaled $945,000.

Other Revenue includes revenue from free-to-guest services provided to hotels not receiving Guest Pay services and the sales of system equipment and service parts and labor. Other revenue decreased $857,000 or 27.6% due to decreased equipment sales to international licensees.

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Gross Profit (exclusive of other operating expenses discussed separately below). Gross profit totaled $35.5 million for the third quarter ended September 30, 2002, an increase of 8.2% over the third quarter of 2001 on a 10.4% increase in revenue (dollar amounts in thousands).

Gross profit on Guest Pay interactive services increased 8.9%, or $2.8 million, on a 12.5% increase in related revenue. Guest Pay direct costs (primarily studio license fees, license fees for other interactive services, Internet connectivity fees, and the commission paid to the hotel) are primarily based on related revenue, and such costs generally vary directly with revenue. As a percentage of revenue, the decrease in gross profit margin from 58.1% to 56.3% was primarily due to connectivity costs related to Internet-enhanced television and to nominal increases in hotel commissions.

Gross profit on other services decreased $139,000 or 12.3% in the third quarter of 2002 from the prior year quarter. The decrease was due to lower sales of equipment to international licensees. The gross profit margin increased to 44.0% in the third quarter of 2002 due to lower costs related to cable programming services, which resulted from favorable pricing and incentive arrangements.

As a percentage of revenue, the Company’s overall gross profit margin decreased from 56.9% to 55.8%. The decrease in gross margin from Guest Pay interactive services was partially offset by an increase in other gross margin as described above.

Operating Expenses. The following table sets forth information in regard to the Company’s operating expenses for the quarter ended September 30 (dollar amounts in thousands):

Guest Pay operations expenses consist of costs directly related to the operation of systems at hotel sites. Guest Pay operations expenses increased 7.4%, or $528,000 in the third quarter of 2002, compared to the third quarter of 2001. The increase resulted from additional costs incurred with the addition of 75,200 average rooms, offset by continued cost control efforts and improved operating efficiencies. Per average installed room, Guest Pay operations expenses decreased 2.3% from $3.08 per month during the third quarter of 2001 to $3.01 per month during the third quarter of 2002.

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Selling, general and administrative expenses increased $378,000 or 7.1% in the third quarter of 2002 compared to the prior year quarter. The increase was substantially attributed to professional fees related to the InnMedia lawsuit which was dismissed with prejudice in August and the dissolution of the InnMedia entity. As a percentage of revenue, such expenses decreased to 9.0% in the third quarter of 2002 from 9.3% in the prior year quarter.

Depreciation and amortization expenses were $19.2 million in the third quarter of 2002 versus $16.3 million in the year earlier quarter. The increase is driven by the demand for the installation of, or upgrade to, the digital platform, which resulted in an additional 75,200 average rooms placed in operation. At the end of third quarter of 2002, the interactive digital system had been installed in more than 226,000 rooms. Additionally, other increases were associated with software costs and other capitalized costs including service vans, equipment, and computers that are related to the increased number of rooms in service compared to the prior year. As a percentage of revenue, depreciation and amortization expenses increased to 30.2% in the current quarter from 28.3% in the third quarter of 2001.

Operating Income. For the reasons previously described, the Company generated operating income of $2.9 million in the third quarter of 2002 compared to $4.0 million in the third quarter of 2001.

Investment Gains (Losses). Prior to the second quarter of 2001, the Company owned a minority interest in Global Interactive Communications Corporation (“GICC”) resulting from the merger transaction involving ResNet Communications LLC (formerly the Company’s majority-owned subsidiary) in 1998. In the second quarter of 2001, the Company transferred its equity interest in GICC back to GICC and has no further financing obligation to GICC. As of December 31, 2001, the Company had an investment balance in GICC of $316,000. During the third quarter of 2002, the Company received $179,000 in cash from the sale of GICC’s bankrupt assets and recognized an investment gain of $179,000. Additionally, the Company contributed $252,000 to InnMedia during the third quarter of 2002 for its share of pre-dissolution operating costs. The $252,000 was recorded as an equity loss in the same period.

Interest Expense. Interest expense was $8.3 million during the third quarter of 2002, an increase of 6.9% due to increases in long-term debt to fund the Company’s continuing expansion of its digital platform. Average principal amount of long-term debt outstanding during the quarter ended September 30, 2002 was approximately $346 million at an average interest rate of approximately 9.5% as compared to an average principal amount outstanding of approximately $315 million at an average interest rate of approximately 9.8% during the comparable period of 2001.

Net Loss. For the reasons previously described, the Company’s net loss decreased to $5.5 million in the third quarter of 2002 from a net loss of $6.8 million in the prior year quarter. Third quarter 2001 net loss included a $2.1 million extraordinary charge associated with the write-off of debt issuance costs related to the refinancing of the Company’s bank credit facility.

EBITDA. EBITDA (defined by the Company as earnings before interest, income taxes, depreciation and amortization) increased 8.8% to $22.1 million in the third quarter of 2002 as compared to $20.3 million in the prior year quarter. This increase is primarily due to a 9.7% increase in the average number of installed rooms receiving Guest Pay interactive services, and improved operating efficiencies as described above. As a percentage of total revenue, EBITDA was 34.7% in the current quarter compared to 35.2% in the prior year quarter.

EBITDA is not intended to represent an alternative to net income, operating 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.

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Discussion and Analysis of Results of Operations
Nine Months Ended September 30, 2002 and 2001

Revenue Analysis. The Company’s total revenue for the first nine months of 2002 increased 8.3%, or $13.6 million, in comparison to the same period of 2001. The following table sets forth the components of revenue (in thousands) for the nine months ended September 30:

Guest Pay interactive revenue increased 9.3% or $14.6 million, in the first nine months of 2002 in comparison to the same period of 2001. This increase was attributable to a 10.8% increase in the average number of installed Guest Pay interactive rooms, offset by a 1.3% decrease in average monthly revenue per room. The following table sets forth information in regard to average monthly Guest Pay interactive revenue per room for the nine months ended September 30:

Average movie revenue per room decreased 1.4% as a result of a 150 basis point decrease in occupancy levels versus the same period of 2001. Other interactive service revenue per room decreased by 1.1% also due to the decrease in occupancy levels versus the same period of 2001.

Other Revenue 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. Other revenue decreased $998,000 or 12.3% due to decreased equipment sales to international licensees.

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Gross Profit (exclusive of other operating expenses discussed separately below). Gross profit totaled $101.4 million for the nine months ended September 30, 2002, an increase of 7.0% over the first nine months of 2001 on an 8.3% increase in revenue (dollar amounts in thousands).

Gross profit on Guest Pay interactive services increased 7.0%, or $6.4 million, on a 9.3% increase in related revenue. Guest Pay direct costs (primarily studio license fees, license fees for other interactive services, Internet connectivity fees, and the commission retained by the hotel) are primarily based on related revenue, and such costs generally vary directly with revenue. As a percentage of revenue, the decrease in gross profit margin from 58.9% to 57.7% was primarily due to connectivity costs related to the Internet on television product and to increases in hotel commissions.

Gross profit on other services increased $251,000 or 8.5% in the first nine months of 2002 from the prior year nine months, and the gross profit margin increased from 36.3% to 44.9%. These increases were due to lower costs of sales related to international licenses and lower costs related to cable programming services, which resulted from favorable pricing.

As a percentage of revenue, the Company’s overall gross profit margin was 57.8% compared to 57.1%. The nominal decrease in gross margin from Guest Pay interactive services was partially offset by an increase in other gross margin as described above.

Operating Expenses. The following table sets forth information in regard to the Company’s operating expenses for the nine months ended September 30 (dollar amounts in thousands):