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Executives

Ann Parker - Director of IR

Scott Petersen - Chairman and CEO

Gary Ritondaro - SVP and CFO.

Analysts

Alex Lieblong -Key Colony

LodgeNet Interactive Corp. (OTC:LNET) Q2 2009 Earnings Call July 28, 2009 5:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the LodgeNet second quarter 2009 earnings conference call. The company will first share its prepared comments followed by a question-and-answer session.

At this time, we'd like to turn the call over to Ann Parker, Director of Investor Relations. Ms. Parker, you may begin.

Ann Parker

Thank you, Operator. Good day everyone. I'd like to thank all of you for taking the time today to listen to our second quarter 2009 conference call.

You should have received copies of our earnings release. If not, please call me at 605-988-1001. We will make sure you do get a copy.

Our speakers for today's call will be Scott Petersen, Chairman and CEO of LodgeNet; and Gary Ritondaro, our Senior Vice President and CFO. Scott and Gary will review our second quarter 2009 earnings and will then welcome your questions and your comments.

This call is being webcast live over the Internet through our company website, www.lodgenet.com. We also have slides posted on our website which correspond with today's comments and they can be found under the investor section.

Before we get started, I'd like to remind you that some topics to be discussed today that do not relate to historical performance may include or constitute forward-looking statements within the meaning of the federal securities laws 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. Certain of the risk factors which could affect the company are set forth in the company's 10-K and other filings.

With that said, I'll now turn the call over to Mr. Scott Petersen. Scott?

Scott Petersen

Thank you, Ann and good afternoon, everyone. The second quarter results once again showed that our strategic focus on cost control and diversified revenue growth is reducing the impact of the challenging economic environment on our company.

As a result, we generated a significant expansion of our free cash flow and enhancements to our profitability metrics. If you take a look at some of the highlights on slide two that we've posted on our website, we have right-sized our operations to the economic environment, operating expenses were down 21% while we managed our capital investments lower by over 70%.

We continue to focus on our long-term strategic growth initiatives which are producing results. Revenue from those initiatives was up 12% versus the first quarter of last year and gross profit was up nearly 60% as we continued to improve the profitability of these initiatives.

As I said, as results were driving free cash flow, second quarter free cash flow was up 35% from last year and for the first half of this year 2009, free cash flow equaled $30 million versus just $3.7 million last year and that's $1.34 per share just in the past six months.

As I said, we're also improving our profitability metrics. Operating income increased 42% during the quarter. Our net loss decreased by 30% and for the first half of 2009, we posted right around $1 million of positive net income for the company.

Beyond controlling and managing our operations during the quarter, we also closed a convertible preferred stock offering which generated right around $54 million of net proceeds. It substantially strengthened our balance sheet and it created a substantial cushion around our debt leverage ratio covenants, what remains a very uncertain economic environment.

At this point, I'm going to turn the call over to Gary to give you some more details and thoughts about the quarter, and I'll be back to provide a little bit of color at the end. Gary?

Gary Ritondaro

Thank you, Scott and thank you for joining us today. If I may direct you to slide number three, you'll notice that we're showing a growing diverse revenue streams, while overall our revenue decreased about 11.2%. We are expanding our revenue with growth initiatives from hotel services and other revenue businesses which are system sales and services, healthcare and advertising.

The decrease of 11.2% was certainly driven by the 21% decrease in our guest entertainment revenue, but was offset somewhat by the 10% increase that you see on the chart, increase in hotel services and 15% increase in other revenue mainly from our Professional Solutions but Healthcare also had a very good quarter.

Revenue from our strategic growth initiatives generated $47 million of revenue for the quarter, which was 39% of our increase versus 31% in Q2 of '08, diversifying our revenue to a broader base than just guest entertainment and therefore is less reliant upon occupancy rates and guest purchases.

On slide number four, you'll see the revenue per room comparison and, of course, this mirrors what we just saw on slide number three. The hospitality business generated $21.38 of revenue per room, a decrease of about 10% quarter-over-quarter, but with two of the three businesses within hospitality producing growth quarter-over-quarter.

Guest entertainment decreased 20% period-over-period mainly due to the occupancy rates which is certainly a major driver for guest entertainment. Occupancy rates were down about 760 basis points, or 11.4% period-over-period. I would point out that this rate decrease on guest entertainment was actually less than the decline we saw in the first quarter of 2009.

The balance of the decline was due to fewer purchases by the guests who were actually staying in the rooms. Conversely, hotel services increased 10% consistent with the increase that we had in the first quarter.

We continue to rollout our HD television programming, which means more channels and higher revenue per property. We're certainly continuing to convert certain properties to HD television programming from analog, which is also increasing our revenue and later on you'll see the increase in our gross profit. Revenue for this business increased $3.1 million quarter-over-quarter.

System sales had an increase of 35% quarter-over-quarter as we continue to deploy broadband system sales and more contracts within Professional Solutions. We had an increase of $2.5 million within system sales period-over-period.

While other revenue has been impacted by the slowdown especially in our advertising, you will see that Healthcare was flat period-over-period. Healthcare, just one other point, installed five systems during the quarter and we have a solid backlog of six properties to be installed over the next two quarters.

Moving onto gross margins, which is on slide number five. You'll see here that during the quarter each of our hospitality businesses actually achieved gross margin improvement versus the first quarter of 2009, while the overall gross margin was up 90 basis points versus that first quarter. We continue to expand the margins from our new revenue initiatives and we continue to control costs being the major component driving the increase of this gross margin.

As you can see on chart number five, our total gross margin, however, quarter-over-quarter, was down 290 basis points and this is due to the revenue composition this quarter.

We saw the reduction in guest entertainment revenue on the previous slides, but I will tell you that new initiatives had a solid margin but it's certainly lower than the guest entertainment margin that we've enjoyed historically.

But conversely, we're not deploying our capital for those businesses. Under hospitality, guest entertainment was certainly impacted by the occupancies mainly as we saw lighter business travel which further impacts the mix of products sold and, therefore, the overall margins within guest entertainment.

This was offset somewhat by lower hotel commissions, which is based on pay for performance. Under Hotel Services, which is comprised of broadband service revenue and TV programming, you'll see that we had a margin improvement of 13%, an expansion of 460 basis points from the second quarter of last year.

The expanding margins for broadband Internet is driven by cost reductions within this business, primarily due to the outsourcing of the call center that we talked about last quarter and other cost control measures implemented this year. TV programming margins are increasing driven by the conversion to HD programming versus the analog programming.

Within system sales and related services, we showed a margin here of 30% which is a significant expansion versus the 17% that we showed for the second quarter of last year. We're expanding our margins for Broadband System Sales and from Professional Solutions, which were driving this margin expansion. Again, it's an issue of controlling our installation costs and right-sizing the organization.

On slide number six, you can see that we continue to produce significant reduction in our operating expenses period-over-period. Of course, on this chart we're showing you a combination of system operations and SG&A.

Our Q2, we had $22.4 million of total operating expenses, a 21% reduction from Q2 of '08 and in line with the guidance that we issued. This reduction offsets about 60% of the reduction that we saw or decline that we saw in gross profit.

Several factors are impacting our SG&A and our system operations expense. We continue to integrate the acquisitions that we made back in 2007, continued to gain operational efficiencies quarter-over-quarter mainly associated with back-office operations and field service.

And then, of course, we continue to monitor and control our general costs that were implemented earlier this year. As you recall, we had a workforce reduction late in Q4 and then in the first quarter of 2009, we certainly have limited hiring through essential job functions and job openings during the second quarter and we continue to control general operating expenses as we continue to have a freeze on salaries and wages and we continue to eliminate the 401(k) match are just some of the examples of how we are controlling these costs.

On slide number seven, you'll see the profitability metrics which are adjusted operating cash flow and operating income. The adjusted operating cash flow was impacted certainly by the decline in revenue in guest entertainment. Adjusted operating cash flow was down 14% compared to the second quarter of 2008. As I mentioned, the decrease is due to guest entertainment which is offset to some degree by the increase in revenue and profitability from the strategic growth initiative as well as the reduction in operating expenses.

Operating income, however, was up 42% compared to the second quarter of 2008. In addition to the items that I just mentioned about adjusted operating cash flow, there was a 20% decline in depreciation expense period-over-period.

We have accelerated depreciation in some of the acquired assets becoming fully depreciated and then we have lower capital spending over the last year or two, which also is reducing our depreciation going forward. All of these are driving lower depreciation and we expect this trend to continue for the balance of the year.

On slide number eight, you'll see here that we had a net loss of $5.2 million compared to a net loss of $7.5 million for the second quarter of last year, or a 30% improvement. If you adjust for items that we don't expect to recur, we get a loss of 2.9 versus 3.7 and really the important part here is the amortization of purchased intangibles. Of course, this analysis represents a true comparison once we take out the nonrecurring items to see how the business is actually performing.

Then as Scott mentioned, for the first half we had net income of just short of $1 million compared to a $20 million loss for the first half of 2008, certainly a significant improvement period-over-period.

As we've mentioned several times, on slide number nine, we continued to manage our capital investments during this economic period. As planned, we invested $5.7 million during the quarter compared to $19.8 million last year and the amount of capital invested this quarter was within our guidance.

As you can see on slide number 10, we continue to enjoy a larger percentage of the capital coming from hotel contributions. Right now on a trailing 12-month basis, hotels are contributing about 31% of the capital on a trailing 12-month basis versus about 7% back around April of 2000, which is when we acquired the On Command company. Certainly, again, from our perspective, this is a very positive change in how you we're funding the capital investments going forward.

On slide number 11, you see the increase in free cash flow. We've improved cash flow to $14.5 million from $10.8 million last year. This is driven by the increase in revenue and cash flow from our strategic initiatives, the reduction in operating expense and certainly the reduction in our capital investments.

Slide number 12 gives you a further breakdown of how we've spent our capital. You'll notice that each category of use of cash was reduced this quarter versus the first half of 2008, including the cash we used to pay interest and for working capital.

Pre-investment cash flow was stable at $41.2 million, or the equivalent of $1.83 per share, and this was accomplished despite a reduction in revenue. After capital investments for corporate assets, minor extensions and major renewals which totaled about $7 million compared to $27 million last year, we had $34 million of cash pre-expansion cash flow and this also equates to $1.51 per share and our pre-expansion cash flow last year was $15 million.

Within the major renewal categories, we converted 6,800 rooms, of which almost 100% were HD systems and of course, we did that after we received another long-term contract prior to making that investment. The average investment per room was $266 versus $314 for the second quarter of last year, a 15% reduction. Again, the reduction is coming from reduced component costs as well as installation expenses.

From the pre-expansion cash flow, we invested $3.9 million for new rooms during the first half of '08 versus $11.5 million last year. We installed 4,300 new rooms, about 96% of those rooms were HD. Again, the average investment dropped about 22% from 410 down to 320 for the same reason that we just talked about.

Our free cash flow after all capital investments was $30.2 million versus $3.7 million for the first half of '08, and the $30 million of free cash flow is equivalent on an annualized basis of $2.68 per share.

Slide number 13 talks about the covenant analysis and strengthening our balance sheet. As Scott mentioned, we completed the preferred stock offering in June, generated almost $54 million of net proceeds.

The consolidated debt at the end of the quarter was $547 million and $486 million on a net-net basis. You can see on the slide that on July 1st, we used some of the proceeds from the sale to repay debt of almost $28 million.

The bank adjusted operating cash flow was $130.7 million, which differs slightly from our adjusted operating cash flow due to the severance payments which we cannot subtract from the bank AOCF.

The leverage ratio the end of the quarter was 4.19 times versus the covenant of 4.25, but on a net-net basis, the leverage ratio at the end of the quarter was 3.72 and was certainly that final stepdown of 3.5 which is effective on September 30th of 2010, means that we have about five quarters to reduce our leverage ratio by less than 25 basis points. So I think that puts us in very good shape at that point.

I'll turn the call now back to Scott for some further comments.

Scott Petersen

Thank you, Gary. I would like add a few thoughts to the equation and also give you some thoughts on how we're thinking about the balance of this year.

First, I'd like to talk about several products and solutions announcements we made at the Annual Hospitality Technology Trade Show in June.

If you look on slide 14, you'll see that we are expanding our offerings to the market with some of the leading technology companies of the world and we believe these announcements reflect a recognition by these leaders that joint product offerings represent the most effective access for them into the hospitality market.

Our announcement for the HITEC included joint releases with Apple, where we announced an enhanced version of our IPTV solution which incorporates a powerful graphics capability of the Mac Mini into our system. We also had an announcement with Intel, where we also demonstrated their new iCon Mobile Concierge device, which incorporates their new Atom processor for mobile Internet devices.

LG Electronics also had a joint release with us in which we announced several enhanced interactive applications using their ProCentric technology that's built into their televisions and then we also put out an announcement about a new product offering from our own company called the LodgeNet 360 solution, which is an integrated IP network solution for high-definition television, broadband, telephony, digital signage and in-room automation that supports leading technologies from companies such as Cisco, Mytel, Motorola and others.

I think the bottom line here is that these announcements reinforce the strong strategic position we've developed within the hospitality industry and we look forward to leveraging that position for the benefit of both our customers and our shareholders.

On slide 15, we present some thoughts regarding the outlook for the balance of 2009. The headline here is that we will continue to operate the company based on our current conservative management plan until the traveler economy begins to rebound. From a revenue perspective, we do anticipate some improvements in quarter-over-quarter comparisons during the remainder of the year.

During the second quarter, the revenue generated from the leisure traveler was definitely stronger than from the weekday or what I would call the business crowd. In fact, when Marriott announced their earnings a couple weeks ago, they indicated that their corporate occupancy was down some 18% from one year ago and I think that provides a good insight into some of the trends that we're also seeing.

Certainly lower gas prices and discounts in hotel rooms are positive factors for us. So that should help us on the upside, however, the tight business travel budgets and uncertain consumer confidence levels will probably continue to temper our results.

On the B2B side of our business, where we sell systems and solutions to our hotel and healthcare customers, we are seeing the impact of tighter CapEx budgets on our sales. Now, while we believe these revenues will increase substantially over time and we certainly are showing nice quarter-over-quarter improvements during the last several quarters, we think these revenues will generally remain at their current levels, their dollar levels over the next several quarters.

I guess two other comments with regard to Healthcare. As Gary indicated, they had a strong installation cycle during the second quarter and I would also note that we've already signed five contracts for new installations during this quarter or during this month of July, but of course, most of these will not be fully installed until next year. So we can bet business does continue to build nicely despite this economic environment.

Then with regard to our hospitality B2B business, I would also want to point out that a significant part of our revenue does come from reoccurring revenue streams generated from the sale of TV programming and broadband support services, and we certainly will continue to benefit from these revenues as they are under fixed longer-term contracts with our hotel customers.

On the balance of the slide, you'll see our anticipated general ranges for various drivers of our operating results. All of these factors are within our current experience and we will continue to repay our debt facility to the extent necessary to remain in comfortable compliance with our leverage ratio requirements.

One slide 16 and 17, you'll see our guidance for the third quarter. Our revenue variance is based on a 15% to 20% reduction in guest entertainment revenue quarter-over-quarter. That revenue was down 23% in the first quarter, 20% in the second quarter and we are looking for equal to better relative performance during the third quarter.

Then on slide 17, I want to highlight our guidance with respect to leverage at the end of the quarter. The required ratio decreases at the end of this quarter, the third quarter, from 4.25 times down to 4.0 times. You can see on the slide that we are anticipating roughly a 3.7 times ratio at the end of the quarter on a net-net basis.

And just to do the math on that that represents about a $40 million cushion from a debt level perspective and almost a $10 million cushion from an adjusted operating cash flow point of view. So, we believe both present very comfortable levels for us.

So as I said on previous calls, I believe the results we are posting reflect an outstanding job being done by the entire LodgeNet team. We moved early and decisively. We made very meaningful cuts to our costs and our capital that are sustainable and will improve our operating results for the foreseeable future.

And we did this while maintaining good relations with our customers and our employees and I believe these efforts place us in a strong position as the economic environment will begin to rebound.

So with that, Operator, could you explain the procedure for asking questions?

Question-and-Answer Session

Operator

(Operator Instructions)

Scott Petersen

Operator, are there any questions?

Operator

First question come from Alex Lieblong from Key Colony.

Alex Lieblong -Key Colony

Well, I think it would be helpful when you're going over this cash flow per share, what is the fully diluted share count now? So I think that was a little misleading.

Scott Petersen

The data point there would be coming off the GAAP shares outstanding today. So your point would be as if the [preferred] stock offering was on an as converted basis, right?

Alex Lieblong -Key Colony

Yes, sir.

Scott Petersen

I have to get back with you. I don't have that number, Alex. But we'll post that out. That's a good data point to have.

Alex Lieblong -Key Colony

Am I correct in thinking that we were diluted about 50%?

Scott Petersen

I believe it's less than that.

Alex Lieblong -Key Colony

Ballpark?

Scott Petersen

40. I believe 26…

Gary Ritondaro

35% to 40%.

Scott Petersen

If you took with the [shoot] that then went out, if you would take the existing cost, we have converted, I think it would be the as converted would roughly equal just shy of 40%.

Alex Lieblong -Key Colony

I guess, what I'm saying is, where we had 2.68-ish per share free cash flow, we'll go through that later.

Gary Ritondaro

Yeah, it's not new. It's about $1.80, I think. We have $1.80 now...

Alex Lieblong -Key Colony

Right, if my math is correct. I think it's in that range.

Scott Petersen

And then you would need to take off the interest cost. So there would be incremental cash flows coming down through the P&L, because there wouldn't be a dividend nor the interest factor attached to that, I believe, too.

Gary Ritondaro

Right.

Alex Lieblong -Key Colony

Okay, so you're saying that $1.80, that is per share for the six months.

Gary Ritondaro

No, that's an annualized 12 months, Alex.

Alex Lieblong -Key Colony

Okay, that's $1.80 versus $2.68?

Gary Ritondaro

Yes.

Alex Lieblong -Key Colony

Okay, I'll found myself now. I didn't have my notes. What was the free cash flow last quarter?

Gary Ritondaro

Give me a minute here. As we presented, about $15 million.

Alex Lieblong -Key Colony

Okay, we were $16 million this quarter?

Gary Ritondaro

Yes, about 14.

Alex Lieblong -Key Colony

Okay, where did I get the 16, I don't know. Is there anyway when you're going forward, say in this hospital, what we're doing with hospitals say, okay, how many beds that were actually got online now versus kind of keep where we can kind of count the apples please?

Scott Petersen

I'd be glad to do that.

Gary Ritondaro

That information will be in our 10-Q when we release it, but yes....

Alex Lieblong -Key Colony

I don't have the attention ability to read a 10-Q.

Scott Petersen

Okay.

Alex Lieblong -Key Colony

Any chance of getting a better deal from Hollywood on your revenue sharing?

Scott Petersen

Our general relationships with Hollywood are two to three-year output deals, so to speak, where based on a certain revenue that is attached to the box office. We would make some representation of how broadly we'd distribute a title and then what the rate would be. Most of those are very few in the window right now, we renegotiate most of those will in a sense, we acquired On Command two years ago.

Alex Lieblong -Key Colony

Right.

Scott Petersen

So there's always a possibility. I would tell you don't think that's a significant opportunity for us at this time. But your point is well made.

Alex Lieblong -Key Colony

How long is your contract? I mean so you signed new contracts with them and how long does that have to run?

Scott Petersen

I think generally some are like in two-year term, others in three-year terms.

Alex Lieblong -Key Colony

If you have got the only game in town, looks like, but anyway, say, when you're talking about this Internet service for hotels. When I stay in a hotel, is there anyway of knowing that's one of your hotels if you are doing the Internet or if it's just Joe Blow doing it for them?

Scott Petersen

Anyway to a head count on that.

Alex Lieblong -Key Colony

You mean as you're there whether or not it is the LodgeNet service, so to speak?

Scott Petersen

Yes, I'm curious about that and also just from reading, is there any way I can pick up how many hotels we're doing that for now versus...

Gary Ritondaro

On the five quarter summary at the back of the press release, Alex, we do give the room count on a quarterly basis. We do it based on what room counts.

Alex Lieblong -Key Colony

Okay, for the Internet?

Gary Ritondaro

For the Internet, right. That would be the broadband rooms. So that's roughly 219,000 at the end of the quarter.

Alex Lieblong -Key Colony

And did I also notice on room count on the earnings and I've had two or three earnings calls, I apologize. Are rooms that we got right now actually went down from last year, is that correct?

Scott Petersen

That is correct. As part of this cycle where we're being much more I guess tight with our capital investment levels at this point in time. We're getting so much larger churn factor on the lower end of the market. So we're trying to be very disciplined there. The ones that are turning out generally are below $10 or been probably in this environment even an $8 revenue per room per month.

Alex Lieblong -Key Colony

But you're saying 90% of that is coming from the bottom of the barrel?

Scott Petersen

Yes.

Operator

(Operator Instructions)

Ann Parker

If there are no more questions, we'd like to thank everyone for joining us today. Again, a reminder that replays of this call can be accessed over the next month via the Internet through our company website and you may go to www.lodgenet.com to access that and the slides used during this webcast will also be archived on our website for your reference under the investor section. If you have any difficulty downloading those slides, we would be happy to send them on request. Thanks again everyone and have a good day.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This concludes our program for today. You may all disconnect and have a wonderful day.

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