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Executives

Ann Parker - Director of IR

Scott Peterson - Chairman and CEO

Frank Elsenbast - SVP and CFO

Analysts

David Kestenbaum - Morgan Joseph

Frank McEvoy - Craig-Hallum Capital

Jim Boyle - Gilford Securities

Dan Mendoza - Prospect Capital Advisors

LodgeNet Interactive Corporation (OTC:LNET) Q2 2010 Earnings Call July 29, 2010 5:00 PM ET

Operator

Good day ladies and gentlemen and welcome to the LodgeNet Interactive Corporation’s second quarter 2010 earnings call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer section and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded.

I would now like to introduce to your host for today's conference Ms. Ann Parker, Director of Investor Relations.

Ann Parker

Good day everyone. I would like to thank all of you for taking the time today to listen to our second quarter 2010 conference call. You should have received copies of our earnings release, if not, please call me at 605-988-1000 and we will make sure you get a copy. Our speakers for today's call will be Scott Petersen, Chairman and CEO of LodgeNet, and Frank Elsenbast, our Senior Vice President and CFO.

Scott and Frank will review our second quarter 2010 earnings and we 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 those can be found under the Investors 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 Petersen

Thank you Ann and good afternoon everyone. During the second quarter, we continued our strategic focus on driving free cash flow, reducing our debt levels and de-leveraging our balance sheet. As we out performed our guidance on all three of these fronts.

During the quarter we produced $22.6 million of free cash flow which was 56% greater than last years second quarter and the 110% greater in the year before that. While we have maximized our cash flow by tendering the conservative operating plan we implemented two years ago, maintaining our recession reduced OpEx and CapEx flat for last year. So the continuation of that plant along with our diversified revenue initiative In light of disappointing Guest Entertainment revenue we experienced during the quarter.

As a result our (inaudible) continued to strengthen, our net debt dropped below the $400 million mark. Our leverage ratio improved decreasing to the 3.4 times level and that level is now below the final step down of our credit facility.

Our strategic initiatives position us to solid revenue growth in the future we see good revenue growth prospects from our diversification efforts, focused on increasing revenues of hotel services sales, about advertising and healthcare our high definition convergence, our poise to accelerate as hotels increase their purchases of HD TVs 2011 and beyond and our recently announced next generation interactive television platform but mainly in vision which connects our interactive system to the internet I believe that holds significant revenue growth prospects from the sales new count and the services to both hotels and our guests.

Now before going in to that I’d like to turn the call over to Frank Elsenbast at this for some comment and color regarding the ESN quarter results. Frank.

Frank Elsenbast

Thanks Scott, while revenue for the second quarter was below our expectations, due to short fall in guest entertainment. We had solid revenue growth from some of our strategic growth initiative a conservative management of capital investment, working capital and operating expenses allowed us to exceed our cash flow guidance for the quarter. We use this cash flow to aggressively pay down debt and drive continued deleveraging of our balance sheet.

Now I'll walk you through the slides that were issued along with press release and take a closer look at some of the key drivers of our financial results. For the second quarter, total revenue was $113 million, a 7% decline versus last year.

On slide number three, we'll see the breakdown between our diversified revenues in guest entertainment. During the second quarter revenue from these initiatives grew to 42% of total revenue versus 38.5% last year. Advertising and hotel services drove this improvement.

Guest entertainment revenues were of 12% for the quarter due in part to the 4.6% reduction in the average number of rooms being served with the remainder driven by the decline in revenue per room. We continue to see conservative buying behavior from our consumers even as the occupancy rates have rebounded.

Guest entertainment revenue was also impacted by fewer hit movies this year. During the quarter our top five Hollywood movies generated $3 million less in revenue than our top five movies did last year.

On slide number four you will see the breakdown of our revenue per room, which for the quarter was $21.22, down 2% versus last year. Strong growth in hotel services and advertising offset over half of the decline in guest entertainment. It is also important to note that revenue per room from our growth initiatives grew impressive 7.3% for the quarter.

Hotel services revenue per room increased 7.3%, driven by growth in our television programming revenue as we increased the number of rooms receiving high-definition programming and increased the average channel lineup.

Revenue per room from systems sale was down slightly versus prior year as the growth in our professional services business was offset by a soft quarter in broadband installation. Advertising revenue for the quarter was $2.6 million, an increase of over 50% versus prior year. The growth was driven by increases in channel leasing revenue and a 30% increase in advertising revenue as several national advertisers have expanded their presence on our platform.

Gross margins improved by 40 basis points versus Q2 of last year. The strong margin performance was driven by improvement for every business unit during the quarter. As we continue to manage our cost structure, maintain pricing and balance the impact of changes in our mix of business.

Moving on to slide number six, operating expenses for the quarter were $22.9 million which is largely flat versus last year and prior quarter. We continue to manage our cost structure very closely and expect our expenses to remain flat versus the run rate for the first half of the year.

Adjusted operating cash flow for the quarter was $27.9 million which is just below the low end of our Q2 guidance due to the revenue shortfall on guest entertainment discussed earlier.

On slide number seven, you will see that LodgeNet has delivered consistent AOCF production in the $28 million to $32 million per quarter range over the last all quarters. This consistent performance is an indication of the strength of our installed room base and the success of growing diversification effort. Even during challenging economic times, we are able to achieve steady AOCF and solid operating margins.

For the past four quarters, the company has consistently achieved 25% AOCF operating margin. Moving on to slide number eight, you will see our bottom line profitability continues to improve; operating income for the quarter was $6.1 million, which is a 30% over last year. Lower depreciation and amortization contributed to the improvement as a result of our reduced capital investment over the last two years. D&A for the quarter was down $5 million versus prior year. Also highlighted on page eight is our improvement in net loss per common share and a loss of $0.18 per share on a full diluted basis, this has decreased 45% over the past two years. Consistent AOCF production has combined with lower depreciation and amortization as well as lower interest expense to drive this improvement.

On Slide number nine you will see our free cash flow has increased dramatically over the past two years. For the quarter we generated $22.6 million of free cash flow which is above our guidance and more than double the free cash flow the company generated in the second quarter of fiscal 2008. Our free cash flow improvement is driven by several factors. Capital investment reductions during the economic slowdown, aggressive repayment of debt which has driven down our interest and continued focus on reducing investment in working capital.

On the next slide you will see a more detailed breakdown of our free cash flow results. Our preinvestment cash flow of $27 million during the quarter was a 34% improvement and represents a $1.08 per common outstanding share or $0.67 per share on an as converted basis. After investing $4.4 million in capital projects for the quarter we generated $22.6 million of free cash flow again a 56% increase versus last year.

On a year-to-date basis free cash flow is $46.2 million which is the equivalent of a $1.85 per outstanding share and reflects the strong cash flow potential of our business model even during economic slowdowns. On slides 11 and 12 we have laid out our progress on reducing debt levels and de leveraging our balance sheet in the second quarter we used the majority of our free cash flow to pay down our debt the net debt reduction of $21 million for Q2 brings our total debt down to $396 million of rejection of over $200 million during the past two years.

Our consolidated leverage ratio for the quarter was 3.52 with the current covenant at 3.75 on a net debt basis our leverage ratio was 3.44 which is below the final covenant step down that will occur at the end of the third quarter. I’ll conclude with the review of the financial guidance which you will find on slide 13 and 14. For the third quarter we are expecting revenues to be in the range of a 116 million to quarter 120 million.

This guidance reflects a 3% to 8% decline in guess entertainment revenue per room for the third quarter. On a more positive note we are expecting our diversification efforts to accelerate their growth as their business pipelines have grown substantially during the first half of the year leading the way will be healthcare advertising and services, and system sales which on a consolidated basis will generate strong double digit sales growth over the last year in the third quarter. At AOCF level we expect to be in the range of 27 million to 30 million.

These AOCF projections will include consistent assumptions on gross margin and operating expenses for the third quarter at the mid point of growth revenue and AOCF the guidance will indicate an AOCF operating margin of 24.4%, slightly below the margin we achieved this quarter.

On slide 14, we roll our Q3 guidance into our leverage ratio calculation. You will see that under both the low and high end of our Q3 guidance, the company will achieve our final step down in our financial covenants with a leverage ratio in the range of 3.38 to 3.44 versus the covenant of 3.5.

With that, I will turn the call back to Scott.

Scott Peterson

Thank you, Frank. Before going to your questions I would like to make a few comments regarding our outlook for the reminder of 2010 and 2011. As I said at the beginning of the call, I remain confident that our strategic initiatives position us for solid revenue growth in the future.

On slide 15 you will find some of the summary points. First, one of the primary drivers of our future growth will be the conversion of our interactive television based to high definition systems, which systems continue to outperform our analog platforms.

Our current high definition base is generating about 50% higher revenue than our average installed room. Our revenue generated from the high def systems from guest entertainments and television programming equaled $27.40 per room per month during the quarter as compared to our overall average in revenue of about $18.50 from the same two sources of revenue.

However, our near-term growth has been limited by very tight hotel CapEx budgets this year given the state of the economy and while we know expect to HD unit growth to be less than we originally anticipated for this year. We do anticipate substantially higher unit growth in 2011 as hotel budgets are expanded next year.

Additionally, we foresee solid growth prospects from other strategic initiatives in the coming quarters. Frank, reviewed some of the outlook for the first quarter but we will see increasing revenues from hotel services as hotels converts to high definition television and operate their broad band systems.

We see increasing system sale revenues, as hotel results improve and result in increased budgets that is forecast for capital expenditures, with specific to comment on international system sales we expect incremental revenues from outside of our operating areas United States and Canada in the next foreseeable future as we had additional international licensees such as the recently announced agreement we did with (inaudible) for system sales in the Middle East and India, two very fast growing areas for the hotel industry.

For Advertising services they certainly had solid growth in the first half of this year, we expect that to continue specially with our improving economy. And healthcare is on track for solid revenue growth in the second half of this year. We totally six facilities contracted in and backlog and we expect installation to accelerate during the next two quarter.

And at last we believe our next generation platform which we call a division working with the solid opportunity to increase revenues from our interactive television, platform, we unveiled Envison of the hotel technology show in June and that believe its well received by the hotel industry Envison connects our interactive system to the internet or the cloud service fee which is a new technology direction you might be hanging about within the casino electronics market and we opportunities with Envision from subscription and transactional revenue with initial deployments to begin next year in 2011.

Now the cost lines are some of the introductory slides we have slides that the hospitality press had the technology show and I believe it present a good overview of our new product line.

So on slide 16, you can see there is, and visual will be offered on two technology platforms, one, called DV or say for Digital Video and the IP of course for Internet Protocol. We believe it's important for us to have both platforms covered to provide greater choice for hotel customers and the various capabilities that these technologies can provide.

We believe the DV platform will be the workhorse. It has a cost structure somewhere to our current HD platform, we think is a very cost competitive and presents a very good investment opportunity for us and it has some very robust features for the industry.

And then the IP platform. The main difference there will be that the hotels will be responsible for the purchasing of the internet clients whether it’s the Apple client that presents the most industry leading capabilities for graphics in the presentation then we also displayed a high-tech show for a medium client who will be also introduced next year. But given clients' and hotels' investment there, it will provide hotels with greater marketing and capabilities for the system.

The next page on slide 17, you'll see that we're entering the world of apps. As it is frequently discussed from the world of iPads and iPhones and other devices like that. So the various features will be packaged and say application or apps, you'll see there is general packages represented on the page from eCompendium, which is intended to take the written materials that you find within the hotel room and put them on screen, saving hotel's expense, printing expense et cetera. There is eConcierge, eConnect, eConference and ebranding and you should think of the apps that hold potential for hotels to drive their revenues or increase their efficiencies will be offered to the industry on a subscription model. So many pennies per room per day for the use of the software and interactive system and the apps such as the ability for guest to buy tickets, onscreen, make reservations to local restaurants; order pizza delivered to the hotel all through the television, those types of transactions we see on rev-share model with the transaction partner on the other side.

And of course Envision will have our expanded set of entertainment apps which of course provides the widest array of content choices and we are also pleased to note that Envision will feature a credit card purchase option which we think will also be very interesting opportunity for guest to use a different purchase method and hopefully drive incremental revenues in the process. That said we expect initial installations during the first half of next year and our goal with Envision is to make our interactive systems even more relevant to leading hotels and guest.

So operator with that will you please explain the procedure for asking questions.

Question-and-Answer Session

Operator

Ladies and gentlemen, [Operator Instructions]. Our first quarter comes from the David Kestenbaum of Morgan Joseph.

David Kestenbaum - Morgan Joseph

Can you just reconcile your previous free cash flow guidance to the current free cash flow guidance where it was $60 million to $65 million for the year, and now we're given a nine-month type of number? What do you expect to happen in the fourth quarter? Can you just elaborate on that?

Frank Elsenbast

Well, the guidance that we have provided is on a nine month basis. So what we have allowed for in the third quarter is for a modest increase in our capital spending that we will see because some of the capital budget may open up with some of our hotel partners and then some of the working capital improvement that we saw in the second quarter, some of those are timing based and we will swing back a little bit in the third quarter. Those are largely the changes.

Scott Petersen

And David I think for the full year, originally we are talking 60 to 65 for the year and I think that moves kind of more towards the 70 range.

David Kestenbaum - Morgan Joseph

And then how about the target on the debt reduction, which was previously $400 million? Where do you think you can get that down to? I guess you can even get that lower now, right?

Frank Elsenbast

Right and if you look at the guidance slide on slide 14 you will see that the consolidated debt as of 930 should be in the range of 385 to 388.

David Kestenbaum - Morgan Joseph

And can you talk about what happened in the healthcare business this quarter? It was down sequentially, but you're expecting some growth going forward. Can you just talk about that?

Scott Petersen

There is a sense of a seasonality for the business. We find that the healthcare industry generally starts with a fiscal year on July 1 and ends at the end of June. Of course that year-over-year comparisons, that would be the same. We tend to get a flurry of contract signings in the third and fourth quarter for installations, then starting third and fourth and as you get to the last year that seem to be there were more installations kind of got pushed off and got completed in the first and second quarters of last year meaning 2009. This year we didn’t have that kind of the backlog from the contract signing during the second half of 2009 where we’re more installed in those current time frames the outlook is we have see a very good interest in the platform so we'd get six contracts installed waiting installation example like MD Anderson Kansas or out of Houston social university of Texas that contract be given the size of the facility spread over a multiple quarters given the pound and in some of those factors kind of came in to it so.

Overall I seem to get to see a very strong as Frank indicated poor guidance for the healthcare in the fourth and the third quarter actual will well over 40% increases third quarter this year verse in last year. So I think we are going to see a very nice reversal here in the second half.

David Kestenbaum - Morgan Joseph

And then could you talk about what you’ve seen on guest entertainment services revenue in July. You are guiding towards definitely improvement from where you were in the second quarter but it seemed like at least the backdrop was pretty good as far as utilization of the hotel rooms filling up but yet the numbers didn’t bear fruit so just talked about you’ve seen.

Scott Peterson

Sure, well its there is the couple of factors in the second quarter there was clearly the quality of content a factor this year verse last year and there is the data point that Frank mentioned from the top five titles generated by $3 million less revenue for previous and the prior year and I think simple math that’s roughly $0.50 a room a month in top line revenues so I would say a year ago third quarter was strong for titles the hangover which I think was our most popular title for the year not the top it was one of the very top was introduced in the third quarter so the comp on that I would say there might be some continuing comparisons in the third quarter between the quality content this year versus last. I’m not saying this year has bad content, but I think there were some exceptionally strong titles last year.

There is more travel this year than last. That’s just public data points. However, we are finding that, the content aside, that consumers are still quite cautious. And second quarter clearly, with drop in consumer confidence levels that were seen certainly the last several months, and I think contributed to a more cautious consumer.

I think business travel that has started up again this year versus last, I think many business people are under orders to be very conservative on their spending on the road, and even if perhaps our movie purchases have never been reimbursed by some organization, I still think there is a general flavor of conservative behavior so to speak this year versus other years as occupancies, there might have been a different relationship to occupancy and purchase. So, we don’t have another airline industry or the hotel industry where we have a forward look at bookings and those types of things.

So our guidance really is saying that we don’t know for certain what each month brings, but we think a reasonable range for third quarter performance. We’d be thinking that entertainment would be roughly down the same kind of range that we saw in the second quarter and that’s where the guidance came down, with of course the offset in some nice improvements in revenue cash flows from the diversified revenue streams.

Operator

Our next question comes from Frank McEvoy of Craig-Hallum.

Frank McEvoy - Craig-Hallum Capital

Nice job on the free cash flow in the quarter, but I wanted to talk a little bit more about the HD video-on-demand conversion outlook. And you talked about they're kind of carrying that back a bit. Can you maybe give us maybe a range of where you expect to be the number for installs this year? Or if you want to just put it in terms of the number of HD rooms you might target by the end of the year?

Scott Petersen

Sure may be a little backlog of course, we have raised some capital in March to create some (inaudible) so we can be more aggressive and to do the conversion of analog to high-def but our hotel partners were ready roll and but as we rigged back to the market with our sales organization clearly finding the hotel CapEx budget are varying pace this year and the industry is kind of leading 2011 bit more investments within that space. So of course you know the incrementally equity that we raised in March did use that temporary basis to reduce there is a best use of cash but that remains our plan as to accelerate installations, when the industry is ready also on the terms of the business model that we have been discussing where the hotels are responsible like the in-rooming (inaudible) so then (inaudible) partners program, so its not the model where we put up all the capital like you know the new CapEx indexes in our side with the (inaudible) $150 million per rooms, the hotels were by the television that has our technology embedded with the (inaudible) with a acceptable MATV system you know past of the signal have been weaker when we make investment in the quarter software the update interactive head end.

We are introducing that business model. Deals are starting to move and a lot of times we are hearing right now, let's plan for next year in 2011. So we're thinking, originally our thoughts were we'd be in the 50,000 to 55,000 range this year for HD unit growth. We're probably thinking that’s more in the 35,000 to 40,000 range, maybe 45,000 range for the full year.

The third quarter could be probably up somewhat from our run-rate in Q1 and Q2, and Q4 could be up from there and from some of the deals that we're seeing right now. But, that would be the range and then I would, as I said in my remarks, I would anticipate substantial increases and opportunities for 2011. Of course, then our business equation will be as where do we allocate, how much capital do we want to allocate into that space and where is our best opportunities for that capital.

Frank McEvoy - Craig-Hallum

So Scott, are the hotels then pretty much across the board giving you a feeling that they're going to loosen their check, their pocketbooks or whatever in 2011 and spend more?

Scott Petersen

The hotel industry of course is starting the budgeting process. So a lot of conversations at this point with some of the larger customers I think as they are preparing their budgets. Their pulmonary words seem to suggest that the brands would love to push their franchise owners much more aggressively. If you get into high-def, I think the big question will be is how the other hotel owners and managers feel about their business prospects for 2011, whether or not they fund it to the level that the brands would like or whether or not there is some middle ground there. But, clearly we'll be up next year for some best.

Frank McEvoy - Craig-Hallum

And then the buy rate in the quarter was a little bit below where I thought it might be. I think on a sequential basis the way I calculated it was down from about just under 11% below the overall in Q1 to about 14.5% decline in Q2. You talked about the impact of the Hollywood movie lineup, the $3 million. If I adjust for that it still is down around 10.5%, pretty much flat with Q1. Are there other factors that are coming on? I mean, some of the hotels are starting to raise prices. Is that much of an issue, or is there some other ones that you're seeing out there that maybe you can respond to, for example, I mean, if the consumer's a little more price sensitive, are you seeing any opportunities to maybe change price or reduce prices and see if that drives higher sales?

Scott Petersen

Right, Frank I think that’s exactly right. Its one of those where it’s a different consumer today than it was 12 months or 23 months to 24 months ago. We are actively from a marketing standpoint. Looking at pricing strategies to the consumer and looking to enhance how we think about that in some of the programs we do a lot of cash from our price elasticity perspective I would tell you one of my primary focus over the next three, six, 12 months would be is to help the organization elevates this kind of approach to the merchandising factor when it comes to communicating and trying to incent or motivate guest to buy products.

The experience of a high-def platform is very good. But we saw softness on both the high-def from a movie standpoint. All the platforms saw, similar all the platforms did see reductions in buys in the quarter of high-def platform of course was the lowest impact we will have the least impact versus the platform so I think that’s positive for us as we move to high-def because it clearly is a better display device and present a better value proposition to the guest.

Frank McEvoy - Craig-Hallum

But so the same hotel room year-over-year was even down a little bit?

Scott Petersen

The second quarter it was down a little bit, that’s right. Prior quarters have been positive period-over-period.

Frank McEvoy - Craig-Hallum

Can you give us a kind of a range of what it was down on the HD side?

Scott Petersen

It was about half of the average.

Frank McEvoy - Craig-Hallum

You talked about Envision and alternate payment systems. Now the alternate payment system, is that going to be available on your existing systems as well? Is that something you can upgrade, or is it only available on the Envision?

Scott Petersen

We have been testing with our existing Marina platform. So we have two, we have the on-command platform, we have the LodgeNet platform, digital platforms out there in operating. We have been testing this capability on the existing LodgeNet Marina platform and we are starting in the month of August, to start to roll that out to a broader base. We have been testing at 70 properties I think it was in that ballpark looking for impacts on revenue whatever. So we will start to roll that out to the existing high def and analog Marina base this fall.

This time it is still little questionable how broad we are going to be able to get this far but that is the capability that is backwards compatible.

Frank McEvoy - Craig-Hallum

Is that kind of a function of the hotels as well, what kind of equipment they have? And do they pay for some of that upgrade?

Scott Petersen

There is basically a software as we just seem to access to internet connection and most of our properties have that at a reasonable cost or even accessing the hotels internet connection for that service. So it is relatively a minor and it is all primarily software.

Frank McEvoy - Craig-Hallum

And can you give us an idea what the impact has been so far in those 50 to 70 properties that you will trial by then?

Scott Petersen

Well it has been net positive. And I would say it has perhaps even greater appeal for the non-theatrical content that we order.

Frank McEvoy - Craig-Hallum

Are we talking 10%, 20% increase in buy rate or?

Scott Petersen

Single digits.

Frank McEvoy - Craig-Hallum

And then I guess in terms of from Q3 you talked about strong increase in the areas like advertising system sales and healthcare it sounds like healthcare is probably the primary driver for that or I know its across all three but if I were too choose pick one that would be the highest increase in healthcare I think you mentioned Scott like 40% year-over-year.

Frank Elsenbast

This is Frank the growth rate across all three of those will be well into the double digits healthcare and advertising will both be very material growth rates probably because they are coming out smaller base but they really will be up considerably versus prior year.

Frank McEvoy - Craig-Hallum

Okay great. And just I guess kind of another question on gross margins. I think, Frank, you mentioned they improved across all product lines. Is that sustainable you think, or is that something that you can continue to improve?

Frank Elsenbast

Well as the revenue diversification efforts continue to grow in that’s great for the diversification of the revenue we will continue to have a little bit of a mixed impact on our gross margin because the guest entertainment business is at a 60%. So that will overtime that may start to bring down the gross margin we will break that out for you. How much is the mix impact versus rate impact when we start to see that but right now for this quarter it was really consistent result across all of the business units.

Compared to the single biggest impact year-on-year change came from our advertising services as they saw nice pump in revenue and they have largely a fixed cost structure so all of that increase in revenue really dropped down to gross margin.

Operator

[Operator Instruction] Our next question comes from Jim Boyle of Gilford.

Jim Boyle - Gilford Securities

Scott, looking at the progress and the moderation of quarterly revenue declines, would you guesstimate that Q4 revenue is still going to be negative or flattish year-on-year, if the economic recovery stays gradual?

Scott Peterson

Well, on a total revenue per year basis, the 2% down was our best tops and the great slide started with the recession. So, I believe it will be moving into the positive territory. I don’t have the crystal ball for Q4, but it seems to me we are down 2% in the second quarter. I am hoping it’s moving to the positive territory in the next two to three quarters.

Jim Boyle - Gilford Securities

And Frank, in the out years, what’s your leverage range goal?

Frank Elsenbast

Well, once we get below the 3.5 to the third quarter, we’d like to get it down to 3.25. We get another benefit on our interest rate when we get it below 3.25. Once it is that low, there won’t be aggressive debt repayments. I mean we could probably get it down to around 3. But we feel there’s probably going to be better investment opportunities for us in investing in the hotel properties than just continuing to pay down debt.

Jim Boyle - Gilford Securities

And Scott, finally, HD room penetration in one to two years, you hit 20% or you break through?

Scott Petersen

You break through that, that’s easy. Absolutely.

Jim Boyle - Gilford Securities

In one year, or is it going to take two?

Scott Petersen

One year for sure and we are roughly at 15% now. I mean in 2011 you are going to see I mean the industry will be buying, the economy will be better and we are going to be in the position to invest more aggressively in that space alongside out hotel partner. So the debt penetration curve will definitely take off.

Operator

[Operator Instructions] Our next question comes from Dan Mendoza of Prospect Capital Advisors.

Dan Mendoza - Prospect Capital Advisors

What was CapEx in the quarter and what are you expecting for the full year?

Frank Elsenbast

CapEx for the quarter was $4.4 million.

Dan Mendoza - Prospect Capital Advisors

And for the full year?

Frank Elsenbast

I think we are probably around $20 million on a full year basis/

Dan Mendoza - Prospect Capital Advisors

And will that be a little bit less given the hotel CapEx constraints than maybe you had initially planned?

Frank Elsenbast

Yes that is lower than we originally assumed. Our original budget had the third quarter and then especially the fourth quarter starting to accelerate getting up almost near $10 million but given the response that we have had so far from our hotel partners are probably not quite ready to start really spending. So and we have been running that a little between $4 million and $5 million in the first couple of quarters. It will probably go up a little bit in the back half but not a lot.

Dan Mendoza - Prospect Capital Advisors

And then I have a question for you both short term and longer term. What sort of impact do you think sort of Netflix and other folks having kind of a download model might have had on your per-room revenues in Q2 and going forward?

Scott Petersen

Yes, the download model, the content is the same, or actually it tends to be about 30 days delay from what Netflix would have had or does have for their straight DVD rental business. So I would say, probably from a laptop viewer's standpoint, most PCs have had a DVD drive for many years and whether or not its coming off a DVD or downloaded to the laptop, I don’t think has a material difference from guests' standpoint.

We clearly do and have been managing the company around the theory that those types of access to the content in different forms, and if it's on an iPad versus a laptop, is that really a difference from a consumer standpoint. So different device but the same window. And that window tends to be 30, 60, 90 days after we first get the title, so it's an old. We have the earliest window as it comes out of theaters. But we did and I guess I'm going back to my phone.

We are managing that business assuming that we do long term secular headwinds from those types of access to content we did in different devices. So that’s what we talk a lot about and had such a great focus also on driving diversified revenues that are not dependent on guest entertainment purchases. So blocking down revenues from hotels for TV program and for broadband services, providing threshold services, solutions for that and et cetera. So in the near term, in the second quarter, I don’t think that was an impact. Not going to say that, if you look over a three-year, four-year period of time that there hasn’t been some headwind because of that but I don’t think that’s a short term issue.

Dan Mendoza - Prospect Capital Advisors

And the last question. Just can you spend a little time on the healthcare business and talk about the profitability and cash flow characteristics of that business today and as it gets bigger?

Scott Petersen

The healthcare business basically is a systems sales model for us. So whether the systems that we have created for the hotel industry with some very minor adjustments, its basically different content but primarily it's the same core interactive engine delivers entertainments but also more importantly information and education content into the hospital market and so we offer assistance for sale.

The sell price typically runs around a $1000 or so for bid and on that we are generating a 40% to 45% gross profit margin on the system sale. So very nice profit margin at the time of sale and that we ramped at sale with a service agreements to provide content, to service and maintenance and then other services around that and that has been running $20 to $25 per bed per month and I believe that's also right around at 40%, 40 plus like gross profit so.

Very next business for us we have roughly about 10,000 beds that we serve today. Our market you know the entire healthcare market is about a 1 million beds I would say prime turf would be some more in the 3000 bed side would be competitive markets bigger properties.

Our keys customers today those are basically earlier adopters whether its Brigham and Women's out of Boston, its it's MD Anderson Cancer Center out of Texas. We have University of Chicago teaching hospitals in the Chicago area. So there were some interesting early adopter leading organizations and so overtime that will be continue to be a nice growth opportunity for us. Cash flow characteristic is its all cash flow for us.

And our operations are such that we are able to leverage kind of the hotel mother ship for installations and field service, lot of the software development into business, we are the great, dedicated group of about 10 people that are really focused on driving growth and using third parties in that space to drive that growth also.

Operator

[Operator Instructions]

Frank McEvoy - Craig-Hallum

In terms of the number of rooms, guest entertainment rooms has been declining a bit, roughly 4% to 5% year-over-year. Do you have any idea where that might level off what might help level that off?

Scott Petersen

Historically, we would have had a trend rate of like 2% to 3% per year. A lot of times these properties that are moving out of the system and in the past was condolization of hotels or just certain properties just not being competitive in the market. Some others just for credit based on financial issues on our side. It's been more rapid over the last couple of years, and we are guiding this year to be basically down about 100,000 units like similar to what we were in 2009 because with our combination with on-command kind of our taking a more deliberate approach to capital spend and focusing our capital on the right properties.

The lower revenue producing properties that we have served in the past and on-command has served in the past I think one has clearly got the message that they shouldn’t expect a all three deal for the next go around and so we are seeing typically sub-$10, even sub-$7 properties are the properties that are leading the system and at the same time during this balance cycle, there has been new construction, new properties coming on board, has been cut back dramatically so that the past you would have seen even with the same amount of copies leaving the system you would have had much less net loss because of much healthier new construction pipelines so. Next year I though that it was a fact I think next year into this year housing is expected roughly somewhere to 90 to 100,000 loss we saw last year. We are cleaning up the base and that’s in 2011, beyond I would expect to get that more toward the long term trend that’s a 2 to 3%.

Frank McEvoy - Craig-Hallum

Okay. Great. And then maybe a little bit on Envision, about what the business model is on that. I mean, is this something that existing properties will upgrade to, either upgrade to Envision DV or Envision IP?

What's kind of the possible revenue that you get up front and then I think I heard you talking a little bit about revenue sharing as well? And then does it get more price options as well in terms of some of these different apps for people to get entertainment at different price points? Where does that come into play if at all?

Scott Petersen

Well its there is a thing that basically the industry is moving to high def this is going to be put high debt we are providing High Def interactive you know at the next level where you got power internet connection to the clouds so this will be used anything that has a very powerful renewal tool for us so its not just HD-TV but it’s a lot of cool apps that on the one hand these new apps like eCompendium that both helps hotels reduce printing costs for the rooms so they are more green there are lower costs there is a lot of expenses lot of potential printed materials that hotels could eliminate for a very modest subscription fee to a platform driving revenues to the room service. Putting the room service menus proactively on screen and driving those kinds of revenues so those would be areas where you would get a hotel subscription fee from a hotel for providing those.

And then transactional things I think are also interesting that have never been before. So, you get to Minneapolis, you turn on the television, you find out what tickets might be available for that night or the next night with various venues. Pizza applications, so just like on TiVo at home, you could order pizza that will deliver to your home somewhat type of concept that happen in the hotel room.

Those would either a rev-share with the transaction provider, so, whether it’s the restaurants on the ticketing agency. And then the revenue from Guest Entertainment, there are some incremental ads that are as far as new types of content that we could also be internet sourced. So, it could be the opportunity to buy a package to watch internet video, so you can go to YouTube and watch the 20 most popular titles on that night, but the guest is paying some type of access fee to use the television as the display device versus watching it or bringing a laptop along, et cetera. Those things are still under development. We’ll see whether or not there is a consumer demand for it, but all these possibilities are made possible because of the platform, and I think our opportunity and our upside then is finding the right thing that guests find value in, hotels find value in, and drives our revenues in the process.

Frank McEvoy - Craig-Hallum

So on those apps, are those apps that you develop or are you making it open so that other developers can create apps for your platform?

Scott Peterson

We will be an open app environment and you’re going to kind of control that environment. You know the iPhone, of course, Apple still makes sure that it’s a quality app before it’s released. So we would see working with third parties like which what hotels are like apps on their platform, we would work with their airline partners or their rental companies and apt into their reservation systems so that our guests can book for later next week or next month so you know it’ll definitely open we are clearly moving in the direction of the world of more open systems.

Frank McEvoy - Craig-Hallum

And that’s ready for launching it sometime, what, next year, first half?

Scott Petersen

Well the first installations will be in the first half of next year.

Operator

[Operator Instructions]. I am not showing any further questions at this time would you like to continue with any further remark.

Ann Parker

Thank you operator and thanks everyone for joining us today, again a reminder that replay of this call can be accessed over the next month via the internet through our company website www.lodgenet.com. And 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 your participation in today’s conference this concludes the program you may all disconnect everyone have a great evening.

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Source: LodgeNet Interactive Corporation Q2 2010 Earnings Call Transcript
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