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Executives

Ann Parker – Director, IR

Scott Petersen – Chairman and CEO

Frank Elsenbast – SVP and CFO

Analysts

David Kestenbaum – Morgan Joseph

Frank McEvoy – Craig-Hallum

Pallo Blum-Tucker – Aladdin Capital

Peter Reed – Mast Capital Management

Alex Khatibi [ph] – Investment Advisor

LodgeNet Interactive Corporation (OTC:LNET) Q3 2010 Earnings Call Transcript October 26, 2010 11:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the LodgeNet quarter three 2010 earnings call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. (Operator instructions) As a reminder, today’s call is being recorded.

At this time, I would now like to turn the conference over to the Director of Investor Relations for LodgeNet, Ms Ann Parker. Ms Parker, you may begin.

Ann Parker

Thank you operator. Good day everyone. I would like to thank all of you for taking the time today to listen to our third 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 do 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 third 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 Web site www.lodgenet.com. We also have two sets of slides posted on our Web site, which correspond with today's comments, one is labeled the Q3 2010 earnings, and the other is labeled as the supplement to the Q3 earnings. They can both be found under the Investors Section of the Web site.

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 third quarter, we continued our strategic focus on driving free cash flow, reducing debt, and governing our business with our very strategic initiatives. I guess we are very pleased with the results that we saw from our strategic growth initiatives. The revenue per room was up almost 13% versus one year ago, and we see accelerating growth in High Definition convergence starting now in the fourth quarter.

Our free cash flow continued to be the top financial highlight, over $15 million was generated during the quarter, which exceeded our guidance, and our trailing fourth quarter free cash flow number right now is right around the $80 million mark. During the quarter, we continued our conservative operating plan. We maintained our OpEx structure that we had in place for this year, and then again we saw substantial reduction in the average investment per

High Definition room installed during the quarter down about 23% versus one year ago, which really pushes the return then on our invested capital within the new High Definition space. Of course we continued to strengthen our balance sheet. We achieved our final covenant step down during the quarter and we ended the quarter on a net debt basis right about 3.4 times.

So with that said, I am going to turn the call over to Frank Elsenbast, our CFO, for additional comments and color on the quarter. Frank?

Frank Elsenbast

Thanks Scott. For the third quarter, the company saw significant revenue growth from our strategic initiatives including Healthcare, System Sales, and Advertising while our Guest Entertainment business declined versus last year.

Gross margins were very strong across every service line with an overall increase of 60 basis points versus last year. Our results were within our guidance range for both adjusted operating cash flow and earnings per share. Cash flow results for the quarter exceeded our guidance. The company paid down $14 million in debt during the quarter and achieved the final covenant step down by delivering a net leverage ratio of 3.40.

I will now walk you through the slides that were issued with our earnings release last Wednesday. Starting with slide number 3, revenue for the quarter of $114 million was a 6% decline versus last year. During the third quarter, revenue from our diversification initiatives increased 9% over last year, and now comprised 43% of total revenue, up from 37% last year.

Guest Entertainment revenues were up 15% for the quarter, due to the 5% reduction in the average number of Guest Entertainment rooms with the remainder driven by the decline in revenue per room. We continued to see the impact of poor Hollywood content, and conservative borrowing behavior from our customers even as occupancy rates have improved somewhat. The year-on-year decline from the Top 10 Theatrical Releases was $3.3 million, which accounted for nearly 30% of our Guest Entertainment revenue decline.

On slide number 4, you will see the break down of our Hospitality revenues. Hospitality revenue per room was $21.55, down 2% versus last year. Strong growth in Hotel Services, System Sales, and Advertising offset 70% of the decline in Guest Entertainment. Revenue per room from our growth initiatives grew nearly 13% versus prior year.

Hotel Services revenue per room increased 9.3% driven by growth in our television programming revenue as we increased the number of rooms receiving High Definition programing and expanded the average channel line up. Revenue per room from System Sales was up 21% as we continued to grow our sales related to systems installation and design work for our hotels and other key partners. And Advertising revenue per room for the quarter was up 40% versus prior year driven by increases in channel leasing revenue at certain networks of purchasing distribution on our platform.

We continued to see very strong performance from our High Definition systems. On slide number 5, we provide a comparison of our revenue performance from High Definition systems versus our analog base. For the trailing four quarters, our revenue per room was 60% higher in High Definition rooms versus our analog rooms. This comparison reflects 51% higher Guest Entertainment revenue as buy rates are significantly higher when compared to our analog rooms. In addition, TV programming was 82% higher as hotels purchased larger channel packages for their guests after they have upgraded their properties to High Definition.

For the quarter, we added 7500 High Definition rooms to bring our HD installed base to 254,000 rooms or 15% of our Guest Entertainment room base. We are beginning to see the pipeline of upgrades build as we look to the fourth quarter in 2011. We expect to add approximately 15,000 High Definition rooms in the fourth quarter, and for the full year 2011, we expect to upgrade or install 100,000 to 125,000 rooms. This level of additions would increase our high def penetration to approximately 23% by the end of next year.

Gross margins improved by 60 basis points versus last year driven by strong margin performance across every service line during the quarter. Year-on-year comparisons are provided on slide number 6. Significant improvements were seen in Advertising Services, as they continued to benefit from strong revenue growth and a decline in their fixed cost structure. In addition, Guest Entertainment increased margins due to lower commissions paid to hotels, and lower royalty expenses paid to studios. It is also important to note that the company achieved this margin expansion while further diversifying the business stay on Guest Entertainment.

On slide number 7 is a snapshot of our operating expense trend. We continued to manage our cost structure very closely and expect our expenses to remain flat through the end of the year. Adjusted operating cash flow for the quarter was $27.9 million, which was within the Q3 guidance of $27 million to $30 million. On slide number 8, you will see that our $27.9 million of AOCF for the quarter is equal to our Q2 performance and consistent with the performance over the last five quarters. In spite of the recent decline in topline revenue, our management team remains focused on preserving gross margins, controlling operating expenses, and delivering steady profit and cash flow results.

The bottom line profitability of the company continues to improve as we realized further reductions in our interest expense and depreciation and amortization. On slide number 9, you will see our operating income for the quarter at $6.8 million increase 29% over last year driven by a $4 million reduction in D&A. Our loss per common share also improved significantly versus last year with a loss of $0.12 per share on a fully diluted basis, this has improved 60% versus fiscal 2009 and improved 33% versus prior quarter.

On slide number 10 we break down our cash flow for the quarter. The company continues to generate significant cash flow from operations. At $20 million for the quarter, it was a slight reduction from the $20.6 million generated last year, with the lower AOCF results being partially offset by lower interest expense. Capital investment for the quarter was $4.7 million, with $2.9 million of investments on product development, corporate assets and $1.8 million for High Definition installations, and other upgrades to our properties.

Free cash flow for the quarter of $15.3 million was above our guidance range of $10 million to $13 million, due to lower capital investment levels and favorable changes in working capital. Slide number 11 shows a significant improvement that we have seen in our free cash flow over the last two years. Free cash flow on a trailing 12-month basis has increased to $80 million in the current quarter versus $25 million in the fourth quarter of 2008 as we have reduced capital investment and operating expenses during the economic slowdown.

On slide 12 and 13 we have laid out the specifics on our debt reduction and covenant compliance. In the third quarter, we used the majority of our free cash flow to pay down debt. Debt reduction for the quarter was $14 million, which put our net debt at $382 million. The third quarter marked the final covenant step down for our consolidated leverage ratio to 3.5 times EBITDA. We achieved a leverage ratio of 3.47 on our outstanding debt and remain compliant with all covenants within our credit agreement. On a net debt basis, our leverage ratio for the quarter was 3.40. Going forward, we will continue to carefully manage the business as we focus on ensuring covenant compliance and increasing our investment in essential High Definition upgrades.

I will conclude with a review of our fourth quarter financial guidance, which you will find on slide number 14. We are expecting revenue to be in the range of $108 million to $112 million. This guidance reflects a 5% to 10% decline in Guest Entertainment revenue per room for the fourth quarter. This range is consistent with our experience in the first three quarters of the year. We are also expecting our diversification efforts to continue their strong growth trends. Healthcare, Advertising Services, and System Sales will deliver strong double-digit growth over prior year. Adjusted operating cash flow is expected to be in the range of $24 million to $27 million. These AOCF projections reflect a cost structure consistent with spending levels in the third quarter.

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

Scott Petersen

Before turning to your questions, I would like to make a few comments regarding our outlook for the remainder of 2010 and also into 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 of the (inaudible) you will see the highlights of the outlook. First of all, of course one of the primary drivers if not the driver will be the conversion of our interactive base to High Definition television systems. Frank indicated the High Definition base is performing very well and generating about 60% higher revenues than our analog base, and the installation activity is starting to increase, which I think bodes very well for us for the balance this year of course and then into 2011.

With regard to Guest Entertainment performance, we are certainly applying significant focus within the space on ways to improve our revenue beyond of course the longer-term strategy of upgrading to High Definition platform. During the quarter, we announced the reorganization with Derek White, who has been the president of our hotel networks over the past several years, I have asked Derek to take responsibility for all guest room entertainment as the new president of Interactive and Media Networks. So all of the variable revenues from the Guests and from sponsorships are within the room come within the purview at this point of time. Derek is a very talented executive based on the New York area and we have numerous tasks and initiatives underway, and this will be a very busy area for us over the next several years. For example, we are starting to roll out now the fourth quarter of a credit card purchase option in to about third of our base, which will be implemented over the next six months and our testing has showed positive revenue impacts from the guests where they have more opportunities, and more ways of purchasing entertainment within the room, and of course purchasing on a credit card is a contrast to the traditional method of only being able to charge to the room.

In the fourth quarter, we would also see implementing a new merchandising format where the guests will be presented with our interactive main menu at the turnout of the television rather than the more linear welcome channel, which has historically been our approach and our testing area has also shown positive revenue impacts with more awareness of the guests of the services that we have to offer by going interactive right at turn on.

I would also tell you we are testing various things for example, during this fourth quarter now, we have a test in the markets where we are testing peer [ph] pricing where the just released titles are those of the titles that we have before the release to DVD, and long before the release to cable and satellite. So we are pricing those at a premium with really relationship to the ticket price at the box office, and then the library titles are the titles that get more into the older window where the titles would be on cable pay per view, we are pricing those more in relation to that value proposition and then we will certainly know more about that merchandizing approach in the first quarter as the data comes in. But those are some of the things that we are looking at to look at driving revenue performance across the board, and then for 2012, part of our strategic business plan will be doing an overall marketing I would call it a re-launch with a total refresh in our pricing promotion and messaging to the consumer looking to maximize the revenue that we can generate from our existing base.

And then of course we see additional solid growth prospects from our other strategic initiatives in the coming quarters that Frank has certainly highlighted, our outlook for the fourth quarter and we see that continuing into 2011. And lastly we believe our next generation platform Envison represents a solid opportunity for us to increase revenues from our interactive television platform both from new subscription revenues that we see hotels are signing up for based on halves on our system saving them operating cost or driving new on property revenues, and also from transactional revenues that we will participate in as guests that use various apps to access the Internet for services that make their stays more convenient and pleasant.

Lastly, just to bring to your notice and kind of based on the Envison concept, we have our (inaudible) old technology at the technology show we had that in Boston here a couple of weeks ago where we invited our top hotel customers and the industry thought leaders and we unveiled some more commission about Envision in our High Definition systems there. This data you will find on our Web site on supplement information as has been indicated early on. Those are some of the slides that we presented at the technology show that I thought you might be interested in.

On the one hand, we did release some recent findings from studies from Nielsen and from Rentrak. Nielsen, basically one of the key findings from a recent survey there was that the best screen available within the consumers’ purview given where they are at wins. So within the high def screen being the best available device, if that presents itself, it clearly wins versus the mobile device that might be the best screen available on the plane or when it is in transit. I think the Nielsen service is also interested to show that consumers right now consume media about 140 hours per month on the television while they consume media only about three hours in either their PC or their mobile device. So by far the TV has a huge lead as far as consumer behavior in accessing media. So we think that bodes well for us especially as we move to high def. And then Rentrak, one of their key findings recently was that VoD is becoming more important than ever and as you think about LodgeNet, we are not a DVD company, we are a company that provides a vast array of content of video on demand for the guests and we would see that continuing in the future. So both of those we presented to our hotel customers just supporting the overall value proposition that we do bring to the market.

And then also, we presented a variety of different aspects which emphasize the value of our new High Definition platform as a powerful guest touch point for the hotels themselves, particularly when you consider what the High Definition display can do versus the older analog sets. We showed a variety of credit users of our system that Starwood has implemented in their various brands, and they are bringing their brand message and their brand image right to the main menu and then the screens within our interactive platform. We also showed powerful presentation, how presentations now is possible for room service ordering through the High Definition display that presents in room or driving revenues for the guests or hotels I should say by having more advantageous presentation of interim food service ordering.

And then we also showed some of our new additional apps, one there is a flight info app, so if you are in the Chicago area you can see real time how all the flights are tracking out of O’Hare. For example, we are also making restaurant reservation at a local restaurant using our system. So the flight info would be a subscription base type apps that hotels sign up for and of course the reservation apps would be more transactionally based for us.

And then lastly one of the really kind of the highlights of the conference was we demonstrated the ability to take a guest’s mobile device and we demonstrated this both on an android phone and also on a ipad, I was carrying both of those devices into the remote control for interactive television system. So downloading the app very quickly and easily and basically turns into remote control, so volume up, volume down, all the interactive menuing is totally accessible on that app. You can purchase a movie, in the future might even have the ability to download a movie to go, etc, but it did create quite a buzz, and I think the overall demonstration did show that it is a very interesting business opportunity for us in the future as we kind of work thorough that and the business models and how that might play for us in the future.

So it was overall a successful conference we believe and wanted to show you and talk to you about some of those concepts just so you have those also in the back of your mind as you think of LodgeNet in the future.

So with that, operator would you explain the process for asking questions.

Question-and-Answer Session

Operator

Excellent sir. (Operator instructions) Our first question comes from David Kestenbaum with Morgan Joseph.

David Kestenbaum – Morgan Joseph

Okay, thanks a lot. Can you guys talk about your recent bond offering, what happened and what your plans are going forward?

Frank Elsenbast

Sure. Hi David, this is Frank Elsenbast. I think you understand the process that we went through. We did go out and explore the potential of refinancing our existing bank debt with a high-yield offering, and as we got into the marketplace, we found that the combination of both the price of that offering and some of the terms and covenants that went along with the high-yield offering were going to be too restrictive or too expensive for us. So we decided at this point in time to simply back away from that offering.

We do have a very favorable credit facility right now with a very low interest rate at LIBOR plus 200. We do not need the immediate covenant relief that – maybe that was an issue that some people felt we needed the covenant relief, we did not so we backed away from the offering. We explored it because we thought it might be a good time for us to get some covenant relief as we head into this window where we will be spending a lot of money to upgrade our properties to high definition and it would give us more flexibility if we had possibly a little higher covenant on the leverage ratio.

And so that was really the genesis for us exploring it but as we got into it, we just found the terms and the pricing were not going to be what we initially thought they were going to be, so we simply backed away.

David Kestenbaum – Morgan Joseph

Okay, and can you talk about what you plan to do when you swap rolls off in June?

Frank Elsenbast

We currently have a swap for $437 million at about 5% and we will be examining what the right thing to do is as we near the end of that swap agreement. So we do have until June of next year, and depending on what the market is doing we may decide to go without a swap or we may decide to put a swap in place and lock in these low interest rates.

David Kestenbaum – Morgan Joseph

Okay. And then finally can you talk about the Guest Entertainment room base, which declined, it seems like it has accelerated and it declined over 5% this quarter. Can you just talk about what is happening there and do you see it stabilizing in the next few quarters?

Scott Petersen

Hi David, this is Scott. Basically we have been, I guess you might say, improving the overall base over the last couple of years especially after the acquisition of On Command, I think there are a lot of properties on both companies’ ledgers that historically we had to make proposals under the old traditional programs where we put up all the capital and it was very – there was no investment that were kind of (inaudible) from the hotels’ perspective and with the combination of the two companies and our message to the market, the hotel market kind of rationalizing the business model going forward, it is really the low end of the base where the full contract, the original contracts have expired. In fact most of these properties would even be after some sense of an automatic renewal on the original contract.

They are quite confident that we would certainly not give them any flavor to the contrary where we would not be coming back to them to make a major investment in their properties to take them to high def. So they are basically electing at this point in time just to go to basic model and remove the interactive television platform. The average revenue generated from this space is well below our average revenue of our entire base, so in certain respects that is where that is at. During the quarter, I would say there was probably some sense of the operation, I do not think there is anything unusual that happened there rather than just kind of continuation of that kind of activity.

I would tell you that we are working to 20/11 right now. We will have greater focus on retention from a standpoint of selling even though it might not make sense for those customers to be interactive television customers of ours but told to really perhaps be more focused to lock them down for broadband services that we could provide whereas our capital is not involved but it is a service they are looking for, same thing as retaining them also as a basic television customer going forward.

So, looking at kind if improved marketing there to elevate our retention but from a pure Guest Entertainment room base, you should that is still to decrease somewhat over time. I think the 100,000 kind of per year rate will start to decrease as we go through next year. I think we have seen that by far the most kind of churn out during the last couple of years during the great recession. So, overall that is kind of what is happening in the background. It is not where we are losing the room counts to competitors. There are about on a single hand one could identify those and really the competitors at this point in time would be very high priced or high end cost IPTV systems that a select few properties are experimenting with this at this point in time, but we really do not see that as any kind of volume-type competition.

David Kestenbaum – Morgan Joseph

At the base how many do you think are these low-end hotels?

Scott Petersen

It is well over 80% and within that base also would be where like the (inaudible) credit issues, etc, where our operating costs are not being covered by the revenues.

David Kestenbaum – Morgan Joseph

Okay thanks.

Operator

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

Frank McEvoy – Craig-Hallum

Hi, good morning everyone.

Scott Petersen

Hi.

Frank Elsenbast

Hello Frank.

Frank McEvoy – Craig-Hallum

So I just have a quick follow up, maybe I misunderstood what you were just answered on that. On the base that you have of rooms, what percentage of them are in conservative end now that might be accounted for just let and go over the course of next year that would be roughly 1.8 million in Guest Entertainment rooms.

Scott Petersen

Yes Frank, when we are in the road recently, kind of our base, about 40% of the base that we have installed today is on the upward trajectory of the marketplace, about 40% in the mid market, I think it is roughly about 15% independent which tends to be covered more towards the upper end, and then about 4% within the economy segment, I think 4% or 5%. Most of the churn is coming out of that 4% to 5% of the economy segment. There will be selective properties within the mid market that perhaps will not be performing also. But as long as the property is free cash flowing, to a great extent, we want to maintain them as a customer. We may be – any incremental cash flow we can generate, we certainly want to. So we are not shaking them away but at some point in time they do decide that it makes sense for them just to go to the basic cable.

Frank McEvoy – Craig-Hallum

Okay. On Guest Entertainment we calculated by rate, it looks like it was down about 17% year-over-year in the third quarter, and that has trended worse over the last three quarters. Can you give any color on what the buy rate was during the months of the third quarter? Was it pretty consistent or are they improved, or any color on that?

Frank Elsenbast

Frank, I would say that the results through the quarter were pretty consistent. There was not a big spike up or down.

Frank McEvoy – Craig-Hallum

Okay, and in your text over the earnings release, you mentioned that the movie content was a bit of an issue in Q3 in spite of the movies, any idea what the revenues might have been, Guest Entertainment revenues if there has been a more normal movie line up?

Frank Elsenbast

Well, the total decline from the Top 10 was $3.3 million. So certainly we would not have expected to have gotten all of that back but if they would have been more in line, I think we would have been looking at getting approximately half of that back, so maybe another $1.5 million.

Frank McEvoy – Craig-Hallum

Okay. And then the free cash flow, you did a very nice job on the free cash flow, mostly upside from what we are expecting was an increase in accounts payable sequentially, an increase of almost $4 million, and looking back over the course of the year, since the beginning of the year, accounts payable has gone up by almost $20 million. So my question is that a sustainable level or is there some point assuming where you need to bring that down to pay your content providers? What do you think is sort of a reasonable level of accounts payable on a going forward basis?

Frank Elsenbast

Right and just to be clear Frank, we always pay our content providers. So what you are seeing is there is a slight increase in the days payable outstanding, and we are negotiating with our content providers on payment terms. We have longstanding relationships with all the studios and direct TV who are the majority of the folks that we are dealing with here. So you have seen an increase in the DPOs and when some of that swing back, it will swing back somewhat in future quarters, I would not say all of it will swing back and then of course there are other levers within our working capital that we will also go to. We have consistently improved our accounts receivable and the speed of our collection on our accounts receivable and managing down our investment and inventory.

So, we will continue to manage our total working capital very closely as this is a big component for our business, and we do not want to have too much cash tied up in working capital.

Frank McEvoy – Craig-Hallum

Okay. Kind of changing gears a little bit, could you talk a little bit about some of these initiatives, the tiered pricing for example and the alternate payment systems if there is any early readout on what the benefits might be in terms of buy rates that sort of thing?

Scott Petersen

When it came to the credit card as an alternate purchase option, we have been testing that on these smaller group of properties, 50 properties since late spring. So we chose kind of middle single digit improvements on revenue. Certainly guests who are traveling on business when it comes to a lot of times movie purchases are not reimbursable, so I think the folks that are finding to be attractive to them to put on a credit card versus kind of show up on the room bill that goes back through the expense account basis.

Some of the things there is kind of a single-digit improvements perhaps with the interactive menu would turn on within that same kind of range. So you kind of take a lot of these different factors together. I do not think there is any (inaudible) that doubles by rate or takes – so when you get the opportunity, you put all these things together in restructuring the marketing and the messaging to the consumer, some of the pricing like these tiered pricing. We have had it up and we clearly have an advantage window versus the rest of the universe. I rather felt that we have done a good enough job to communicate that to the consumer in the room that movies before you can see them on cable pay per view or you could buy the DVD at Wal-Mart or Best Buy or whatever the case might be.

I was just reinforcing those messages and then of course as that content ages our revenues tend to drop off quite a bit. We are thinking that perhaps if we price it more on what you would pay on your local cable system for video on demand and one is on the same window that it would be able to drive revenues for us. So that is a little hypothesis at this point in time. The great thing about our system is we can create all types of scientific price tests and studies, and look at the data and then make educated decisions on which are the right initiatives to move forward with.

So with Derek onboard and we are tuning up the team, have a lot of good people onboard now and we will be looking at some other talent onboard. I think I would look for a relative improvement actually over what we have seen this year, and then of course an improving economy on top of that I think would also only help drive revenues on top of that.

Frank McEvoy – Craig-Hallum

Okay and then just jumping back to the HD again, thanks for putting out the numbers on what you expect to see the number of installs and conversions this quarter and for 2011, any idea what that – can you give us any color on the capital expenditures for that and what it might mean for CapEx for Q4 and for 2011?

Frank Elsenbast

Sure thing. I think most of those rooms are going to be upgrades. So if you apply the number of rooms times a number somewhere in the 150 to 200 range and we generally use 175 midpoint that is going to be the CapEx that you are talking about.

Frank McEvoy – Craig-Hallum

Okay great. And then for your Guest Entertainment, they see we had much higher buyer rates assuming the prices are similar so over the last four quarters, I would assume I guess roughly a 50% higher buy rate for HD, video on demand systems which is nice. Do you have any information on that for just the third quarter? Did it get even better or you may have any color on that and also same room that was HD a year ago is HD this year, can you give us any color on what the buy rate was for video on demand systems?

Frank Elsenbast

Frank, in answer to your first question, the data for the third quarter, the revenue the high def room on Guest Entertainment HD was very similar, it was actually 52% higher in high def when compared to the analog base. I am sorry, could you repeat the second question?

Frank McEvoy – Craig-Hallum

If you look at that sell around the same room basis, kind of analogous to same store sales basis on a year-over-year basis, if you have an HD room that was in place in the third quarter of last year, what was the buy rate third quarter of this year for the same room on average? Did it go down a bit, or was it up a little or, can you understand the question there?

Frank Elsenbast

I think so, I think so, when you look at it year on year, the trend is it was below last year. So the comparative data point is for the 12 months it was down about 1% compared to the base being down about 10% and for the third quarter we tend to see the decline, I think someone asked this question on the second quarter as well and that decline is about half as much in the third quarter as it was compared to the analog base.

Frank McEvoy – Craig-Hallum

Okay. I am going out to jump out and get into queue and let someone else ask a question. Thank you.

Frank Elsenbast

Okay Frank.

Operator

Our next question comes from Pallo Blum-Tucker with Aladdin Capital.

Pallo Blum-Tucker – Aladdin Capital

Good morning.

Scott Petersen

Good morning.

Pallo Blum-Tucker – Aladdin Capital

I think my question was already asked about the bond offering but if I could have a feedback on that, are you exploring other options, for instance the secondary equity rates or are you still looking to tap the high yield market at some point?

Frank Elsenbast

This is Frank. I would say it is highly safe to assume that we are going to be looking at all the options that are out there and we certainly want the credit markets are as strong as they are right now, we will continue to look at alternatives out there and it could be anything from bank amendments and a high-yield offering if the conditions and the terms are correct. We will balance the price of the capital versus the covenants that we have to live with under that agreement and also we want to address our 2014 maturity at some point. So those three variables we will be balancing against each other and determining what is the right balance sheet structure for us.

Pallo Blum-Tucker – Aladdin Capital

Okay. Is the 100,000 to 125,000 HD rooms next year, is that assuming any sort of capital market activity or is that just reallocating cash from typically what you would use the debt repayment to CapEx?

Frank Elsenbast

Right. That does not assume any capital markets activity. That is simply using the cash that we generate from our operations. If you could do the math on that, on the 100,000 to 125,000 rooms you are talking about capital just on high def upgrades a little over $20 million and that is still well below the cash we generated from our operations, is still well below what we have spent on capital investments in the past, and we really see next year as the ramping year as the pipeline for high def upgrades tilts, and we would hope that the $22 million would be the minimum we spend on it next year, and it will grow into 2012.

Pallo Blum-Tucker – Aladdin Capital

What is the longer term target assuming you maintain the current bank facility in that leverage?

Frank Elsenbast

We would like to get – assuming we could maintain the current credit facility, there is a little bonus for us if we get below 3.25 leverage ratio, we drop another 25 basis points on our interest rate, so we would certainly plan to get below that, but we would not rush to get it below 3. We really see the options as paying down very, very low cost debt or potentially investing that in high returning capital projects that would have properties to upgrade them up to high def.

Pallo Blum-Tucker – Aladdin Capital

Okay and then kind of switching gears more like an overall kind of strategic question, the HD rooms that you upgraded or built already, they obviously generate a lot more revenue than the analog room. At a certain point have you upgraded or built other rooms in maybe the higher end for hotels that are more like they do utilize the HD services and will the difference between the HD rooms and the analog rooms start to decrease as you go into hotel rooms that do not necessarily need HD upgrade?

Scott Petersen

Yes, this is Scott Petersen. I would say there is a somewhat of a skew of our existing base of high def rooms towards the upper end of the market. It is still quite broad cross-section but somewhat early movers were at the kind of be at the upper end of the market. Basically, every hotel will be converting to high def over some period of time. Just like within the home market right now, it is like 65% of US households have high def displays, it is going at like 90% is projection by next year. The hotel industry will that is when will kind of display that it is available for purchase and as the upgrade televisions go, that is where they will go, and guests clearly expect that.

Now if we invest capital, we look at each property individually, look at the revenues we are generating, so the great news from our standpoint today is all the activity is really on properties we already have a relationship with. We have a track record, we know they are generating. So as we make our investment decision in the terms that we would offer the hotel on the upgrade that is based on real data and of course and we have always typically paid higher commissions to properties that generate higher revenues. So you have this kind of pay per performance curve. So our business model today is making certain that hotels provide capital support by either buying the right television or covering the interim equipments, covering the costs of the MATV, any upgrades that are required of wiring them on the wall so to speak to make the systems work, our new business is really focusing our capital at the hardware and interactive software at the head end that makes the interactive systems work.

So we have lower revenue producing property. We would – basically our financial proposal to them would take that into account and we are looking for the same type of return on invested capital even though the average revenue might not be as high as our existing base, return on invested capital will be at or above where we are targeting today. It is just part of how we do business and we fully expect that – the proposal we have on the marketplace today are being accepted on those kinds of terms, so our key factor here is return on invested capital not just raw revenue per dollars generated. So overall I think it is a very solid business model going forward and we are going to generate a lot of good returns for our shareholders.

Pallo Blum-Tucker – Aladdin Capital

Okay. So the 18 to 24 months is the return that you are kind of expecting over the long term.

Scott Petersen

Yes. We use an example, if the room was only generating $10 of revenue, we would trap the financial proposal of that property of either they are going to buy down the capital upfront for us so that the revenue that would come out of that property would still keep us in that 18 to 24 month timeframe, and that is generally what would happen, it would be a capital buy down to make the financial equation work for us.

Pallo Blum-Tucker – Aladdin Capital

Okay, thanks a lot.

Scott Petersen

Okay.

Operator

Our next question comes from Peter Reed with Mast Capital Management.

Peter Reed – Mast Capital Management

Good morning and nice quarter.

Scott Petersen

Hi.

Frank Elsenbast

Thanks Peter.

Peter Reed – Mast Capital Management

Could you talk a little bit about in 2011, how you should sort of manage your leverage ratio while seeking to spend an increase in the amount of HD rooms that you are upgrading, and how you are sort of triangulate that with your leverage covenant compliant?

Frank Elsenbast

Sure Peter, this is Frank. Well, it will not be much different than how we run the business today, but the good news is we will not need to work towards another step down in the leverage ratio. So we will continue to run the business very cautiously to make sure that we remain compliant with the covenant and the business does operate pretty steady as it goes through the quarter, so we will have a good idea on where the EBITDA is trending for the quarter and that will inform our decisions on how we need to pace our capital investments through the quarter as well. You really see us taking that free cash flow that historically has been devoted almost exclusively to paying down debt to shifting to more of a balance between paying down debt and also investing in a High Definition rollout.

Peter Reed – Mast Capital Management

Is it implicit in that analysis or strategy that you are talking about do you have confidence that if you were to see higher declines in Guest Entertainment revenue then you would expect that you would have additional layers in operating cost that you can take out to sort of navigate that compliant?

Frank Elsenbast

Yes, I would say that we still as a company have leverage that we can pull whether it is within operating expenses or within our capital expenditures or within working capital that will allow us to remain compliant even as we see a further decline if there were to be a further decline in Guest Entertainment.

Peter Reed – Mast Capital Management

Last one just to go back to working capital, would it be fair to say that you do not expect it to be material use of cash in the fourth quarter?

Frank Elsenbast

I think that is fair.

Peter Reed – Mast Capital Management

Okay. Thank you very much.

Operator

Our next question comes from Alex Khatibi [ph] with Investment Advisor.

Alex Khatibi – Investment Advisor

Hi, good morning. I have a question in terms of your capital allocation for next year. I mean it looks like even when you raise CapEx guidance you are still going be going on with a pretty good amount of free cash flow, and given that your covenant situation seems to be fixed, I was wondering if your board is concerned perhaps with big purchases or do you see any other capital allocation perhaps that you might take?

Frank Elsenbast

We will see how 2011 plays out. We are happy that we have reached the last step down and our first step frankly is to focus on increasing our investment in the high def rollout. And if when we look at that, how that is going to pace through the year, we will then evaluate if there is just excess cash that we need to find another purpose for, we will look at other opportunities which of course could include a share repurchase. But right now, we are just very focused on remaining compliant with the covenants and accelerating high def investments.

Alex Khatibi – Investment Advisor

And are you having ongoing conversations with your bank group or are they just happy with the progress that you guys continue making on the leveraging situation, continuing to get paid down?

Frank Elsenbast

I think the existing bank group is very happy with the current situation and we are also in frequent conversations with the agent bank and staying in touch with the bank group and where the credit markets are?

Alex Khatibi – Investment Advisor

And more of a big picture question, I know in many of your presentations, you compare yourself to almost like a small cable operator, I was just wondering what prevents some of the cable companies entering a line of business and do you see any (inaudible) on that potentially?

Scott Petersen

Alex, this is Scott Petersen. This company has existed since 1980, of course that was the dawn of cable, so we have actually established our business during the process of cable being our potential competitor all the way through. When it comes to the interactive side, there is a variety of factors that has created a success opportunity for us that cable has never really addressed from anything from the window we have as far as content has always been advantaged to cable by three to six months. Probably we are a specialized product, we are service offering to hotels. The residential system does not actually fall into hotels. The subscriber is there on a monthly basis recurring a billing without one relationship. We have a lively relationship with each one of the guys that faces into the hotel management system for billing, etc. Not blocked the sites but there are a lot of detail like that. Also we cost to engineer our systems that make them – we were installing a full system right now well below the cost of what cable just what a box might cost for a cable in your home. So the cost aspect too we have put together something that is totally designed to deliver on an economic basis with the hotel industry.

And then lastly probably the most important is the way the services are contracted and blocked by hotels, whether you are a regional hotel operator or a national brand, they do not want to go from cable company to cable company to make a deal for properties within this cable jurisdiction and then the next one. Of course the brands would like to have, for example Starwood wants to have every (inaudible) to have the same working trio from Boston to San Diego. Of course even broader concepts would be globally, we are more likely to have the same working trio in Berlin as in Boston. So no cable company, no telecom company can provide that type of national coverage and even global coverage eventually this is the way we are going to think about life with maybe alliances around the globe with some of our other operators that within Europe or in the Far East.

So you put that all together has created an interesting success opportunity for us for various entry if you want to think about the other way. Cable does tends to have, if they are just talking about basic TV services, they have been successful in the past, about half of our rooms have taken the basic cable from the local cable operator versus us to have relationship with direct TV. We have actually in that world of high depth now, our penetration there. Our success rates tend to be 70% to 80% of our high def properties taken from us. That is why you are seeing nice revenue improvements and cash flow improvements on the Hotel Services line. Every quarter we are reporting higher and higher revenue there at increasing margins so I think when it comes to it we are all tied up, we also basically have a better product and price advantage than cable has traditionally in the analog world.

So overall it is a very interesting kind of niche market that has given us a great opportunity and I think it will continue to thrive and grow.

Alex Khatibi – Investment Advisor

Thanks and just one more question. I know you touched on room churn a little bit and product question, but just for kind of modelling purposes, should we expect next year to be trending back to about 3% rate in terms of rooms that you guys are going to give up?

Scott Petersen

I think you are going to see we have been in the 5% type range. I think that will be trending towards 3, I do not know if we are going to get all the way to 3 next year but I would suggest in the next couple of years we should be kind of surfing that number again.

Alex Khatibi – Investment Advisor

Alright. Thank you.

Scott Petersen

Thanks.

Operator

I am showing no further questions on the phone.

Ann Parker

Thanks 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 Web site www.lodgenet.com and the slides used during this webcast will also be archived on our Web site 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 day.

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