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Executives

Ann Harper – Director, IR

Scott Peterson – Chairman, President and CEO

Frank Elsenbast – SVP and CFO

Analysts

David Kestenbaum – Morgan Joseph

Frank McEvoy – Craig-Hallum Capital

Mike Demaray – Elevated Capital

Peter Reed – Mast Capital Management

Michael Platt – Blue Mountain Capital

LodgeNet Interactive Corporation (OTC:LNET) Q4 2010 Earnings Call February 25, 2011 10:30 AM ET

Operator

Good day ladies and gentlemen and welcome to the LodgeNet fourth quarter 2010 earnings conference call. At this time, all participants are in a listen only mode. Later we will conduct a question and answer session and instructions will follow at that time. (Operator Instructions). As a reminder, this conference call is being recorded. I would now like to turn the call over to your host, Ann Harper, Director of Investor Relations for LodgeNet. Please go ahead.

Ann Harper

Thank you operator. Good day everyone. I’d like to thank all of you for taking the time today to listen to our fourth quarter 2010 conference call. You should have received copies of our earnings release. If not, please call me at 605-988-1000 and we’ll make sure you get a copy.

Our speakers for today’s call will be Scott Peterson, Chairman and CEO of LodgeNet Interactive and Frank Elsenbast, our Senior Vice President and CFO. Scott and Frank will review our fourth quarter 2010 earnings and will then welcome your questions and your comments.

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

Before we get started, I’d like to remind you that some topics to be discussed today that do not relate to historical performance may include or constitute forward-looking statements within the meaning of the Federal Securities laws and 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 (inaudible) by 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 Peterson.

Scott Peterson

Thank you Ann and good morning everyone. During 2010 we continued to deliver on our strategic plan, which is focused on driving free cash flow, strengthen our balance sheet and growing our business through strategic initiatives.

Free cash flow continued to be a top financial highlight. It was up 23%, $80 million in 2010 versus the prior year and on a fully diluted share basis, that free cash flow represents about $2.00 per share which represents substantial value for our common shareholders given our current share price.

We also continued to strengthen our balance sheet. We reduced our debt levels by 20%, just shy of $100 million during the year. As a result, we improved our leverage ratio ending at 3.5 times on a net debt basis.

Third, our strategic missions are driving growth and producing results. During 2010, our diversified revenue initiatives generated nearly 8% greater revenue per room with higher margins on that revenue versus the prior year.

We had particularly strong revenue cash flow growth from advertising and healthcare. Advertising revenues were up more than 40% benefiting from a recovering ad market and transition to interactive media and overall, diversified revenues are now approaching $200 million per year and represented 43% of our total revenue last year. That’s more than double the revenue contribution percentage versus 2006 when we kicked off this initiative.

High definition rooms continue to generate 6% greater revenues compared to our analog systems. Our interactive platform is now in 270,000 of our rooms. That’s only 16% of our interactive room base so this continues to represent a significant growth opportunity for us.

And we’re pleased to announce today we successfully launched our first Invision site. That’s our next generation interactive platform in January. We’re very pleased with the results so far and I’ll tell you more about that in a few minutes.

And lastly, we re-launched our broadband business with a new strategic alliance with DOCOMO interTouch, which we announced in early January. We also believe this represents an excellent growth opportunity for our company as less than 10% of our media rooms presently take broadband services from us.

So at this time, I’m going to turn the call over to Frank Elsenbast, our CFO, for further comment and color regarding the results.

Frank Elsenbast

Thanks Scott. I will take a few minutes to provide a financial review of our fourth quarter and full year results. I’ll be referring to the slides that were issued this morning with our earnings release and are available at our investor relations website.

As an overview of the quarter, the company saw significant revenue growth from our revenue diversification initiatives including health care, system sales and advertising, while our guest entertainment revenue declined versus last year.

Gross margin remained strong at 43.8%, which is flat to Q4 of last year. Our results meet our guidance for both adjusted operating cash flow and earnings per share, and we’re slightly below the low end of our revenue guidance.

The company paid down nearly $17 million in debt during the quarter and achieved a net leverage ratio of 3.35 times, which is significantly below our leverage covenant of 3.50.

Starting with slide number three, full year revenue for 2010 was $452 million, which was a 6.7% decline versus prior year. Guest entertainment revenue for the full year declined by 12.6%. This decline was partially offset by the strong growth in our diversification efforts led by advertising, which achieved 43% sales growth in 2010.

In the fourth quarter, total revenue of $107.3 million was a decline of 5.3% versus prior year. We continued to see the impact of poor Hollywood content and conservative buying behavior from our customers.

Within guest entertainment, revenue from the top five theatrical releases in the fourth quarter was down 39% versus last year and accounted for over $4 million of the fourth quarter decline in guest entertainment.

On slides number four and five you will see performance by product line on a revenue per room basis for the full year and Q4. The Q4 revenue per room performance of $20.64 is even with 2009 revenue per room.

The significant growth of our diversification initiatives over the past year offset the entire decline in our guest entertainment business and helped us achieve performance which is even versus last year for the first time since Q2 of 2008 when we were first entering the economic decline.

In the fourth quarter, hotel services, system sales and related and advertising services increased their per room revenue versus last year by over 13%. A few comments about the performance by service line.

Hotel services revenue per room increased 8.9% driven by growth in our television programming revenue as we increased the number of rooms receiving high definition programming and pricing increases versus prior year.

Revenue per room from system sales was up 18% as we increased revenues from the design and installation of media systems for our hotel partners.

Advertising continued its strong performance with revenue per room up 64% as carriage revenue and advertising showed strong growth in the quarter. For the full year, advertising revenue was up 52% on a per room basis while also significantly increasing gross margins from 12% to 46%.

Our high definition systems continued their superior performance. On slide number six we provide an update on our high definition platform versus our analog base. For the trailing four quarters, revenue per room was over 60% higher in high definition rooms versus our analog rooms.

Guest entertainment continues to perform over 50% better with higher buy rates and revenue from TV programming was 80% higher as more hotels purchase this service from LodgeNet when they upgrade their properties to high definition and purchase larger channel packages for their hotel guests.

For the quarter, we added over 16,000 high definition rooms, which exceeds the guidance of 15,000 that was provided on last quarter’s earnings call. Our install base of high definition systems now stands at 270,000 rooms, or 16% of our guest entertainment room base.

We see the continued roll out of our high definition platform as an ongoing revenue and cash flow opportunity. We are in conversations with many of our major hotel brands and expect to see upgrade activity accelerate through the course of 2011.

Gross margins for 2010 improved 30 basis points versus last year through broad based improvements across most of our businesses. Most significantly, we continued to improve margins in guest entertainment due to lower commissions and cost savings measures that reduce ongoing operating costs.

Our advertising business continued their strong margin performance through the increasing scale and reducing their fixed cost base. It is important to note that the company is improving margins in a challenging economic environment while also significantly diversifying our revenue mix.

This illustrates our ability to both grow high margin new businesses like advertising and health care, while also improving margins in our core businesses of guest entertainment and hotel services.

On slide number eight is the summary of our operating expenses for 2010 versus the last two years. The company has taken significant steps to reduce our operating expenses in our core businesses while also funding investments in our growth areas such as health care and advertising.

In addition, the company continues to fund product development efforts, which are critical to ensure the company remains the leader in product innovation. These investments are starting to pay dividends as we installed our first Invision site this year and have received very positive feedback on the new applications and enhanced navigation system.

Looking forward into 2011, the company remains committed to controlling operating expenses. In January of this year, the company reorganized many of our functional cost centers in an effort to reduce operating expenses and focus resources in growth areas. These actions, along with the continued focus on expense control will allow LodgeNet to reduce operating expenses below 2009 spending levels.

Adjusted operating cash flow for the quarter was $24.6 million, which was within the Q4 guidance of $24 million to $27 million. This decline versus last year was due to declining guest entertainment revenue, partially offset by improvements in our diversification initiative of health care and advertising.

On slide number nine you will see the trend for our trailing 12 month AOCF performance over the past five quarters. In spite of the recent decline in top line revenue, our company remains focused on maintaining our high operating margins and growing our diversification initiatives, which helped temper the declines in guest entertainment.

On slide number ten you will see the continued improvement in bottom line profitability with an 8% improvement in operating income versus prior year. On a per share basis, the improvement versus last year is 29% when adjusted for a one-time benefit in 2009.

We continue to manage the company to maximize free cash flow. You can see the three year trend on free cash flow on slide number 11 with a more detailed comparison over the last two years on slide number 12.

For 2010, we generated nearly $80 million in free cash flow. This is a 23% improvement over last year and more than three times the free cash flow generated in 2008. The improvement is driven by a number of areas including a $5 million decline in interest expense versus last year driven by our aggressive debt reductions.

We reduced our investment in working capital by over $25 million and we maintained a disciplined approach to capital investment by restricting capital spending to a rate just over $21 million a year. Of course the starting point of this cash flow is the strong performance from our install base of 1.8 million of the best hotel rooms in the world.

On slides number 13 and 14, we have laid out the specifics of our debt reduction and covenant compliance. In 2010 we used virtually all of the cash generated from operations to pay down debt. Debt reduction for the year was $96.5 million, which put our year end net debt level at $365 million and our consolidated leverage ratio at 3.35 times on a net debt basis. These levels are well below our current leverage covenant of 3.50.

I will conclude with slide number 15, which lays out LodgeNet’s financial guidance for the first quarter of 2011. We are expecting revenues to be in the range of $107 million to $111 million, which assumes a 4% to 9% decline in guest entertainment revenue on a per room basis for the quarter.

Adjusted operating cash flow is expected to be in the range of $25 million to $28 million and net loss available for common shareholders is expected to be in the range of a $0.15 to $0.06 per share loss.

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

Scott Peterson

Thanks Frank. Before turning to your questions, I’d like to make a few comments regarding our strategic initiatives which I believe are positioning us for growth in 2011 and beyond.

As I see it, the core asset of LodgeNet is our 85% market share of VOD rooms served in the North American hospitality market. We provide services to 1.7 million rooms in more than 9,000 hotels throughout the United States, Canada and Mexico, and in those rooms, we touch about half a billion travelers on an annual basis.

So our business strategy is focused on unlocking the full value of those rooms represent and we believe there is substantial value beyond the returns we are generating from our current analog base today.

As Frank discussed, one of our key growth drivers is high definition. Those systems are generating 60% greater revenue on a per room basis than our analog systems. Our high def interactive platform is now in only 16% of our room base and we know that leading hotels will want and need to transition to high definition over the next several years.

On slide 16, we have a couple of highlights regarding our next generation HD platform, which connects our interactive high definition system to the Cloud and it holds the promise of reinventing the guest experience and creating new revenue streams for both our company and our hotel partners.

Our first installation was in January and we are very pleased with the performance so far. The system now has several new technical components that is driving new features and benefits of our solution. First there is the new hotel portal, which enables a new service we’re calling E companion, where hotels now can provide a wide array of information to their guests using our system, cutting down on paper and printing costs and also using the system to drive on property marketing to drive revenues within their bars, restaurants and other ancillary services.

The system also has a new integration engine which interfaces our interactive platform with the hotel’s backend systems and that type of integration now will now support new on TV services such as breakfast ordering, which can reduce hotel operating costs and also drive greater revenues for our hotel partners.

And the system also now has internet connection so through our television apps, we can connect guest information they want and needs such as on slide 16, you’ll see a stream from flight tracker, which in the room gives update access information to flight information adding local airport by specific flight or by all flights, and also a service from City Search where guests can find out more about local restaurants and attractions and find directions to those venues.

By mid this year, we’ll be introducing an internet entertainment application, which will also provide guest access to a variety of Cloud based content sources, which we believe will be of interest to the guests.

So with Invision, we will be providing our hotels and the guests with a new connected TV experience and our company will benefit from new and expanded revenue opportunities.

On slide 17, I’d like to make a couple of comments regarding the exciting new functionality that we’re testing with regard to mobile applications. The basic version, which we’re testing today in about five properties, turns the guest’s smart phone into our LodgeNet remote control. So having downloaded the app, the guest can look at specific channel listings that are specific to that hotel.

They can actually change channels using their smart phone. They can browse the entertainment options that we have on system at that property. They can actually buy and start a movie on the television from their smart phone device. So they have very interesting, very cool, and as we look to the future, we’re looking at taking the mobile app beyond just the guest room where we see opportunities to also integrate with the hotel’s mobile application.

Some hotels have that today and we think it will be a growth area, so if we integrate both of the mobile apps that can also provide full site service ordering, maps, directories, all those types of things hotels would like to provide their guests.

And we’re also looking into possibly creating a direct consumer relationship beyond the room. So guests can easily use credit cards and points, infinity points to purchase movies. They can do entertainment downloads for example, and also get access to certain travel discounts.

So this is an early stage development, but I believe it could drive guest utilization for our services. I think it also represents some very interesting business opportunities for us in the future.

With regard to guest entertainment, I indicated on our last call that we are focused on a number of initiatives for revenue beyond upgrading our base to high definition. We traded a new interactive and media network group last fall to focus on maximizing our revenue opportunities within the room looking to drive increased revenues from the guests, and also from third parties or advertisers that want access to the guest for their product marketing.

We’ve have numerous tests and initiatives underway. For example, a credit card purchase option where a guest can enter their personal credit card information to pay for the movie versus just charging it to their hotel bill and our testing so far shows positive revenue impact with more ways to purchase.

And we’ve also been testing a new entry into our system. It’s called interactive turn on where when the guest turns on the television it goes to our interactive menus so you can say it automatically puts the guest into our store so to speak, and the testing also shows positive results with greater awareness from this format.

In addition, if you turn to slide 18, you’ll see highlights regarding another initiative that we’re calling VOD 2.0. This spring we’re launching VOD 2.0, which is our marketing initiative to reposition our entertainment services within the guest room.

With VOD 2.0 we’ll have three tiers of pricing for the guests with respect to first run content. We’ll have a pre DVD arrangement of content that will be priced at a premium because it represents the earliest window in the market, then a sub $10.00 grouping of content as it enters the DVD window and then as the content ages, we’ll also provide some sub $5.00 special opportunities for the guests.

At the same time, we’re going to refresh our onscreen look and feel and we are refreshing our marketing message that will drive home the point that we have a very unique and very early window for Hollywood movies generally 60 days before the DVD release and generally 90 days before that content is available on Netflix.

So the goal here is to get more consumers into our store and then present them with new price points and marketing messages that will drive higher purchase rates from the guests.

And lastly, on slide 19, you’ll see some highlights regarding an announcement we made in early January regarding our new strategic alliance with DOCOMO interTouch. The agreement fills three main areas.

First, LodgeNet now has access to their leading global broadband server and software under a preferred distribution relationship. We believe having that software and the server should drive broadband growth for us. We’ve also licensed our conference manager software to them for international markets. So as a result, we could actually generally offer similar solutions to our joint customers both here in North America and Asia.

And lastly, we’re also exploring other international opportunities based on DOCOMO being the largest interactive TV service provider in Asia and of course LodgeNet having global leadership interactive television technology.

So with that operator, I’m going to ask you if you could explain the procedure for asking questions.

Question-and-Answer Session

Operator

Thank you sir. (Operator Instructions) Our first question comes from David Kestenbaum with Morgan Joseph.

David Kestenbaum – Morgan Joseph

Okay, thank you. The first thing is, [inaudible] big issue for the quarter was this Marriott situation. How do you think that plays out as you go into 2013. Have you spoke to them? What can you sense from them of how that rolls out?

Scott Peterson

Hello David. Clearly we’re good relationships with Marriott. We are in active dialog with them about their next generation systems. The systems that are installed in Marriott today are non-command platform as a general rule and would have been installed in 2004 and 2005, that kind of vintage.

So clearly, they’re in the need to update their platforms and move them to the next generation, which I think Invision is a perfect platform for Marriott and other hotels like that. So what I would see would be is that there will be considerable, probably it could be the later part of this year, but certainly next year, where we’re moving Marriott to that new platform, which would then also entail a new business model.

At this point, the content that we’re providing Marriott Hotels today is the same we’ve been providing them for the last five years, six years. They are considering options of modifying that programming, especially with regard to [inaudible content, but at this time, there is no firm decisions as far as the future; clearly nothing that we would see before 2013.

And in that process, you think about Invision, that gives us also the opportunity to open up brand new revenue opportunities for providing the E companion package at the Marriott so they can use the power of our platform for their operations, generate new revenues from the guests for content that streams from the internet and we would see access fees that the guests would pay to get access to the internet, could also be content fees that we share with internet content sources.

So there is a variety of different things that we think will play into it Fundamentally, at the end of the day as we do contracts with hotels, we look to get a certain level of return on our invested capital. A hotel wouldn’t need to take any movie content from us as long as they paid us a proper service technology fee, software fees, just kind of like in hospitals. That’s our business model there.

That gives our shareholders an adequate return. So I think there’s good dialogue, good relationships with Marriott. So it was an interesting story in the quarter. There wasn’t really any new news there, but I see a very good opportunity for us to transition perhaps with a different business model, but still meets all the returns that our shareholders should expect.

David Kestenbaum – Morgan Joseph

Okay. And could you talk about I guess I assume that you tested this VOD 2.0 in a few markets and could you just talk about what you discovered? Was there any cannibalization or were you able to actually drive more revenue per room when you tested it?

Scott Peterson

We tried different price points. That’s part of testing. Certainly sold more tickets, saw even double digit increases in tickets. Sometimes that resulted in lower total revenue, so we’re still kind of working the mix between the three different price point buckets.

Right now we believe where we’re at today without having had the on-screen marketing or the [inaudible] user interface that we will be rolling out with the new price structure in the spring, nor having the benefit of the new marketing messages about the 90 day before Netflix price points.

We’re basically at a price, revenue neutral point at this time so we think that bodes very well because you can take the whole package now and guests become more aware of having value, opportunities at sub five, a pretty broad group of content at a sub $10.00 price point. We think that signals pretty strong that this is the right thing to do long term.

In your launches, we will be doing the fine tuning of the price points and the content as we move forward, but so far we’re very pleased with what we’re seeing.

David Kestenbaum – Morgan Joseph

Okay. And then two quick financial questions. Will there be any restructuring charges from this restructuring in January, and then second, very good job obviously growing working capital, which really helped you see cash flow in 2010. Where do you see working capital going in 2011? Can you still gain benefit from that? Thanks.

Frank Elsenbast

This is Frank. David, on the working capital, we did see a lot of benefit this year as we drew down the amount invested in working capital. In 2011, of course we’re not giving cash flow guidance at this point, but I would expect some of the benefit that we saw in 2010 to reverse in 2011, but we will have to see how that plays out through the quarter.

I think you most of it is through working with our programming providers on our payment schedules and we have good relationships with them and good understandings on when they are going to be paid and what payment terms we have to negotiate.

On the restructuring charges, there will be some modest restructuring charges that come through in the first quarter as there was a head count reduction of approximately 70 positions across the company, so there will be some modest charges that come through in the first quarter and somewhat in the second quarter as well. But certainly will be a benefit for us in the 2011 operating expenses.

David Kestenbaum – Morgan Joseph

Right. And that’s still fits your EPS guidance I assume, right?

Frank Elsenbast

Yes it is.

David Kestenbaum – Morgan Joseph

Okay, thank you.

Frank Elsenbast

Thanks David.

Operator

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

Frank McEvoy – Craig-Hallum Capital

Hi, good morning guys.

Scott Peterson

Hi Frank.

Frank Elsenbast

Morning Frank.

Frank McEvoy – Craig-Hallum Capital

Just want to follow up on the VOD 2.0 question. How quickly do you think that will roll out? Can you give us a feel for what percentage of your base would be covered by that say by the end of the year?

Scott Peterson

By the end of the year it would be 100%. We’re still working on the start month. You’ve got to be in the second quarter and then the question is do we do it big bang theory or do we kind of take a couple bites of the apple. So that part we’re still looking at. But I would say within the third quarter we’ll be 100% converted to the new approach.

Frank McEvoy – Craig-Hallum Capital

Okay. In terms of the, I was going to ask about the Invision as well. How quickly do you think that might roll out?

Scott Peterson

That’s a system or process where the first thing is driving contracts with hotels to sign up for a new seven year or five year deal for the Invision platform, so the sales organization has that. They’re on the street. We’re talking to all kinds of, all the major brands, major management companies that actually own or manage the properties.

So that will take, that will be a process. The Oliver installations will convert over to Invision probably certainly by the start of the third quarter. You’ll see more that will happen now. We did our first in January. I’d expect second quarter we’ll start to increase that, increase the number of private projects, because they also provide an excellent sales opportunity.

Our sales organization take their customers to see a live system in a hotel. I think that sets up apart from the smaller competition we have. It’s usually pretty conceptual and like one property in the United States, and so we’re looking. It’s live. It’s real. Attract the property, the onscreen image in our deck; that is from the property.

If it’s an 1,100 room property, within minutes there’s Chicago O’Hare’s airport. So that’s not a test. That’s a real live installation. So that will take time Frank to roll out, but that’s also why we think it’s very important for [inaudible], focusing on the core install base VOD 2.0.

Frank McEvoy – Craig-Hallum Capital

Invision then is more for the new installations?

Scott Peterson

That will be new installations. There’s some opportunity to take our current high def to that new platform. That would be a software upgrade so that does, with the 270,000 rooms we have today does present a software upgrade opportunity for us, which could happen quicker, but you still have to go through the sales cycle.

Frank McEvoy – Craig-Hallum Capital

And in terms of the HD rollout, I know, I think in the past you were looking for 120,000 or so HD installations conversions in 2011. Any update on that and how might we expect the rollout by quarter?

Frank Elsenbast

This is Frank. We are still working with a lot of the big brands to figure out the exact schedule for the rollout in 2011. I don’t think at this point we’re ready to refine that, refine the annual forecast. We would expect it to build as it goes through 2011 and probably the first quarter we would probably see a little bit of a decline versus what we did in the fourth quarter of 2010 as that quarter had a lot of big properties that came through in one quarter for us. But at this point, we’re not really providing guidance on a by quarter level.

Frank McEvoy – Craig-Hallum Capital

Okay. Kind of related question, is the CapEx then for 2011, any thoughts on – it was a little over $8 million in Q4. Do you see that if the HD is a little bit less in Q1, you think CapEx might step down a little bit in Q1 and then kind of work up from there may be on a quarterly basis that may be approaching or exceeding $10 million?

Frank Elsenbast

Well I think your assumption on the first quarter is right on. We would expect it to come down a little bit just as the high def activity is declining in the quarter. As we get into the second half of the year and we see more high def upgrades and new installs coming, it will certainly grow, but we’re not going to provide a quarterly bogey for it at this point.

Frank McEvoy – Craig-Hallum Capital

In terms of, I guess I’d like to turn now to guest entertainment rooms. The number of guest entertainment rooms, they were down about 5.6, I guess 5.7% year over year at the end of Q4. Can you comment on or give us some idea what the video on demand contract renewal rate was in 2010 or maybe in Q4 specifically and how does that compare to what the rates were in say 2009?

Scott Peterson

Frank, during this recession a lot of hotels didn’t have capital to buy flat panel high def sets. If the contracts came up for renewal, the original expiration date came up during that period of time, they just would go to an automatic renewal and most of those are either on an annual renewal cycle or month to month. It was kind of a mix there.

So renewal rate, it’s not necessarily how we think about it because it’s not every – most of the time it’s just automatically moving and the properties are staying on board. We kind of think about it more on a volume basis so for the last couple of years we’ve been doing about roughly 100,000 fewer rooms of churn out of the system, and during the last two years during the recession, the vast, vast majority of those have been properties that are low producing VOD properties for us.

I think the average is $7.00, somewhere in that ball park. So our better VOD properties are just staying holding tight, waiting for the world to get better, get their CapEx budgets intact and then of course as we come back with more capital, as the economy improves, extend contracts at that point.

This year I would say that I would hope that we’re going to drive down the churn rate, the number of properties leaving and the number of rooms leaving the system. From the standpoint, a couple of different things; one is we’ve also – the folks that create a retention team here to make sure we’re on top of that, to do everything we can for our best customers, make sure they don’t leave the system just for lack of good attention or care so to speak.

And then we’re also looking at one of the reasons that some of the properties have left over the last year or so is that when they went to the high definition free TV programming. Sometimes the equipment they were looking for us to finance the free TV programming because their capital budgets were tight. We were not necessarily in that position at that point to do that, so then they would kind of terminate the entire relationship including the VOD and go to the local cable company and get their high definition channels.

We have created a new program that we’re introducing in the market now where we are going to make that financing piece around the free TV programming more [inaudible]. I guess looking for financing around that either using third party sources and for our best customers would even utilize LodgeNet capital so that the investment we have in place this year, we talk about CapEx, Frank outlined that, would be focusing some of that capital also to retain the free TV business because then you maintain the VOD at the same time.

So you think that holistic package with a bump in high def, VOD plus the incremental revenues from a [inaudible] a very attractive return on capital for us. So I’m hoping you’re not going to see six figures next year with 100,000. Hopefully, we’re taking that down, but that’s a work in progress on our side.

Frank McEvoy – Craig-Hallum Capital

So I mean if you were going to – do you expect the number of guest entertainment rooms in 2011 to go down 3% to 5% or do you think it might be more than that by the end of the year? Anything to help us on that?

Scott Peterson

On a numeric basis, I would hope that we get into the 75,000 range versus the 100,000 range.

Frank McEvoy – Craig-Hallum Capital

Okay. And then one more question and I’ll jump in the queue. I know that HD revenue per room is a lot more but if you look at a same room basis on a year over year basis, did the HD revenue on the video on demand, I think the third quarter was down a couple or 4% or something like that. Any color on that for Q4?

Scott Peterson

No, I think when you look at the performance year over year, the high def rooms continue to perform much better than the analog rooms and I think a data point that we mentioned on the last call is that decline that you tend to see, it varies a little bit but it’s about half of what you see within the analog base.

Frank McEvoy – Craig-Hallum Capital

Got it. All right. Thank you very much. I’ll get back in the queue.

Scott Peterson

All right Frank. Thanks.

Operator

Our next question comes from Mike Demaray with Elevated Capital.

Mike Demaray – Elevated Capital

Morning gentlemen.

Scott Peterson

Hello Mike. How are you?

Mike Demaray – Elevated Capital

Good, how are you? Let’s see, I guess my first question is given that we haven’t see a rebound in def entertainment yet, where are you currently managing the leverage ratio to? Are you going to try to work it down a little bit more or do you want to kind of keep it where it is?

Frank Elsenbast

You were kind of soft coming through so I’ll repeat the question for those on the phone. With the trend on guest entertainment, where would we be looking to manage the leverage ratio going forward I think is the question.

We ended the quarter at a 3.35 leverage ratio net of the cash on the balance sheet. We don’t have any more step downs coming within our covenants, within our bank agreement and so we would, I would say we’re not in a hurry to significantly take that leverage ratio down. It depends on the capital investment opportunities that we have as we rollout high def, introduce new product.

So you should expect to continue to see some delivering as we go through 2011, but I don’t think we would be devoting nearly as high a percentage of our cash from operations to pay down our debt this year as we did last year.

Mike Demaray – Elevated Capital

Okay. And on the financing side, can you give us any commentary on the financing environment. Are you still actively looking to extend the maturity of your debt and maybe can you give us some color commentary on if you are talking with banks or continuing to just monitor the high yield market, what you’re seeing out there.

Frank Elsenbast

It’s always safe to assume that we’re always looking at our balance sheet and what is the best way for us to structure our capital and we always balance what the covenant package, the cost of our capital and the maturity.

Those issues we looked at, we did test the waters in the high yield market this year and we are in frequent conversations with our agent bank on our existing bank facility. So I think it’s just safe to assume that we are always looking at those things. We have a very nice package right now and the issues that we do deal with are the covenant ratios, the leverage ratios and also the maturity of the debt in 2014 and how much flexibility that provides to us.

Mike Demaray – Elevated Capital

Okay. You made a comment on providing third party financing to your customers. That’s something that would make a lot of sense. When you would see that potentially happening?

Frank Elsenbast

Well, we would hope to roll out something in the first quarter of this year.

Mike Demaray – Elevated Capital

Okay, great. And then just bigger picture, I’m curious to know, if I look at the business historically, it looks like back when you were competing on On-Demand, the free to guest entertainment was almost used as a loss leader to kind of get in the door and get pay per view dollars, and it sounds like you guys are kind of rolling the pricing back up and increasing that with renewals. Can you talk to me how your customers are feeling about that increase because obviously they’ve gotten used to the lower cost. Are they taking that well? And then I guess Scott mentioned that you would be willing to do no movies if you had correct return on invested capital. Have you thought about, I mean obviously that shifts your business to less at risk and less also on the revenue side. Can you tell us a little bit about how you’re thinking about that?

Scott Peterson

Sure. I’ll start with the last point first. That’s a theoretical statement. I would tell you hotels today are not looking. You know there are still tight budgets operating in CapEx so philosophically, we’re not in the movie business. That’s a great source to provide cash flow to either for us to pay for our investment and get a nice return in the asset of the hotel or the hotel.

In some cases in the past, we talk about the Venetian in Vegas. So we did a business transaction with them where they put up the capital and bought the system. We maintain it and operate it and program it for them and get a rev share from it but at a much lower spread. It’s a small piece. They have the capital attached.

So we’ve done those in the market. In fact, during the recession, that was basically all we were offering to the general hotel industry. We call it the hotel investment model, and I believe we sold like 17,000 hotel rooms under that model during that period of time, which was quite good.

But hotels as I say are not really in the market for high CapEx opportunities at this time, nor do they want to see their operating costs go up. So I guess I’d put that in the context as we talk to a major customer like a Marriott, we don’t have one model. We have abilities to work with them to come up with the right structure that makes sense for both parties.

When it comes to free guests, On Command, before we bought On Command, our gross profit margin on the TV programming services was roughly about 12% to 13%. On Command definitely had utilized the basic cable programming as a loss leader as they did put that into the overall package, but the properties, their biggest customers generally got free cable at the upper end and they made the return with VOD.

You can see by the margins on the hotel services and the TV programming, we basically are at a point now where we reverse that entire negative margin, because when we first put in On Command that took our overall margin up one basis to zero. That’s been ticking up through the single digits now. We’re in the low double digits; probably have a couple basis points to go yet.

So overall, I would say it’s been accepted. Getting something for nothing, everybody likes to do that when they can. I think they understand that that’s a value package and the rest of our competition; cable, or these other providers like Dish, they all have to do it – have market laid for the cable so that’s what we’re compared against now from a competitive standpoint, not a free give away in the old days of On Command LodgeNet.

Mike Demaray – Elevated Capital

So when you say that your margins are almost there that at a market rate, competitive market rate to the other local cable providers and what not or are you still below them?

Scott Peterson

From a margin, I don’t know where cable would be on margin. I would say from the price point that we’re selling it at, we’re I guess hotel services margin was 13.7% in 2010. That is, we were right in that ball park as a LodgeNet stand alone. So we’re getting the margins that we expect from this business.

Is suspect they’re at or probably slightly better than our other satellite competitors, but we have cost advantages from our scale. The cable deal is kind of behind the curtain. I’m not sure how to think about what their margins might be but we’re definitely competitive.

Mike Demaray – Elevated Capital

Okay, great. And then I just have two more questions. The first one on the additional incremental HD rooms that you guys are adding, are you seeing any difference in the revenue bump that you’re getting from those rooms? Are they about in line with the original HD rooms that were installed or are you seeing that kind of taper off?

Scott Peterson

No, I’d say we continue to see a very healthy lift when we upgrade a room to High def. Quarter on quarter we look at the trends and it does vary a little bit depending on the exact properties that are upgraded in that quarter. But no, I’d say we still see a nice consistent lift.

Mike Demaray – Elevated Capital

Okay, great. And then last, my last question is regarding the hotel networks. It looks like you made a lot of progress there. Where do you see that business ultimately going? Are in a kind of reaching its maximum potential or are we just getting started?

Scott Peterson

I would say we’re more just getting started. We’re looking at some opportunities. Right now, the hotel service, we’re around 350,000 rooms, so we’re trying to figure out how we can take that model and expand on that.

So that’s something, it’s a natural add on to what we’re doing. We’re at the scale now. From an EBITDA perspective, it’s positive. So over the next six to twelve months, that’s something we’re going to have a big focus on.

Mike Demaray – Elevated Capital

Great. Thanks very much guys.

Scott Peterson

Thanks.

Operator

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

Peter Reed – Mast Capital Management

Hi Scott, hi Frank.

Scott Peterson

Hello Peter.

Peter Reed – Mast Capital Management

How you doing?

Scott Peterson

All right.

Peter Reed – Mast Capital Management

Good. The article in the local paper I think referenced cost savings of 5% of operating expenses. Could you talk about how you defined operating expenses for the purposes of that?

Scott Peterson

The Sioux Falls [inaudible]?

Peter Reed – Mast Capital Management

I did.

Scott Peterson

All right. That’s a precedent.

Peter Reed – Mast Capital Management

I’m honored to be subscribed. Online. I don’t get a paper.

Scott Peterson

I think that the data point there this year we spent $91 million of operating expense. That’s SG&A and Ops. And I think the 5% number that was referenced, I believe that was approximately the percentage head count reduction that the company experienced.

Peter Reed – Mast Capital Management

Okay. So we shouldn’t presume that is a $4 to $5 million run rate savings?

Frank Elsenbast

Well, I guess we didn’t say that. In our transcript, we said that we would be below 2009 levels. So there is the reorganization that we did in January. There are ongoing cost containment measures that we have in place. For right now, we’re not providing guidance.

Peter Reed – Mast Capital Management

Okay. Given the – this was referenced a little bit earlier, but given the your first quarter guidance, it would seem like for the first time in a while you probably don’t need to make any term loan payments at the end of the quarter to ensure any breathing room, but it sounds like you may continue to make some. Can you help us think about when you have cash available letting it build for CapEx in the back half of the year as your HD upgrades ramp up and anything else you might have in mind for that.

Scott Peterson

Sure, Peter. I think as we go through the first quarter and the first half, in a period where you maybe don’t have the demand for high def upgrades, to the extent that we have cushion against the covenants, we probably would build some cash balances just so that we would be ready for increased investment in the back half of the year, so I think that’s a very fair assumption to make.

Peter Reed – Mast Capital Management

Okay. And could you talk – your swaps I believe expire June 30. Do you have any thoughts or plans yet on whether you plan to get new swaps or whether until you figure out what you’re doing if anything with the balances, the term loans, that you may just run floating?

Frank Elsenbast

Well with the swaps falling off in June, we will be looking at anything that we are doing on the bank debt. We will certainly be coordinating anything with a swap or a hedge provision with that. So I think it’s similar to the debt markets. We are continuing to look at debt, things that we can do to advantage ourselves with the interest expense as well.

Peter Reed – Mast Capital Management

And presuming that you didn’t do anything this year, those savings would be about $5 million a quarter?

Frank Elsenbast

Of course it depends a little bit on what LIBOR does, but yeah, that’s in the ball park.

Peter Reed – Mast Capital Management

Great. And last question, what is your restricted payment capacity as of the end of the year?

Frank Elsenbast

Well we have under the current credit facility, there is a number of restricted payment baskets so I think it’ a little more complicated question than that.

Peter Reed – Mast Capital Management

Okay, do you still have the ability to make payments on the preferred stock in cash?

Frank Elsenbast

The payment for the fourth quarter was made at the, early in the first quarter. The payment in 2011, we are looking at the restricted payment basket on that right now and there is a point where we would need to discuss that with the bank group to either facilitate a payment under that or if there’s not a cash payment made, then there is a mechanism in place where preferred stock holders would receive additional shares of common stock.

But that is, at the point where that becomes an issue, there will be a, we’ll certainly disclose how that issue is going to be addressed in 2011.

Peter Reed – Mast Capital Management

Thank you.

Operator

Our next question comes from Michael Platt with Blue Mountain Capital.

Michael Platt – Blue Mountain Capital

Hi guys. Thanks for taking the question. Is there some way you can give a little bit more visibility on the revenue lift that you guys talked about with respect to HD upgrades. That 60%, is that comparing it to your analog base or is that comparing the incremental lift?

Scott Peterson

That is a comparison to the analog base.

Michael Platt – Blue Mountain Capital

Okay. And are those generally speaking, the rooms that you’re converting or the sites that you’re converting, are those higher revenue generating than the average lower, any discernable trend there? Just trying to get a sense of what the incremental lift tends to be and what it’s been.

Scott Peterson

Yeah, the room that are upgraded, they are certainly a little, they SKU a little bit to the higher end. It’s not all luxury hotels, so it doesn’t go across the sector. But I’d say on average, it does tilt a little bit towards the upper end on the rooms.

Michael Platt – Blue Mountain Capital

Okay. And what functionally – and forgive me if just less familiar with your business – what does the HD upgrade let you do? Is it simply a matter of offering more interesting type of content or does it actually produce a new revenue stream?

Scott Peterson

It is the same movie content so the first run movies in the analog platform of course is not in the high def format, so the transition to the high def platform gives actually probably greater the cost of storage continues to come down. So now we’re doing two terabyte servers at a location that provides probably 200 movies titles that are available to the guest versus some of the analog systems we might have 480 gig or 750 gig versus the two terabyte.

So it does provide more variety given the storage capabilities and then of course it’s the high def. So if I’m a guest looking to invest, call it $13.00, $14.00 on a movie two hours at a time, having the high quality experience I think is part of driving higher revenues versus kind of poor quality, especially if it’s on a tube TV. I think there’s a big value difference on that.

Michael Platt – Blue Mountain Capital

When you reference an 18 to 24 month payback period, what’s the contractual relationship with the hotel? Are they agreeing to a carrier system for X period of time beyond the annual or monthly renewals? Is that what you’re talking about?

Scott Peterson

Before making any investment we get a contract extension somewhere either between five and seven years. So five years is the minimum. So we’re talking about getting our money back within two years or less on a five year or seven year deal.

Michael Platt – Blue Mountain Capital

And is there a standard with respect to what hardware they’re installing in terms of new HD sets? I’m thinking in terms of the product differentiation versus a guest bringing a tablet and using over the top services beyond the release window. Are there aspect that you guys insist on in terms of the size or the quality a set?

Scott Peterson

The size or the quality of set?

Michael Platt – Blue Mountain Capital

Yes.

Scott Peterson

The hotel industry buys basically commercial sets, LG, Phillips, Panasonic, Sony, Samsung. So there’s a quality. There’s a different quality set that has certain technology embedded in it for the hotel industry. In fact, in the new sets today all the major manufacturers are embedding our communications technology so we don’t even need a set up box anymore. They already have the cards separately, so yeah, it’s a different kind of set up.

Clearly somebody could stream stuff over the top using wireless connection or Wi-Fi connection within the hotel. We don’t really know that data especially if it’s 3G or 4G, but our data coming back from streaming over the hotel system, that data doesn’t suggest that there’s that much activity happening, kind of that video streaming.

Michael Platt – Blue Mountain Capital

Got you. Thank you.

Operator

Thank you. We have a follow up question from Frank McEvoy with Craig-Hallum Capital.

Frank McEvoy – Craig-Hallum Capital

Hello again.

Scott Peterson

Hi Frank.

Frank McEvoy – Craig-Hallum Capital

On entering Q4 your health care backlog you had eight contracts waiting for installation. How many of those were installed in Q4 and what was your backlog exiting Q4?

Scott Peterson

Frank, I believe the number of installs was two in the fourth quarter and I think we’ve got a six facility backlog exiting the fourth quarter.

Frank McEvoy – Craig-Hallum Capital

Okay. It sounds like there were no new contracts signed then if I do my math right. The backlog was eight, now it’s down to six. It’s just those two that you installed?

Scott Peterson

No, we had sales. I’m having a senior moment right now Frank for that detail, but we’ll be glad to get that to you.

Frank McEvoy – Craig-Hallum Capital

Okay. Scott earlier I think in an answer to one of the questions you mentioned that you may be a couple basis points because I think you do mean a couple of percentage points to go on the gross margin for the STD?

Scott Peterson

Yes. I think our standard would be, we’re 13.5% to almost 14%. I would suggest that we still probably have up to 15. Now that’s of course it’s going to be a slow kind of closing of that gap. The big negative ones are coming out.

Actually this year, the one customer that probably will provide some nice incremental increase this year, is we took them off the old program, the heavily sub set program. So I think you’re going to see 15% within the next 12 months.

Frank McEvoy – Craig-Hallum Capital

Okay, and on advertising, should we expect similar growth as you talked about I think 350,000 rooms. I mean do you see it growing 40% to 50% this year or is more like 20% to 30%?

Scott Peterson

It’s going to be the lower range. I think the 20% would be something you could look at. We had some really nice – we did a couple of tierage deals last year so it basically, the search channels want to get access to our guests in the room and we went from paying something for the programming to actually getting paid to hear the programming on a couple of channels. That provided a nice bip.

But overall, the general overall advertising market is coming back and so I think you’re going to see something like that 20% range.

Frank Elsenbast

Frank, just a follow up on your health care question, during the quarter we installed four facilities and we do have a six facility backlog.

Frank McEvoy – Craig-Hallum Capital

Thank you. And then finally, I guess this is a follow up I believe from David’s question earlier talking about the working capital, but really within that is of course the accounts payable that went up a little over $20 million from year end to year end, ‘09 to ‘10. Is that something we should think of? I mean obviously the accounts payable, days payable went up quite a bit and that’s without that – that may have helped you stay in compliance, but what I’m getting at is when you see – you think that might be coming down on an absolute basis or can you continue to just to keep at these high levels? Is that something that the content providers are okay with?

Scott Peterson

Well we are in conversations with all the content providers on this right. But it think it is safe to assume that will, some of that will swing back in 2011. We will not continue to operate at that long of a day’s payable outstanding.

Frank McEvoy – Craig-Hallum Capital

So it will probably come down. Okay, got you. Days payable would go down.

Scott Peterson

Yes.

Frank McEvoy – Craig-Hallum Capital

Okay. All right. Thank you.

Scott Peterson

Thanks Frank.

Operator

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

Peter Reed – Mast Capital Management

Hi. One quick follow up; when you talk about the payback on the HD upgrades and HD conversions, what’s the implied – when you say 18 to 24 months, what’s your implied revenue projection? Is it flat line? Does it grow? Does it decline a little bit?

Scott Peterson

No, we assume that when we upgrade a property to high definition, we get a lift from that installation and then we expect the revenue to trend similar to how the other high definition businesses or site have turned. So currently there is a decline factored into that high definition revenue per room after the initial lift.

Frank McEvoy – Craig-Hallum Capital

Great. Thank you.

Operator

Thank you. I am showing no further questions at this time.

Ann Harper

All right. Thanks everyone for joining us today. Just a reminder that replays of this call can be accessed over the next week via the internet through our company website, www.lodgenet.com. The slides used during this webcast will also be archived on our website for your reference under the investor section and 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 conference and you may now disconnect. Everyone have a wonderful day.

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