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Monica DiCenso - JPMorgan

Executives

Scott Petersen - Chairman and CEO

Frank Elsenbast - Senior Vice President and CFO

LodgeNet Interactive Corp. (OTC:LNET) LodgeNet Interactive Corp Presents at J.P. Morgan TMT Conference May 17, 2012 8:30 AM ET

Monica DiCenso

Thanks for coming out, and I'm Monica DiCenso. One of the media analysts here at JPMorgan, and I'm pleased to welcome LodgeNet to our TMT Conference.

Today, from the company speaking is Scott Petersen, President and CEO, and Frank Elsenbast, Senior Vice President and CFO. Thanks again, guys, for coming.

Why don't we start off with a general question just for those of us that might be unfamiliar with LodgeNet? Can you give us maybe a couple of minutes on background as to how the business has evolved over the past five years?

Scott Petersen

Sure. Good morning and thanks for attending. LodgeNet is the leading provider of interactive and connectivity services to the hotel industry and also on expanding business within the healthcare space.

About five years ago, we purchased On Command, which is our largest competitor in the space, so together we have about 85% market share of hotels that have interactive television services, and that historically has classically been offering video-on-demand movies, but really interactive television is way beyond that from a scope of services, now really moved into productivity apps informational apps for consumers and travelers. In addition, we provide broadband interconnectivity services also for hotels. So it's kind of very broad description.

In the upper end of marketplace, by the way, I should say about 60% of our rooms are in hotels that rated from upscale to luxury, so heavy concentration there about 20% in the midscale market, and around 20% in the independent market, which of course takes a lot of boutique and historic-type properties that would probably be categorized as luxury if they had brand that was rated by one of the hotel industry situations, and then through our rooms, 1.6 million rooms, about the 1.5 billion consumers each year flow. So it's a very large universe, very interesting demographic highly interactive and also from advertising perspective, which is one of our initiatives very attractive from advertiser's perspective.

Monica DiCenso

Healthcare is how much of your business?

Scott Petersen

Right now it's about $10 million of our $427 million of revenue. So it's a early stage, but it really leverages our technologies, our interactive systems we created for hotels, takes in the patient room and it's not only entertainment, but probably more importantly it's information for families, about services that the hospital has, and even more importantly patient education. So doctors who prescribe films for a patient to watch or the family to watch before the patient goes home on what to do, what not to do to try to reduce readmissions, or before a procedure, just so there's more information in the patients' hands and they could be more engaged by their experience

Monica DiCenso

I think last year you launched a new cloud-connected Envision platform. What does that bring to the guest? What kind of revenue opportunity is that for you guys?

Scott Petersen

Sure. I would say we are once again in the forefront of interactive television. Interesting enough, we installed our first video on demand systems 20 years ago in the hotel industry. So in 1991, we were doing video-on-demand when cable companies were just thinking about it and what that might mean in the space. Our interactive platform right now or you might see ads on television about consumer sets that connect to the internet and you can do lots of cool things in your home, but that does take a sense of technical competence and somebody actually connecting it to the internet to make it work. We are doing that now in the hotel industry, so but now we are transitioned of course to high definition systems in hotels, and hotels need to have invested in the flat panels and some of the other infrastructure necessary to delivery high def.

We take that high def system, which by itself is already increasing our revenues by about 60% from the revenues we are generating in our analog platforms to high def and now you connect that beautiful screen to a pipe to the internet and now it's instant information about what is happening in the hotel, at the brand, airport, flight arrivals, departures, restaurant reservations, all those types of things. That really is an opportunity to bring real-time connectivity into the television screen and hotel room is the display device.

Then the other factor with our Envision, so Envision is our brand name for that internet connected interactive television device. And then on top of that next layer up, we announced at the end of last year kind of our four-screen strategy. So it's no longer just communicating with the guest on the flat panel television room but it's also whatever screen that they are using. So whether it's your smartphone device or tablet or laptop, all of those screens are now coming together in Envision. So hotels can publish create the content, once published, multiple plays, et cetera.

Monica DiCenso

You mentioned the transition to high-def. Where are we on that? Because if you stay at the hotel hideous to do.

Scott Petersen

You should write note to that hotel. Tell their owner to spend a little capital.

Monica DiCenso

Yeah.

Scott Petersen

We only have in 22.5% of our rooms do we have a high-def interactive experience. The remaining 70-some percent, some of those have tubes, Tube TVs and some have flat panels, but the hotel has not invested the capital to bring in high-def, basic TV channels, nor signed a contract with us to bring the entire system up to the full high-def interactive standards. So that's during the recession, we're all capital constrained within that space, hotel industry is coming back, balance sheets are getting better but it is not back to the good olds days. So the capital spend is the one area from the hotel's perspective that's kind of our leading indicator and activity is moving in the right direction there.

Most importantly, from our standpoint is that as the price of interactive television high-def sets are coming down for the hotel industry to purchase, our capital costs are coming down quite dramatically. The cost of a full high-def interactive system right now is about $140 per room, three years ago it was over $300.

So, you think about we are generating the same or actually more revenue today on that high-def platform than we did three years ago, so it's very powerful economic engine for the company.

Monica DiCenso

In essence, so isn't it benefits the hotel as well to transition.

Scott Petersen

Yes, absolutely. Because all of us that travel in the upper end of the market place we are full high-def account. Right? And so, you see if it's the analog feeds on a flat panel or for tube TV, it certainly is distracted from, what do you expect from the hotel. You select it.

Monica DiCenso

Yeah. I don't want to mention their name.

Scott Petersen

Okay.

Monica DiCenso

You guys launched a mobile app in January. Can you just update us as to how that's doing and what kind of functionality is on the horizon?

Scott Petersen

Sure. What that is really about very cool kind of expansion of that four-screen strategy, so were just before the start of the panel here, it's a free app, downloadable from either the iTunes store or the Android market. We just launched in the very end of the January, and we are promoting that of course on the television system in the room. So it's a free download with the very first I think most powerful immediate action or benefit for consumers is that it turns into a remote control for that specific set.

In the hotel industry a lot of times you the sets have not been, don't have the electronics to give you an easy program guide, so most of the time you'll see little piece of paper in the hotel room that says CNN is on a certain channel or HBO. With the mobile app now, you with a six digit code, you are connected. Your smartphone to that specific hotel, that specific television, so now all the various channels that are on the system are on your smartphone or your tablet with the flick of the finger you can go through the entire channel line up, hit CNN and the TV automatically switches to that. We're having some upgrades coming in the near future there would be actually an interactive program guide.

Other things from a hotelier's perspective, you could order room service on your tablet or your smartphone. You don't have to be in your room. You could be at the pool side. You could actually be coming back from a meeting as long as you already checked in hotel, you could order something for your room, order other things pillows, blankets, other types of requests. And then the other aspect is it's also takes us beyond the guest room. So and beyond the hotel, so one of the other powerful features that's under development is basically a traveler app.

So at this hotel now, I can find out how what restaurants are in the area, maps, eventually it will be you could make reservations for a restaurant, you could by tickets for something that might be at the garden here in Boston. So we are hoping that this turns into a very useful and powerful app that travelers will attach themselves to use regardless of where they're at in the hotel or beyond.

Monica DiCenso

I would assume there's some functionality required in hotels and to placing order for room service and have it delivered and all that.

Scott Petersen

Right.

Monica DiCenso

So, how have hotels responded and thinking again or people spending more when they use that app versus just traditionally picking the phone and calling.

Scott Petersen

Right. And, what we are finding is, so we introduced this Envision platform just one year ago right now, and of course there's always little bit of time of selling and educating the industry, but the adoption for Envision has been accelerating very nicely. All of last year, we sold about 40,000 rooms or signed contracts for 40,000 rooms for the new Envision platform in the first quarter by itself, and we increased that by 75% to over 70,000 rooms.

So our adoption for the hotel industry hit the 75,000 room level is more than all of our competition combined within the space. So they need to sign the contract with us and then for room service ordering or one of the other major features of Envision is the base app is the eCompendium. So putting all what use to be pretty material in the room, the cost of that updating menus, all those things, information about the hotel and the area that can be done on the television, which can also publish to the mobile app, to the tablet. So it's very much of a cost savings opportunity for the hotel. It's more environmentally friendly and of course it's starting to add more revenue for us.

So, in the 70,000 rooms that we have under contract as we ended the first quarter about 40% of the rooms that we had installed, which is about 40,000 by the end of first quarter and we are subscribing to these apps. So hotels were paying us and monthly subscription fee, and now it's averaging right around $4 per room per month, which our overall revenue from movies within those rooms is about $15, $16. So that was a 25% increase in revenues just from those apps, so we're very pleased about that exceeding our expectations and even probably the better part is, they are useful for the hotels, but there is really a software-as-a-service offer from our perspective, so it's very high margin.

It's going to contribute very meaningfully to our bottom line or free cash flows as this continues to roll. So we're very pleased with hotel adoption at this point.

Monica DiCenso

Okay. Great. When you are showing us the app earlier, we saw a Delta ad at the bottom. Any expressions about your ad network and what's going on there and what are your expectations for that?

Scott Petersen

Sure. Well, one of the 1.6 million rooms that we do serve, we have a $0.5 billion, $500 million travelers flow through our rooms each year, and the demographic of that individual is very high end from an education, from an household income perspective from professional status. So we represent a very unique digital out of home marketplace that we have in the past last year, we did about what, $8 million in advertising revenues, Frank? Somewhere in that ballpark, and our goal now is really to expand that with the technologies and also the four-screen strategies.

So, on one hand the Delta app that showed up onto the mobile app is just one of those where we have an ad running on our high-def platform in the room. It shows up on the mobile app, on the smartphone or the tablet. So of course that Delta is perfect for all traveling, we all need to make choices on airlines. We see a major expansion next year as we're with the general ad insertions on the basic TV channels that are displayed in the hotel room. We have had a system, where we did and ad insertions on 10 channels On Command platform, so it came with the acquisition.

Proves the business points, but of course digital out of home advertisers users are really exploding in this space. So this next year, we're expanding that network from up 300,000 rooms to about 500,000 rooms. We're taking it from an analog platform to a high-def platform, expanding from number 10 channels to over 20 channels. So the impression is we have to sell to this very strong demographic. It's going to go from about 1.2 billion impressions to over 5 billion, and so we think that will be a huge.

Before making $8 million top line on a $1.2 billion impression business, that we think four-fold increase in revenues would not be out of the question on that at classic media it's very high margins once you cover your fixed cost, which in our case should also be very pretty modest.

Monica DiCenso

You mentioned digital out of home being popular area we cover outdoor and see the same thing. How does pricing compare on your apps and your other devices versus what advertisers might see in a local market. Just wondering what your advantage is and how you are approaching it and obviously you have a desirable demo.

Scott Petersen

Desirable demo and then it's on meter. Meter from standpoint it's not billboard or passive kind of viewership, all of our systems are interactive from a television standpoint or from the smart device standpoint, so we have that data. We've have Nielsen in the past and we'll use them to give the blessing and certifications of viewership. So we believe that's even our market that niche will be going to be very attractive to the advertising world and we'll grow right along with the overall industry.

Monica DiCenso

Can you talk about your revenue and diversification and shed some when did you start, what are the focus on and how big do you think it become?

Scott Petersen

Sure. I'd as Frank talk about that.

Monica DiCenso

All right. Okay.

Scott Petersen

He's pretty, but he is smart too.

Frank Elsenbast

The business use to be primarily focused in video-on-demand revenues. A few years ago that was 80% of our revenue and the company started to diversify away from just focusing on video-on-demand services.

Back in the day that was kind of the highest and best use to that of that real estate to sell movies, but with that valuable demographic going through in 1.5 million rooms, there's an opportunity to sell additional services to the hotels. So we're currently running about 50-50, half of our revenues coming from guest entertainment and half coming from diversification efforts.

And how big can that become, I think the ability that we have to launch, things like mobile and Envision into broad room basis rapidly and also the launch of our advertising network. Next year we would expect to have the diversification initiatives grow to over 60% in the foreseeable future.

Monica DiCenso

I don't know if you want to answer this, but are they all profitable today?

Frank Elsenbast

Well, when you look at the initiatives that we've talked about, the advertising and Envision apps and also the mobile app, they are extremely high margin businesses, so they are replacing guest entertainment, which does have a high margins of 60% gross margin business but I would say all three of those initiatives are going to operate about 60% gross margins and a very low fixed cost structure to along with them. So yes they are all profitable and we sell that services like TV programming, which is just a good base service to provide to the hotels but it's kind of a commodity. So that's 15% margin but it's a great service to provide. It locks down rooms and provides a good base for you to sell other services to the hotels.

Monica DiCenso

Okay. Any questions from the audience? Or else, I'll keep going? Okay.

Maybe you guys can talk about just the current operating environment on consumer traveler and just hotel perspective, speaking to myself how these devices give movies on and things like that, selling packages?

Frank Elsenbast

Sure. Overall the occupancy rates have been lifting since the recession was really took hold in 2009-2010. I think travelers are still cost conscious. I know corporations are it's not back to the good old days except for maybe JPMorgan maybe that's kind of different situation.

As we launched our diversification initiatives five years ago along broadening our base with a basic theories. We already have one core relationship with the hotel customer because of the interactive, VOD service. How can we sell more and more services to that customer, which gives us more revenue opportunities leverages our fixed cost.

One of the primary reasons than just good business was, we also, now we face some headwinds when it comes to how consumers or consuming media want to consume media et cetera. So we have some distinct advantages of about having the best screen in the room. So as you carry your iPad, whatever, we still have the, I think the research would be is consumers tend to go the best screen available at any given time. If you are at a smaller screen or larger screen, so we do have the big screen.

We have the earliest window, so the content that's available from a movie-perspective on the iPad is generally 60 to 90 days after we have it available in our hotel room. So we have a special window with the airline industry that the studios have basically created and preserved for 30, 40 years and about 60% to 65% of the revenue we generate on any given first win title is within that two-month window before it goes to DVD and/or streaming that would happen in over 90 days thereafter.

And if you think all the people who are buying content from us, the VOD in a hotel room or VOD channel, so to speak is the fifth most watched channel in the hotel room by number of people and length of view. So it's the broadcast networks first and then the HBO Showtime are right around us.

So I think it shows that we do provide a special and niche programming that the mass markets have seen and one who see in the theater didn't see and don't want o wait for and our marketing picture over this past year really started to build in this why wait, treat yourself. We also have created different price tiers in response.

It used to be all the titles were in the mid-teens. Now we have tittles starting as low as 4$.99, are promoting that to have a tier around $10 tittles and then in the mid-teens for the newest content that's only available in our rooms.

We find that about 60% of our guest are going through the menu that says as low as $4.99 looking at the lower rate tittles but then they end up buying the higher priced tittles because when you see I've already seen all those things. So it turns out I haven't seen that, it’s $15 but I'm on the road, I deserve a little treat, and we market around that, stay in the room service or treat yourself.

Family travel also when it comes to it's one price for the entire family. So summer season tend to be strong for us. So those are the from the standpoint of the kind of the competition within the space and then of course with the mobile app we're also trying to make our services beyond just entertainment. So it's really an indispensible app that travelers want, because what's happening here, you know where the restaurants are, find the map, helps you with your hotel stay. So that whole experience is really where we're going. I think we're making some very nice profits.

Question-and-Answer Session

Unidentified Analyst

(Inaudible) headway in Envision is very high end hotels and what not, but you still have this other core basic room base that's been trading away over time. At what point do you see the nexus starting to cross between the world we're in terms of just the trading, the gains you are seeing on the full line Envision.

Frank Elsenbast

Sure. Our room base today is about 20% is in the midscale hotel rooms. Three of four years ago that was about 40%. So the kind of the movement within the midscale and economy I should put in that same bucket as last year was a larger share for (Inaudible) and mostly that came out from that base that from a pure VOD revenue perspective those rooms on average generated about 40% to 45% less than our average room, tended to be smaller, tended to be in that mid scale and their movement was they were looking for basic TV services only, high-def basic TV which most of that business that went to the local cable company and not to another interactive provider.

This year one of our biggest focuses of the company is to reduce the amount of rooms leaving the system, because we would love to give if they want the interactive, which actually keeping the interactive helps subsidize the cost of cable, the basic channels, whatever the commission they earn from guest purchases they want to think about it netting down the cost of HBO. So we have a very strong focus on that this year.

Our churn rate, so to speak, in the first quarter was down about half of what the rate we experienced in the third and fourth quarter of last year so directionally it's moving in the right direction. It's I guess, I would characterize it as more of a turning a ship than being able to pivot on a dime but we have a big focus there and we'd expect that that is going to go towards zero, and then the other thing that has been missing in the hotel industry for the past four years or so has been new construction and new supply that we can serve.

In the past, we would add 50,000 to 70,000 rooms per year. That basically has dried up in the past and over the next couple of years that will start to pick up somewhat. Then the other area where we expect growth to come out of would be the gaming market, so the casino hotel market. Our one underpenetrated space in the U.S. market is, Vegas, Reno, Tahoe, Atlantic City. There was a subsidiary or is a subsidiary of Cox Cable which owns the Las Vegas cable plant that used to buy systems from third-parties and put interactive into the casino hotels.

So you see they don't have their own technology and it seems that their interest in the space has been weaning somewhat. We do have a have a big focus on the gaming market to gain market share there and net new rooms to our base. So I think taking all those together, room counts will, that curve is bending and will continue to bend and I would that I'll start to go positive, it's going to take out some time, but I'm hoping it will. I've been there before. I know we can get there.

Monica DiCenso

Anybody else from the audience?

I want to touch on something you said earlier about firms being bought early. We had some studios here talking about how they expect windows to compress over time wondering how you guys deal with that as your relations with the studios and (inaudible) change and you have to pay more or something for that access.

Scott Petersen

Right. Well, if anything, I think everybody everything is compressing forward. So five years ago, we didn't get title 60 days after they were released, we got them a 70 to 75 days, and then they were 70 or 75 days before went to DVD. We're all kind of moving forward on that.

I would say with Magnolia Pictures, (Inaudible) organization, we actually have most of their tittles on the same day and date, and if fact we've done 30 days in advance of theatrical release. So there's been a situation where you could use the hotel industries advanced marketing.

The key factor for us I think is the sooner we get it, the better it is for us, because people who are buying the films in the hotel space they are looking for that alternative to the theater because they don't have time to go to theater. It's too much hustle, babysitters, lines, all those things. So, if we would have all the tittles on the first day that would assist us in our revenues. One of those where, there was a test year it was two years ago, and I lose track of time, where DIRECTV did some examples of actually hotel window tittles in the home. Price point was right around $30, and I don't think that, it was not successful.

Monica DiCenso

That was well, too steep.

Scott Petersen

Well, too steep, and then the studios (Inaudible) then how many tickets I'll earn. Do I lose in the theater fight if I provide that opportunity in the home sooner? So it's a delicate balance that I know the studios are strolling with us. We do represent, and of course our tickets generally are running, now they have tickets around mid teens. So it's a very nice lucrative window for them, so I think that just provide us a lot of practical protection over time.

Monica DiCenso

It makes sense. We can just jump into free cash flow plans for the audience for next two years? I think that’s a fair question.

Frank Elsenbast

The business does throw off a lot of cash and in addition to paying down our debt we also are reengaging on upgrading high-definition by rooms. So we've been running capital spending was running at about $20 million a year for the last couple of years and we do expect that to pick up as we accelerate the rate of high-definition rooms installed. So we'd see a higher percentage going to our HD upgrades and there is also a capital investment to launch the advertising network as well. So we'll see more investment in our rooms versus what we had probably since 2008 through 2011.

Monica DiCenso

Okay, and just looking at your balance sheet you can go back a couple of years, could you kind of talk about where you are today versus than what's an optimal leverage and structure for that?

Frank Elsenbast

So, we ended the first quarter with about $350 million in debt outstanding. Our leverage ratio is about 3.6, and we think that an optimal leverage ratio for us is probably around three or little below three. I think it does make sense for the business to carry a certain amount of debt given the long-term contracts that we've got and just a lower cost to capital. So I think we will continue to de-lever but that that should leave plenty of cash flow for the increased investment that we see over the next four years really is probably the time period where we would upgrade the majority of our rooms to high-definition.

Monica DiCenso

Okay, and outside of the HD upgrades, and I know you won't talk about acquisition, per se, are there any areas you think you may want to get into be of interest where this and competitors. You already mentioned Vegas and what's going on there into the casino hotels?

Frank Elsenbast

I'd say there is a handful of little competitors out there that have an IP solution that we look at occasionally but clearly we haven't bidden on any of those. I would say for us that is technology that we have developed as well and we are integrating with our base system for us and unless there is a large customer base that comes along with that, I'm not sure it really make sense for us, and as Scott said, we've got 85% market share. There's not anybody out there that has a meaningful footprint that we could acquire.

Monica DiCenso

Okay. If we focus a lot of the conversation about the hotel side, which is obviously the bulk of your business, but maybe just jumping back to healthcare and where do you see the big opportunities there for growth and what do you think that business looks like in a few years?

Frank Elsenbast

Well, right now we're at 15,000, 16,000-bed, so it's a pretty small business. The U.S. market has 900,000 hospital beds in it. We think our addressable market is 400,000 to 500,000 beds and right now again this is not a market that has a big competitor out there. It is largely underserved. There's probably about two or three competitors with a similar footprint to ours. So I think there is a lot of room for organic growth within the industry and what we think will impact it is as healthcare reform gets rolled out hospitals are under more pressure to improve patient engagement, patient education, reduce re-admittance. Our system it leverages a technology that we have in the hospitality space, but it's a great tool for educating and entertaining a patient as well. So to the extent they can watch a video about their knee surgery, answer certain questions to make sure they understand the procedure and what they need to do in recovery. They've shown great results for that.

Monica DiCenso

Anything else from the audience? Thanks for coming. Appreciate it.

Frank Elsenbast

Thank you very much.

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