The following discussion should be read in conjunction with our Consolidated Financial Statements, including the notes thereto, appearing elsewhere herein.

Special Note Regarding Forward-Looking Statements

Certain statements in this report or documents incorporated herein by reference constitute "forward-looking statements." When used in this report, the words "intends," "expects," "anticipates," "estimates," "believes," "goal," "no assurance" and similar expressions, and statements which are made in the future tense or refer to future events or developments, are intended to identify such forward-looking statements. Such forward-looking statements are subject to risks, uncertainties and other factors which could cause the actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. In addition to the risks and uncertainties discussed elsewhere in this Report and in Item 1A of our most recent Annual Report on Form 10-K for the year ended December 31, 2011 and filed on March 15, 2012, in any prospectus supplement or any report or document incorporated herein by reference, such factors include, among others, the following:

† the effects of general economic and financial conditions;
† the economic condition of the hospitality industry, which can be particularly affected by general economic and financial conditions, as well as by factors such as high gas prices, levels of unemployment, consumer confidence, acts or threats of terrorism and public health issues;
† decreases in hotel occupancy, whether related to economic conditions or other causes;
† competition from providers of similar services and from alternative sources;
† changes in demand for our products and services;
† programming costs, availability, timeliness and quality;
† technological developments by competitors;
† developmental costs, difficulties and delays;
† relationships with clients and property owners;
† the impact of covenants contained in our credit agreement, compliance with which could adversely affect capital available to finance growth, and the violation of which would constitute an event of default;
† changes to government laws and regulations and industry compliance standards;
† potential effects of litigation;
† risks of expansion into new markets and territories;
† risks related to the security of our data systems; and
† other factors detailed, from time to time, in our filings with the Securities and Exchange Commission.

These forward-looking statements speak only as of the date of this report. We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

Executive Overview

We are the largest provider of interactive media and connectivity services to the hospitality industry in the United States, Canada and Mexico. Our primary offerings include guest-paid entertainment, such as on-demand movies, advertising services and hotel-paid services, including cable television programming, Internet access services and interactive applications through our Envision and Mobile platforms. As of June 30, 2012, we provided interactive media and connectivity services to approximately 1.6 million hotel rooms in North America and in select international markets, primarily through local or regional licensees. In addition, we also have a growing presence in the healthcare market, where we sell and maintain interactive television systems which provide on-demand patient education, information and entertainment to healthcare facilities throughout the United States. As of June 30, 2012, our systems were installed in 75 healthcare facilities, representing approximately 17,600 beds.

The Company experienced a 13.0% decrease in total revenue, to $92.8 million for the second quarter of 2012, a decrease of $13.9 million compared to the second quarter of 2011. The decrease was primarily due to a 12.2% decline in the average number of Guest Entertainment rooms served and also by a 1.4% decline in Hospitality and Advertising Services revenue per room. Guest Entertainment revenue per room decreased 13.8% quarter over quarter, while revenue generated from non-Guest Entertainment services increased 13.5%. Revenue generated from non-Guest Entertainment services comprised 53.7% of total revenue for the current quarter.

Guest Entertainment revenue decreased $13.8 million or 24.3%. The decrease was driven by the 12.2% reduction in the average number of Guest Entertainment rooms served period over period and a 13.4% decline in movie revenue per room. We are focused on stabilizing our room base and Guest Entertainment revenue.

Hotel Services revenue was $32.2 million in the current quarter, a decline of 5.8% over the prior year quarter, primarily due to a 9.6% decline in the number of rooms receiving cable television programming services. On a per-room basis, Hotel Services revenue increased 7.0% quarter over quarter, driven primarily by an increase in the number of rooms receiving high definition ("HD") cable television programming services and the expiration of contracts with unfavorable terms. System Sales and Related Services revenue per room improved 44.5%, related to television programming systems sales. Our advertising services subsidiary generated revenue of $1.4 million, a decrease of 36.1% compared to the second quarter of 2011, as we continue the transition of our advertising platform from analog to an expanded HD platform. Our healthcare subsidiary revenue was stable at $3.2 million quarter over quarter.

Our total direct costs decreased $5.0 million or 8.3%, to $55.1 million in the second quarter of 2012 as compared to $60.1 million in the second quarter of 2011. The decrease in total direct costs was driven by lower sales volume in Guest Entertainment and Hotel Services, resulting in lower hotel commissions, royalties and programming fees. Advertising Services direct costs were lower due to the transition to our new advertising platform. Total direct costs as a percentage of revenue increased to 59.4% for the second quarter of 2012, compared to 56.4% for the prior year period, due primarily to a change in the mix of products and services sold.

System operations expenses and selling, general and administrative ("SG&A") expenses decreased $1.6 million or 7.6% quarter over quarter, to $19.0 million in the second quarter of 2012 compared to $20.6 million in the prior year quarter. Factors driving the improvement period over period include reduced system repair costs, professional services expenses and content distribution costs, as well as reduced payroll-related and facilities costs as a result of expense reduction initiatives. Depreciation and amortization expenses were $18.0 million in the second quarter of 2012 versus $17.8 million in the second quarter of 2011.

The declines in Guest Entertainment revenue and room base during 2012 caused the Company to reassess and update our financial plans to reflect these changes in our Hospitality business. These matters were qualitative factors impacting the recovery of our Hospitality reporting unit goodwill, and triggered an assessment of goodwill on an interim basis during the second quarter of 2012. As a result of our impairment test, we recorded a non-cash asset impairment charge in our Hospitality segment of $92.6 million related to goodwill. In addition, we recorded a $1.4 million non-cash asset impairment charge related to intangible assets in our Hospitality segment under depreciation and amortization expenses. See Note 3 to the Consolidated Financial Statements. As a result of the factors noted above, operating loss was $95.5 million in the second quarter of 2012 compared to operating income of $8.2 million in the prior year quarter.

We generated $28.6 million of cash from operating activities as compared to $8.4 million in the second quarter of 2011. The increase in cash from operations was related to an increase in accounts payable, the result of extending terms with our vendors. Cash used for capital investments was $10.9 million in the second quarter of 2012, compared to $6.0 million in the second quarter of 2011. In June 2012, we made the required quarterly payment of $2.5 million on our term loan and prepaid $17.0 million.

Our immediate priorities are to address our continued room churn and stabilize our Guest Entertainment revenue. We are working to stabilize the room base, as room loss impacts our financial results and our ability to sell additional value-added services. Our Guest Entertainment revenue is impacted by several factors, including the availability of alternative content and the proliferation of mobile devices, as well as the look and operational performance of our interactive systems. We plan to stabilize our Guest Entertainment business by exploiting our advanced Hollywood content window, simplifying our menu screens to facilitate more movie purchases, enhancing our pricing and promotional strategies and standardizing our operating systems.

In addition, we remain focused on following strategic initiatives:

†          continued roll out of HD and Envision systems;

†          launch of the expanded high definition Advertising platform;

†          continued growth of our Healthcare business; and

†          monetization of the LodgeNet Mobile App.

We continued to make progress on certain strategic initiatives. During the quarter ended June 30, 2012, our Envision platform was installed in over 18,000 rooms, bringing the total rooms under contract to 88,000. Our LodgeNet Mobile App is available in over 610,000 rooms as of June 30, 2012. During the quarter, we upgraded or installed approximately 15,500 rooms with HD interactive systems. These additional rooms brought us to over 340,000 HD rooms installed at the end of the second quarter, representing 24.1% of our Guest Entertainment room base. Our HD platform continues to generate over 60% more revenue per room versus our analog base. The average cost to install a HD room was $143 in the current quarter compared to $140 in the prior year quarter.

Hospitality and Advertising Services Businesses

Our Hospitality and Advertising Services businesses include television content sold to hotels and/or the respective hotels' guests. The products can include interactive video-on-demand ("VOD"), cable television programming, Internet services or advertising services, and have an analogous consumer base. All products and services are delivered through a proprietary system platform having related satellite communication technology, and are geared towards the hotels and their guests.

Guest Entertainment (includes purchases for on-demand movies, network-based video games, music and music videos and television on-demand programming). One of our main sources of revenue, generating 46.3% of total revenue for the quarter ended June 30, 2012, is providing in-room, interactive guest entertainment, for which the hotel guest pays on a per-view, hourly or daily basis.

Our total guest-generated revenue depends on a number of factors, including:

† The number of rooms on our network. Our ability to maintain our room base is dependent on a number of factors, including the number of newly constructed hotel properties or properties serviced by a competitor, and the attractiveness of our technology, service and support to hotels currently serviced by us.

† The occupancy rate at the property. Our revenue also varies depending on hotel occupancy rates, which are subject to a number of factors, including seasonality, general economic conditions and world events, such as terrorist threats or public health issues. Occupancy rates for the properties we serve are typically higher during the second and third quarters due to seasonal travel patterns. We target higher occupancy properties in diverse demographic and geographic locations in an effort to mitigate occupancy-related risks.

† The buy rate of hotel guests. This is impacted by a number of issues, some of which are not under our control. Specific issues impacting buy rate include:

† The number of rooms equipped with our interactive high-definition television ("iHDTV") systems. We typically earn higher revenue from a property when we convert it to our iHDTV platform. Our ability to expand our iHDTV room base is dependent on a number of factors, including availability of capital resources from the hotels and us to invest in HD televisions and equipment. We are focused on accelerating the installation of our iHDTV systems as hotels increase their purchase of HD televisions.

† The popularity, timeliness and amount of content offered at the hotel. Our revenues vary, to a certain degree, with the number, timeliness and popularity of movie content available for viewing, and whether the content is presented in digital or analog format. Historically, a decrease in the availability of popular movie content has adversely impacted revenue, and the availability of high definition content has increased revenue. Although not completely within our control, we seek to program and promote the most popular available movie content and other content to maximize our revenue and profitability.

† The price of the service purchased by the hotel guest. Generally, we control the prices charged for our products and services, and manage pricing in an effort to maximize revenue and overall profitability. We establish pricing based on such things as the demographics of the property served, the popularity of the content and overall general economic conditions. Our technology enables us to measure the popularity of our content and make decisions to best position such content and optimize revenue from such content.

† The effectiveness of our promotional and marketing campaigns. We believe we can promote increased browsing activity through: tiered pricing; an improved user interface and navigational experiences for hotel guests; and enhanced merchandising and marketing of the latest content in our exclusive hotel window. By increasing browsing activity, attracting new buyers and lifting buy rates, we believe we can improve theatrical movie revenue per room. Certain merchandising and promotional pricing programs may, in some cases, have a negative impact on revenue before they are modified or suspended.

† The availability of alternative programming and portable devices. We compete directly for customers with a variety of other content providers delivering content across different portable devices. Competing content providers include cable and satellite television companies; Internet streaming services, including Netflix, Hulu and Amazon; and Internet websites which provide access to free adult content, including streaming video. These sources of alternative content can be delivered across a variety of portable viewing devices, such as laptop computers, smart phones and iPads®.

† Consumer sentiment. The willingness of guests to purchase our entertainment services is also impacted by the general economic environment and its impact on consumer sentiment. Historically, such impacts were not generally material to our revenue results; however, since the last half of 2008, economic conditions have had a significant, negative impact on our revenue levels.

The primary direct costs of providing Guest Entertainment are:

† license fees paid to major motion picture studios, which are variable and based on a percent of guest-generated revenue, for non-exclusive distribution rights of recently released major motion pictures;

† commissions paid to our hotel customers, which are also variable and based on a percent of guest-generated revenue;

† license fees, which are based on a percent of guest-generated revenue, for television on-demand, music, music videos, video games and sports programming; and

† fixed monthly Internet connectivity costs.

Hotel Services (includes revenue from hotels for services such as television channels and recurring Internet service and support to the hotels). Another major source of our revenue is providing cable television programming, hotel services applications on our Envision and Mobile platforms and Internet access services to the lodging industry, for which the hotel pays a fixed monthly fee.

† Cable Television Programming. We offer a wide variety of satellite-delivered cable television programming paid for by the hotel and provided to guests at no charge. The cable television programming is delivered via satellite, pursuant to an agreement with DIRECTV®, and is distributed over the internal hotel network. It typically includes premium channels such as HBO and Showtime, which broadcast major motion pictures and specialty programming, as well as non-premium channels, such as CNN and ESPN. With the launch of the high-definition configuration of our interactive television system, we also began offering high-definition cable television programming to the extent available from broadcast sources and DIRECTV.

† Envision. The Envision platform is our next generation, cloud-connected interactive television platform. This is considered our standard platform and, as of June 30, 2012, we had 177 systems installed and providing services to approximately 62,500 rooms, and had over 88,000 rooms under contract. Envision supports extensive branding, as well as a variety of interactive applications designed to assist hoteliers to increase on-premise revenues and save operating costs. In addition, Envision enhances the guest experience by allowing expanded purchase options, to enable purchases of certain services through the interactive television system using personal credit cards or their hotel folio. The Envision system also features traveler-centric guest applications, including real time flight data, local information and ecommerce opportunities, such as purchasing tickets for local area attractions and events, reserving tee times and making restaurant reservations. Envision's subscription apps and transactional-based revenues represent an ongoing revenue growth opportunity for the Company as we continue to expand our Envision room base and introduce additional apps. As of June 30, 2012, 41.1% of the installed Envision rooms are subscribing to premium apps.

† Mobile Applications. In 2011, we developed the software and technology to deliver the LodgeNet Mobile App, which brings together guest entertainment, hotel services and local area guide information. We launched the LodgeNet Mobile App in January 2012 and, as of June 30, 2012, it is available in over 610,000 rooms. The app provides travelers with in-room television control and on-demand content discovery capabilities, along with hotel and local area information and services. For hotels, the app can be utilized to provide guests with customized brand and property information services. We expect to drive new revenues from hotels as they subscribe for enhanced mobile services, such as making it possible for a guest to check out of their room or order room service by the pool on their mobile device. The new app will also create a one-to-one marketing relationship with the consumer, where we can drive incremental revenues from advertising, promotional campaigns or from transactional revenue, such as ticket purchases or restaurant reservations.

† Internet Service and Support. We also design, install and operate wired and wireless Internet systems at hotel properties. These systems control access to the Internet, provide bandwidth management tools and allow hotels to charge guests or provide the access as a guest amenity. Post-installation, we generate recurring revenue through the ongoing maintenance, service and call center support services to hotel properties installed by us and also to hotel properties installed by other providers, or through a revenue-share model in which hotel guests pay for Internet and we pay a commission to our hotel customers. While this is a highly competitive area, we believe we have important advantages as a result of our proactive monitoring interface with hotel systems to improve up time, existing hotel customer relationships and our nationwide field service network.

System Sales and Related Services. We also generate revenue from other products and services within the hotel and lodging industry, including sales of interactive television and Internet access systems, HD programming reception equipment, Internet conference services and professional services, such as network design, project management and installation services.

Advertising Services. We deliver advertising-supported media into select hotel segments, from which we earn revenue from the sale of traditional television advertising, place-based digital advertising and promotional marketing solutions. The demographic and professional profile of the traveler within our room base tends to have characteristics we believe are attractive to consumer marketing organizations. By approaching guests with relevant messaging when they are in the comfort of a hotel room, free of distractions, advertisers have a prime opportunity to capture the attention of and connect with these desired consumers. In addition to market demands, our revenue is also dependent on rooms available to promote customer products and services. As of June 30, 2012, we provided advertising and media services to approximately 1.1 million hotel rooms.

During the second quarter of 2012, we continued the transition of our ad insertion business from our analog platform to an expanded high definition platform with over 20 channels, capable of inserting targeted advertising into an existing nationwide direct-broadcast satellite signal. This transition, which will involve a substantial capital investment, will enable us to deliver our advertising content in a more cost-effective manner across a much larger segment of our existing room base, expanding from 300,000 rooms to 500,000 rooms. Successful completion of this transition is dependent upon our entering into a strategic alliance or other relationship with an entity which can provide the funds for the required capital investment. As an initial step of this transition, we discontinued certain services provided through the analog platform in the first quarter of 2012. Our new high definition platform, targeted to begin operations in 2013, will have the scale to attract national advertisers and will also have the ability to target specific designated market areas and zip codes. Longer term, we believe our new advertising platform will have the potential to significantly enhance our ability to monetize the advertising value of our extensive room base and valuable guest demographic.

Key Metrics:

Rooms Served

One of the metrics we monitor within our Hospitality and Advertising Services businesses is the number of rooms we serve with our various services. As of June 30, we had the following number of rooms installed with the designated service:

                                                           June 30,
                                                       2012        2011
Total rooms served (1)                               1,552,701   1,753,132
Total Guest Entertainment rooms (2)                  1,417,932   1,608,079
Total iHDTV rooms (3)                                  341,855     285,626
Percent of Total Guest Entertainment rooms               24.1%       17.8%
Total Envision rooms (4)                                62,498       3,785
Percent of Total Guest Entertainment rooms                4.4%        0.2%
Total Mobile rooms (5)                                 610,350           -
Percent of Total Guest Entertainment rooms               43.0%           -
Total Cable Television Programming (FTG) rooms (6)     894,373     989,133
Percent of Total Guest Entertainment rooms               63.1%       61.5%
Total Broadband Internet rooms (7)                     114,364     164,812

(1) Total rooms served include rooms receiving one or more of our services, including rooms served by international licensees.
(2) Guest Entertainment rooms, of which 93.2% were digital as of June 30, 2012, receive one or more Guest Entertainment services, such as movies, video games, music or other interactive and advertising services.
(3) iHDTV rooms are equipped with high-definition capabilities.
(4) Guest Entertainment rooms installed with our Envision interactive platform.
(5) Guest Entertainment rooms compatible with the LodgeNet Mobile App.
(6) Cable television programming (FTG) rooms receive basic or premium cable television programming.
(7) Represents rooms receiving high-speed Internet service.

High Definition Room Growth

We also track the penetration of our interactive, high-definition television ("iHDTV") system, since rooms equipped with iHDTV services typically generate higher revenue from Guest Entertainment and Hotel Services than rooms equipped with our analog systems. iHDTV room growth occurs as we install our iHDTV system in newly contracted rooms or convert certain existing rooms to the iHDTV system in exchange for contract extensions. The installation of an iHDTV system typically requires a capital investment by both the Company and the hotel operator. During the past three years, iHDTV growth has been constrained by reduced hotel capital spending on HD televisions, given the negative impact of the economy on the hospitality industry. We have increased capital investment levels and are working jointly with our best hotel customers to continue the rollout of high-definition systems within the operating and capital plans of the hotels and the Company. We installed our iHDTV systems in the following number of net new rooms as of June 30:

                                                    June 30,
                                                  2012     2011

Net new iHDTV rooms for the three months ended   15,488   12,383
Net new iHDTV rooms for the six months ended     32,394   15,242

iHDTV rooms, including new installations and major upgrades, are equipped with high-definition capabilities.

Capital Investment Cost Per Installed Room

The average investment cost per room associated with an installation can fluctuate due to engineering efforts, component costs, product segmentation, cost of assembly and installation, average number of rooms for properties installed, certain fixed costs and hotel capital contributions. The following . . .