GOLDEN ENTERTAINMENT, INC. - Quarter Report: 2007 April (Form 10-Q)

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

 

 

Form 10-Q

 

 

Commission File No. 0-24993

 

LAKES ENTERTAINMENT, INC.

(Exact name of registrant as specified in its charter)

 

 

 

(952) 449-9092

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer o     Accelerated Filer þ     Non Accelerated Filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

As of May 8, 2007, there were 24,331,675 shares of Common Stock, $0.01 par value per share, outstanding.

 

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

INDEX

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Condensed Consolidated Balance Sheets

April 1, 2007 and December 31, 2006

 

 

See notes to unaudited condensed consolidated financial statements.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Condensed Consolidated Statements of Earnings (Loss) and Comprehensive Earnings (Loss)

 

 

See notes to unaudited condensed consolidated financial statements.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Condensed Consolidated Statements of Cash Flows

 

 

See notes to unaudited condensed consolidated financial statements.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

 

The unaudited condensed consolidated financial statements of Lakes Entertainment, Inc., a Minnesota corporation (“Lakes” or the “Company”), have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) applicable to interim financial information. Accordingly, certain information normally included in the annual financial statements prepared in accordance with accounting principles generally accepted in the United States has been condensed or omitted. As of April 1, 2007, Lakes owned approximately 61% of WPT Enterprises, Inc. (“WPTE”). Lakes’ unaudited condensed consolidated financial statements include the results of operations of WPTE, and substantially all of Lakes’ revenues for the periods reported have been derived from WPTE’s business. For further information, please refer to the annual audited consolidated financial statements of the Company, and the related notes included within the Company’s Annual Report on Form 10-K for the year ended December 31, 2006, previously filed with the SEC on March 15, 2007, from which the balance sheet information as of that date is derived.

 

In the opinion of management, all adjustments considered necessary for a fair presentation have been included, consisting only of normal recurring adjustments. The results for the current interim period are not necessarily indicative of the results to be expected for the full year.

 

Certain minor reclassifications to amounts previously reported have been made to conform to the current period presentation. These reclassifications had no effect on net earnings (loss) or shareholders’ equity as previously presented.

 

 

At April 1, 2007 and December 31, 2006, long-term assets related to Indian casino projects are primarily related to three separate projects for the Pokagon Band of Potawatomi Indians (“Pokagon Band”), Shingle Springs Band of Miwok Indians (“Shingle Springs Tribe”) and the Jamul Indian Village (“Jamul Tribe”) as indicated in the following tables (in thousands):

 

 

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

Pokagon Band.

 

On March 2, 2007 (the “Settlement Date”), Lakes contracted with a group of investors for their participation in the loans made by Lakes to the Pokagon Band for the development of the Four Winds Casino Resort (“Pokagon Casino”), which loans have been assumed by the Pokagon Gaming Authority. As of the Settlement Date, the face value of Lakes’ notes receivable was approximately $104.2 million, including accrued interest of approximately $33.0 million. On the Settlement Date, Lakes transferred 100% of the Pokagon Gaming Authority loans to the participants in exchange for cash proceeds of approximately $102.1 million based upon the accreted value of the Pokagon Gaming Authority loans less a two percent discount and incurred transaction fees of approximately $1.1 million. The transaction fees were recorded as a reduction of net realized and unrealized gains on notes receivable in the accompanying unaudited condensed consolidated statements of earnings (loss) and comprehensive earnings (loss). Accordingly, based upon the previously recorded estimated fair value of the notes at December 31, 2006, Lakes realized a gain of $0.5 million as a result of the consummation of the participation agreement.

 

The participation agreements also allow the participants to pledge or exchange the notes receivable and Lakes no longer has any rights or obligations to the loans and is isolated, even in default, from liability. As a result, the Pokagon notes receivable participation transaction has been treated as a sale pursuant to Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities (“SFAS No. 140”). The sale does not have any effect on Lakes’ related management agreement with the Pokagon Band.

 

The participation agreements entitled Lakes to appoint an agent for purposes of servicing and administering of the loans. Lakes has appointed Bank of America, N.A. (“BofA”) as it agent for purposes of servicing and administering of the loans. Lakes pays BofA an annual fee of approximately $20,000 for this service.

 

Shingle Springs Tribe.

 

The following table provides the key assumptions used to value the notes receivable at estimated fair value (dollars in thousands):

 

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

 

 

Unrealized losses on notes receivable related to the Shingle Springs Tribe casino project were $0.9 million for the three months ended April 1, 2007, and unrealized gains on notes receivable related to the Shingle Springs Tribe casino project were $1.1 million for the three months ended April 2, 2006, respectively, and are included in the accompanying unaudited condensed consolidated statements of earnings (loss) and comprehensive earnings (loss).

 

Jamul Tribe.

 

The following table provides the key assumptions used to value the notes receivable at estimated fair value (dollars in thousands):

 

 

The net unrealized gain on notes receivable related to the Jamul Tribe casino project was $0.5 million and $6.4 million for the three months ended April 1, 2007 and April 2, 2006, respectively, and is included in the accompanying unaudited condensed consolidated statements of earnings (loss) and comprehensive earnings (loss).

 

 

On March 2, 2007, Lakes repaid its $105 million credit agreement with BofA and certain lenders under a financing facility (the “Credit Agreement”), using proceeds received from the Pokagon notes receivable participation transaction (Note 2) in addition to amounts previously included in a restricted interest reserve account related to the Credit Agreement. Lakes incurred approximately $1.1 million in a prepayment penalty associated with the payoff of the Credit Agreement. The prepayment penalty, along with the remaining unamortized portion of the related debt issuance costs and unamortized discount of approximately $1.8 million and $0.9 million, respectively, were written off, which resulted in a loss on extinguishment of debt of approximately $3.8 million, which has been recorded by Lakes in the accompanying unaudited condensed consolidated statement of earnings (loss) and comprehensive earnings (loss).

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

 

 

The following table summarizes the consolidated share-based compensation expense related to employee stock options and stock purchases and non-vested shares under SFAS 123(R) for the three months ended April 1, 2007 and April 2, 2006, respectively, which was allocated as follows:

 

 

For the three months ended April 1, 2007 and April 2, 2006, no income tax benefit was recognized in the Company’s unaudited condensed consolidated statement of earnings (loss) and comprehensive earnings (loss) for share-based compensation arrangements. Management assessed the likelihood that the deferred tax assets relating to future tax deductions from share-based compensation will be recovered from future taxable income and determined that a valuation allowance is necessary to the extent that management currently believes it is more likely than not that tax benefits will not be realized. Managements’ determination is based primarily on historical earnings volatility, the relatively short operating history of WPTE, and the Company’s current stages of planned operational activities.

 

The Company and WPTE use a Black-Scholes option-pricing model to value stock options, which requires the consideration of historical employee exercise behavior data and the use of a number of assumptions including volatility of the companies’ stock prices, the weighted average risk-free interest rate, and the weighted average expected life of the options. As the companies do not pay dividends, the dividend rate variable in the Black-Scholes model is zero. The following values represent the average per grant for the indicated variables used to value options granted during the three months ended April 1, 2007 and April 2, 2006, and no significant changes to the 2007 assumptions are expected during the remainder of 2007.

 

Lakes’ stock option plans:

 

 

 

 

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

 

 

The following table summarizes Lakes’ stock option activity during the three months ended April 1, 2007 and April 2, 2006:

 

 

The following table summarizes significant ranges of Lakes’ outstanding and exercisable options as of April 1, 2007:

 

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

The aggregate intrinsic value in the preceding table represents the total pre-tax intrinsic value, based on Lakes’ closing stock price of $11.15 on March 30, 2007, which would have been received by the option holders had all option holders exercised their options as of that date. The total intrinsic value of options exercised during the three months ended April 1, 2007 and April 2, 2006 was $0.5 million and $2.0 million, respectively. As of April 1, 2007, Lakes’ unrecognized share-based compensation related to stock options was approximately $2.8 million, which is expected to be recognized over a weighted-average period of 1.5 years.

 

WPTE stock option plan:

 

 

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

 

The following table summarizes WPTE stock option activity during the three months ended April 1, 2007 and April 2, 2006:

 

 

The following table summarizes significant ranges of WPTE outstanding and exercisable options as of April 1, 2007:

 

 

The aggregate intrinsic value in the preceding table represents the total pre-tax intrinsic value, based on WPTE’s closing stock price of $5.14 on March 30, 2007, which would have been received by the option holders had all option holders exercised their options as of that date. No options were exercised during the three months ended April 1, 2007. As of April 1, 2007, total compensation cost related to non-vested share-based options not yet recognized was $4.0 million, which is expected to be recognized over the next 31 months on a weighted-average basis.

 

 

For all periods, basic earnings (loss) per share is calculated by dividing net earnings (loss) by the weighted-average number of common shares outstanding during the applicable period. For the three months ended April 2,

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

2006, diluted earnings per share reflects the effect of all potentially dilutive common shares outstanding by dividing net earnings by the weighted-average of all common and potentially dilutive shares outstanding.

 

 

Lakes evaluated the ability to utilize deferred tax assets arising from net operating loss carryforwards, and other ordinary items and determined that a valuation allowance was appropriate at April 1, 2007 and December 31, 2006. Lakes evaluated all evidence and determined net losses (excluding net realized and unrealized gains and losses on notes receivable) generated over the past five years outweighed the current positive evidence that the Company believes exists surrounding its ability to generate significant income from its long-term assets related to Indian casino projects. Therefore, the Company recorded a 100% valuation allowance against its deferred tax assets related to net operating losses and other ordinary items at April 1, 2007, and December 31, 2006, which is the primary reason that the Company’s effective tax rate is not comparable to the statutory federal rate of 35%.

 

Lakes has recorded deferred tax assets related to capital losses. The realization of these benefits is dependent on the generation of capital gains during the applicable carryforward periods. The Company believes it will have sufficient capital gains in the foreseeable future to utilize these benefits due to significant appreciation in its investment in WPTE, which has a minimal cost basis and could be sold at a substantial gain. The Company owns approximately 12.5 million shares of WPTE common stock valued at approximately $64 million as of April 1, 2007 based upon the closing stock price as reported by NASDAQ on March 30, 2007 of $5.14. Accordingly, the Company has not established a valuation allowance for these deferred tax assets.

 

The Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), on January 1, 2007, the beginning of the Company’s 2007 fiscal year. Lakes recognized a cumulative effect adjustment of $1.4 million to retained earnings as a result of adopting FIN 48. However, the adoption of FIN 48 did not materially effect net operating loss carry forwards, the related deferred tax assets and valuation allowance thereon, or the current quarter’s income tax provision.

 

As of April 1, 2007 and January 1, 2007, Lakes had unrecognized tax benefits of $11.4 million. If recognized these unrecognized tax benefits would impact the effective income tax rate. Interest related to unrecognized tax benefits are recorded in income tax expense. The total amount of accrued interest was $7.2 million and $6.9 million as of April 1, 2007 and January 1, 2007, respectively, and has not been included in the total unrecognized tax benefits amount discussed above. No amount has been accrued for penalties.

 

The Company’s unrecognized tax benefits relate to ongoing examinations for income and franchise tax matters. Specifically, Lakes is currently under audit by the Internal Revenue Service (“IRS”) for the fiscal years ended 2001 and 2000. Additionally, the Louisiana Department of Revenue maintains a position that Lakes owes additional Louisiana corporation income tax for the period ended January 3, 1999, and the tax years ended 1999 through 2001 and additional Louisiana corporation franchise tax for the tax years ended 2000 through 2002. Excluding these matters, Lakes is no longer subject to U.S. federal or state/local income tax examinations by tax authorities for years prior to 2003.

 

The Company believes it is reasonably possible that, within the next 12 months, it could recognize previously unrecognized tax benefits of between $0.6 million and $1.4 million as a result of the resolution of the IRS audit discussed above.

 

 

WPTE litigation.  On July 19, 2006, a legal action was commenced against WPTE by seven poker players (“Plaintiffs”) alleging, among other things, an unfair business practice of WPTE. On March 14, 2007 the Plaintiffs filed a motion for summary judgment in the case and on April 12, 2007 WPTE filed their opposition to the motion. The parties are currently engaged in discovery and a trial date has been set for April 1, 2008. WPTE does not expect

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

any material adverse consequences from this action. Accordingly, no provision has been made in the financial statements for any such losses.

 

Miscellaneous legal matters.  Lakes and its subsidiaries (including WPTE) are involved in various other inquiries, administrative proceedings, and litigation relating to contracts and other matters arising in the normal course of business. While any proceeding or litigation has an element of uncertainty, management currently believes that the final outcome of these matters is not likely to have a material adverse effect upon Lakes’ consolidated financial statements.

 

 

Lakes’ principal business is the development and management of gaming-related properties. Additionally, the Company is the majority owner of WPTE. Substantially all of Lakes’ and WPTE’s operations are conducted in the United States. Episodes of the World Poker Tour^® television series are distributed internationally by a third party distributor. Lakes’ segments reported below (in millions) are the segments of the Company for which separate financial information is available and for which operating results are evaluated by the chief operating decision-maker in deciding how to allocate resources and in assessing performance. The total assets in “Corporate and Eliminations” below primarily relate to Lakes’ short-term investments, deferred tax assets, Lakes’ corporate office building and construction in progress related to a Company-owned casino project in Vicksburg, Mississippi. Costs in “Corporate and Eliminations” below have not been allocated to the other segments because these costs are not easily allocable and to do so would not be practical.

 

 

 

From time to time the Company may elect to enter into derivative transactions to hedge exposures to interest rate fluctuations. The Company does not enter into derivative transactions for speculative purposes.

 

In conjunction with the March 2, 2007 extinguishment of the $105 million Credit Agreement (Note 3), Lakes’ related interest rate swap agreement was also terminated. The termination of the interest rate swap agreement resulted in additional interest expense of approximately $0.5 million which was recorded in the first quarter of fiscal 2007.

 

 

WPTE change in broadcast partner.  Travel Channel, LLC (“TRV” or “Travel Channel”) had until April 1, 2007 to exercise its option to broadcast Season Six of the WPT television series. TRV did not exercise this option. On April 2, 2007, WPTE entered into an agreement with the Game Show Network, LLC (“GSN”), pursuant to

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Condensed Consolidated Financial Statements — (Continued)

which GSN agreed to license Season Six for $300,000 per episode. The agreement also provides GSN options for Seasons Seven and Eight.

 

WPTE online gaming software and support agreement.  On April 23, 2007, WPTE entered into a three year software supply and support agreement (the “CryptoLogic Agreement”) with CryptoLogic Inc., and its wholly-owned subsidiary WagerLogic Limited, collectively referred to as “CryptoLogic”, pursuant to which CryptoLogic will operate an online gaming site for WPTE featuring a poker room and casino games utilizing its proprietary software, in exchange for a percentage of the revenue generated from the site. WPTE will be entitled to approximately 80% of net gaming revenues, from the operation of the site. WPTE will also be a member in a centralized online gaming network with several other licensees of CryptoLogic pursuant to which players will be able to play on WPTE’s branded gaming site on the online gaming network.

 

The CryptoLogic Agreement provides for the poker room to be operational and accessible to players by June 14, 2007, and by September 30, 2007, CryptoLogic is required to have five casino games available. WPTE also has an option, exercisable at any time prior to July 1, 2008, to require CryptoLogic to provide WPTE’s customers with access to a full suite of casino games within three months of such notice.

 

There is a one-time fee of $50,000 payable by WPTE for the initial preparation and launch of the site, and WPTE is required to pay a monthly fee of $7,500 for the management of tournaments, collusion detection, customer support and overall management of the poker room. In addition, WPTE is obligated to contribute 4% of poker room revenue for certain marketing initiatives.

 

As a result of the recent decision to move away from the internally-developed online gaming platform, WPTE will write-off certain property, equipment and other capitalized costs of approximately $2.0 million — $3.0 million during the second quarter of 2007. These assets consist primarily of software and computer equipment related to the online gaming site that WPTE was developing based on the CyberArts software platform.

 

Lakes stock warrant.  Pursuant to the terms and conditions of a financing agreement dated as of February 15, 2006 among Lakes, PLKS Funding, LLC and various subsidiaries of Lakes, PLKS Holdings, LLC (“PLKS”) was granted a warrant to purchase 1,250,000 common shares of Lakes at $7.50 per share (“Warrant”). During April 2007, PLKS exercised and purchased 102,500 shares underlying the Warrant at $7.50 per share and paid Lakes $0.8 million.

 

On May 4, 2007, Lakes and PLKS amended the exercise price of the Warrant (“Amendment”). The Amendment reduced the exercise price of the Warrant from $7.50 per share to $6.50 per share for the remaining 1,147,500 shares underlying the Warrant. In consideration for the reduced exercise price, PLKS agreed to exercise and purchase the remaining 1,147,500 shares underlying the Warrant for an aggregate exercise price of $7.5 million, which was paid to Lakes on May 7, 2007. Lakes is currently evaluating the potential effect this Amendment will have on its financial position and results of operations during the second quarter of 2007.

 

Overview

 

We develop, finance and manage Indian-owned casino properties. We currently have development and management agreements with five separate tribes for casino operations in Michigan, California, and Oklahoma, for a total of eight separate casino sites. We are also involved in other business activities including development of a non-Indian casino in Mississippi and the development of new table games for licensing to both Tribal and non-Tribal casinos. In addition, as of April 1, 2007, we owned approximately 61% of WPTE, a separate publicly held media and entertainment company. Our unaudited condensed consolidated financial statements include the results of operations of WPTE, and our revenues have been derived primarily from WPTE’s business.

 

WPTE creates internationally branded entertainment and consumer products driven by the development, production and marketing of televised programming based on gaming themes. WPTE created the World Poker Tour^®, or WPT, a television show based on a series of high-stakes poker tournaments that airs in the United States and has been licensed to telecast in more than 150 markets globally. WPTE also operates a real-money online gaming website which prohibits wagers from players in the United States and other restricted jurisdictions. WPTE currently licenses its brand to companies in the business of poker equipment and instruction, apparel, publishing, electronic and wireless entertainment, DVD/home entertainment, casino games, and giftware. WPTE is also engaged in the sale of corporate sponsorships. WPTE has three operating units:

 

WPT Studios.  WPTE’s multi-media entertainment division, generates revenue from the domestic and international licensing of broadcast and telecast rights and through casino host fees. Since WPTE’s inception, the WPT Studios division has been responsible for 74% of total revenue. WPTE licensed the WPT series Seasons One through Five to the Travel Channel, LLC (“TRV” or “Travel Channel”) for telecast in the United States under an exclusive license agreement (“WPT Agreement”). On April 2, 2007, WPTE entered into an agreement (the “GSN Agreement”) with Game Show Network, LLC (“GSN”), pursuant to which GSN agreed to license Season Six for a $300,000 license fee per episode. WPTE received an average of $477,000 per episode for Season Five of the WPT television series from TRV. WPTE also has license agreements for the distribution of WPT episodes into international territories for which WPTE receives license fees, net of WPTE’s agent’s sales fee and agreed upon sales and marketing expenses. WPTE also collects annual host fees from member casinos that host WPT events (WPTE’s member casinos).

 

Since WPTE’s inception, fees from TRV under the WPT Agreement and an agreement with TRV relating to the Professional Poker Tour (“PPT”) series have been responsible for approximately 59% of WPTE’s total revenue. For each season covered by the WPT Agreement and related options, TRV has exclusive rights to exhibit the episodes in that season an unlimited number of times on its television network in the United States for four years (three years for the episodes in Season One). WPTE has produced five complete seasons of the WPT series under the WPT Agreement.

 

Under the WPT Agreement, TRV pays fixed license fees for each episode WPTE produces, which are payable at various times during the pre-production, production and post-production process and are recognized upon TRV’s receipt and acceptance of the completed episode. Television production costs related to WPT episodes are generally capitalized and charged to cost of revenues as revenues are recognized. Therefore, the timing and number of episodes involved in the various seasons of the series affect the timing of the revenues and expenses of the WPT

Studios business. The following table describes the timing of Seasons One through Five of the World Poker Tour series, including the delivery and exhibition of the episodes each season:

 

 

 

The agreement with TRV relating to the PPT series, which continues to cover the broadcast rights to Season One of the PPT, was substantially similar in structure to the WPT Agreement with the following exceptions: first, the PPT agreement has a different mechanism for selecting corporate sponsors that grants WPTE more flexibility than it has in the WPT Agreement. Second, upon termination of the agreement, Travel Channel’s revenue share percentage declines over the following four years. There is no revenue share percentage beginning in the fifth year following the termination of the agreement.

 

Under the WPT and PPT Agreements, TRV has the right to receive a percentage of WPTE’s adjusted gross revenues from international television licenses, product licensing and publishing, merchandising and certain other sources, after specified minimum amounts are met. For the three months ended April 1, 2007, WPTE recognized $0.1 million of Travel Channel participation expense that was recorded in cost of revenues.

 

WPT Global Marketing.  Includes branded consumer products, sponsorship, and event management divisions. WPTE branded consumer products division generates revenue principally from royalties from the licensing of the WPTE brand to companies seeking to use the WPT brand and logo in the retail sales of their consumer products. In addition, this business unit generates revenue from direct sales of WPTE-produced branded merchandise. WPTE has generated significant revenues from existing licensees, including Hands-On Mobile, US Playing Card, and MDI. WPTE also has a number of licensees that are developing new licensed products including electronic, casino-based, poker-related gaming machines from IGT, and interactive television games from Pixel Play.

 

WPTE sponsorship and event management division generates revenue from corporate sponsorship and management of televised and live events. WPTE sponsorship program uses the professional sports model as a method to foster entitlement sponsorship opportunities and naming rights to major corporations. Anheuser-Busch has been the largest source of revenues through its sponsorship of Seasons Two, Three, Four and Five of the WPT series on TRV. WPTE also has a sponsorship agreement with Xyience, Inc., a non-alcoholic energy drink developer and distributor, to promote its product as the “official energy drink” for Season Five of the WPT. In addition, WPTE had an agreement with Blue Diamond Almonds to sponsor the WPT Season Five Championship in April 2007 at the Bellagio. WPTE will recognize revenues from these agreements when the Season Five programs are broadcast which began in April 2007.

 

WPT Online.  WPT’s branded online gaming website, currently located at WPTonline.com, features an online poker room and an online casino with a broad selection of slots and table games. Although any Internet user can access WPTonline.com via the world wide web, WPTonline.com does not permit bets to be made from players in the United States and other restricted jurisdictions. This site showcases a WPT-branded poker room featuring ring games, as well as Sit and Go and multi-table tournaments for poker games including Texas Hold ’Em, Omaha, 7 Card Stud, and 7 Card Hi-Lo. Additionally, WPTonline.com features an online casino with a broad selection of slots and table games, including WagerWorks’ exclusive online titles Monopoly^tm, Wheel of Fortune^®, and The Price is Right^tm.

 

Since 2005, WPTE has operated WPTonline.com through a license agreement with WagerWorks, Inc. (“WagerWorks”), under which WPTE licenses its brand to WagerWorks and WagerWorks shares a percentage of all net revenue it collects from the operation of the online poker room and online casino. WPTonline.com

generated approximately $0.6 million in revenues, which are presented gross of WagerWorks costs, for the three months ended April 1, 2007, compared to costs of revenues of approximately $0.3 million.

 

In 2006, WPTE decided to develop its own software for its online poker room. WPTE licensed a software platform from CyberArts Licensing, LLC, and hired 30 employees in Israel to develop software and a support operation. On April 23, 2007, WPTE entered into a three year software supply and support agreement (the “CryptoLogic Agreement”) with CryptoLogic Inc., and its wholly-owned subsidiary WagerLogic Limited, collectively referred to as “CryptoLogic”, pursuant to which CryptoLogic will operate an online gaming site for WPTE featuring a poker room and casino games utilizing its proprietary software, in exchange for a percentage of the revenue generated from the site. WPTE will be entitled to approximately 80% of net gaming revenues, as defined below, from the operation of the site. Under the CryptoLogic Agreement, WPTE will also be a member in a centralized online gaming network with several other licensees of CryptoLogic pursuant to which players will be able to play on WPTE’s branded gaming site on the online gaming network.

 

The CryptoLogic Agreement provides for the poker room to be operational and accessible to players by June 14, 2007, and by September 30, 2007, CryptoLogic is required to have five casino games available (the “Initial Casino”). WPTE also has an option, exercisable at any time prior to July 1, 2008, to require CryptoLogic to provide WPTE customers with access to a full suite of casino games within three months of such notice.

 

WPTE is entitled to the following percentages of net gaming revenue: (a) 78% of the first $150,000 per month, (b) 79% of revenue in excess of $150,000 but less than $500,000 per month; and (c) 80% of the revenue in excess of $500,000 per month. CryptoLogic is entitled to earn the following annual minimum guaranteed revenues associated with WPTE’s online casino: $500,000 for the Initial Casino and $2,500,000 for the full suite of casino games. There is a one-time fee of $50,000 payable by WPTE for the initial preparation and launch of the site, and WPTE is required to pay a monthly fee of $7,500 for the management of tournaments, collusion detection, customer support and overall management of the poker room. In addition, WPTE is obligated to contribute 4% of poker room revenue for certain marketing initiatives.

 

If, at any time after the nine month anniversary of the go-live date, monthly gaming revenues fall below $500,000 for three consecutive months, CryptoLogic has the right to terminate the CryptoLogic Agreement on 90 days written notice. However, WPTE may prevent any such termination through payment of the shortfall of CryptoLogic’s percentage of such gaming revenue within 30 days of receipt of CryptoLogic’s notice of termination. If at any time during the term of the CryptoLogic Agreement the average daily gross revenue, over a 90 day period, derived by CryptoLogic through the Network falls below $125,000, WPTE has the right to terminate the CryptoLogic Agreement.

 

As a result of the decision to move away from the online gaming platform WPTE was developing based on the CyberArts software and stop development of WPTE’s own online gaming site, and sign an agreement with CryptoLogic, WPTE will write off certain property and equipment and related capitalized costs of approximately $2.0 million — $3.0 million during the second quarter of 2007.

 

Results of Operations

 

The following discussion and analysis should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q for the three months ended April 1, 2007.

 

Three months ended April 1, 2007 compared to the three months ended April 2, 2006

 

Revenues.  Total revenues decreased by $1.7 million during the three months ended April 1, 2007 compared to the three months ended April 2, 2006. Domestic television licensee fees decreased $0.6 million in the first quarter of 2007 compared to the 2006 period. The decrease was primarily a result of the delivery of five episodes of Season Five of the WPT television series in the first quarter of 2007 versus six episodes of Season Four of the WPT and one episode of the PPT delivered in the 2006 period. Online gaming, sponsorship and international television license revenues also decreased $1.5 million in the first quarter of 2007 compared to the 2006 period. The decrease of $0.4 million from online gaming revenue during 2007 was primarily due to lower levels of player activity versus the

prior year period. Sponsorship and event revenues decreased $0.7 million due primarily to the timing of not airing any Season Five episodes in the first quarter of 2007 versus the airing of five episodes of Season Four of the WPT in the prior year period. International television licensing revenues decreased by $0.5 million as a result of fewer distribution agreements in the international marketplace. Product licensing revenues increased by approximately $0.1 million in the first quarter of 2007 compared to the 2006 period. The increase was primarily due to higher revenues from Hands-on-Mobile.

 

During the first quarter of 2007, casino management fees were approximately $0.4 million. There were no casino management fees recognized during the first quarter of 2006.

 

Selling, general and administrative expenses.  Selling, general and administrative expenses increased approximately $0.6 million in the first quarter of 2007 compared to the 2006 period. The increase primarily related to additional headcount and professional fees associated with project development.

 

Production costs.  Production costs decreased by approximately $0.3 million in the first quarter of 2007 compared to the 2006 period. The decrease was primarily a result of a decrease in production costs of $0.2 million as WPTE delivered fewer episodes in the 2007 period versus the 2006 period, as noted above. Overall gross margins were 52% in the first quarter of 2007 compared to 63% in the first quarter of 2006. Domestic television licensing margins were 37% in the first quarter of 2007 compared to 44% in the same period in 2006. This decrease was principally because of the delivery of an episode of WPTE’s PPT series in 2006 for which the production costs had been expensed in an earlier period. In addition, online gaming contributed to the overall lower margin in the first quarter of 2007 as a result of an amendment of the agreement with the service provider that was effective in July of 2006, which significantly increased the percentage of revenues paid to that party.

 

Impairment losses.  Net impairment losses were $0.3 million for the three months ended April 1, 2007. There were no impairments for the three months ended April 2, 2006. Future consulting fees related to the Trading Post project are considered unlikely. As a result, Lakes recognized a $0.3 million impairment charge related to the Trading Post casino project with the Pawnee Tribal Development Corporation (“Pawnee TDC”). The Pawnee TDC, together with its three wholly-owned subsidiaries are referred to collectively as the “Pawnee Nation”.

 

Net realized and unrealized gains on notes receivable.  Net realized and unrealized gains on notes receivable were $0.2 million and $15.5 million for the three months ended April 1, 2007 and April 2, 2006, respectively. The net realized and unrealized gains in the first quarter of 2007 related primarily to our notes receivable from the Pokagon Band, the Shingle Springs Tribe and the Jamul Tribe which are adjusted to estimated fair value based upon the current status of the related tribal casino projects.

 

Regarding the Pokagon Band, during March of 2007, Lakes contracted with a group of investors for their participation in the loans made by Lakes to the Pokagon Band (and assumed by the Pokagon Gaming Authority) at an agreed upon price of 98% of the face value of the loans as of the settlement date of March 2, 2007. Accordingly, as of March 2, 2007, the Pokagon notes receivable were adjusted to the negotiated participation price of 98% of principal and stated interest, which resulted in a gain of approximately $1.6 million during the first quarter of 2007, which was partially offset by transaction costs of approximately $1.1 million. This participation arrangement was accounted for as a sale during 2007; however, the sale did not have any effect on Lakes’ management agreement for the Pokagon casino resort project.

 

Regarding the Shingle Springs Tribe, the repayment terms of the notes receivable were revised and the notes will now be repaid over the life of the seven year management agreement rather than over approximately 24 months. This change resulted in unrealized losses on notes receivable of approximately $0.9 million for the first quarter of 2007.

 

During the first quarter of 2006, the net unrealized gains of $15.5 million related primarily to increased probability of opening for the casino development projects with the Pokagon Band and the Jamul Tribe due to favorable events occurring during the first quarter of 2006.

 

Other income (expense).  Other expense for the first quarter of 2007 was $5.4 million compared to other income of $5.4 million for the first quarter of 2006. In March 2007, Lakes’ then existing $105 million Credit Agreement was repaid in conjunction with the Pokagon notes receivable participation transaction discussed above.

This repayment resulted in a loss on extinguishment of debt of approximately $3.8 million during the first quarter of 2007.

 

Other income in the 2006 first quarter period included a WPTE gain on sale of securities of $5.7 million related to a sale of 630,000 shares of common stock of PokerTek, Inc.

 

Taxes.  The provision for income taxes was $0.3 million and $2.7 million for the three months ended April 1, 2007 and April 2, 2006, respectively. Our effective income tax rates were (3%) and 17% for the first quarter of 2007 and the corresponding period of 2006, respectively. In the current year period, the provision was primarily related to Lakes’ interest on a Louisiana tax audit matter. WPTE recorded a provision of $1.3 million for the three months ended April 2, 2006 primarily associated with positive taxable income in the prior period. The remainder of the provision for the prior period is primarily related to Lakes’ reversal of a capital loss, which was reflected as a deferred tax asset, as a result of a settlement with the Kickapoo Traditional Tribe of Texas.

 

Minority interest.  The minority interest in WPTE’s earnings (loss) was approximately ($0.9) million and $1.4 million for the three months ended April 1, 2007 and April 2, 2006, respectively. WPTE’s net earnings (losses) were ($2.3) million and $3.6 million for the three months ended April 1, 2007 and April 2, 2006, respectively.

 

Liquidity and Capital Resources

 

At April 1, 2007, our unaudited condensed consolidated balance sheet included cash and cash equivalents and short-term investment balances of $61.7 million, comprised of Lakes cash of $1.6 million, Lakes short-term investments of $23.0 million, WPTE cash of $7.4 million and WPTE short-term investments of $29.7 million. WPTE cash and short-term investments will not be used in Lakes’ business.

 

On March 2, 2007 (the “Settlement Date”), Lakes contracted with a group of investors for their participation in the loans made by Lakes to the Pokagon Band for the development of the Four Winds Casino Resort (“Pokagon Casino”), which loans have been assumed by the Pokagon Gaming Authority. As of the Settlement Date, the face value of Lakes’ notes receivable was approximately $104.2 million, including accrued interest of approximately $33.0 million. On the Settlement Date, Lakes transferred 100% of the Pokagon Gaming Authority loans to the participants in exchange for cash proceeds of approximately $102.1 million based upon the accreted value of the Pokagon Gaming Authority loans less a two percent discount and incurred transaction fees of approximately $1.1 million. The transaction fees were recorded as a reduction of net realized and unrealized gains on notes receivable in the accompanying unaudited condensed consolidated statements of earnings (loss) and comprehensive earnings (loss). Accordingly, based upon the previously recorded estimated fair value of the notes at December 31, 2006, Lakes realized a gain of $0.5 million as a result of the consummation of the participation agreement.

 

The participation agreements also allow the participants to pledge or exchange the notes receivable and Lakes no longer has any rights or obligations to the loans and is isolated, even in default, from liability. As a result, the Pokagon notes receivable participation transaction has been treated as a sale pursuant to Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities (“SFAS No. 140”). The sale does not have any effect on Lakes’ related management agreement with the Pokagon Band.

 

Also on March 2, 2007, Lakes repaid its $105 million loan with BofA and certain lenders under the Credit Agreement, using proceeds received from the Pokagon notes receivable participation transaction in addition to amounts previously included in a restricted interest reserve account related to the Credit Agreement. Lakes incurred approximately $1.1 million in a prepayment penalty associated with the payoff of the Credit Agreement. This amount, along with the remaining unamortized portion of the Credit Agreement debt issuance costs of approximately $1.8 million and the unamortized discount of approximately $0.9 million, were written off, which resulted in a loss on extinguishment of debt of approximately $3.8 million, which has been recorded by Lakes in the accompanying unaudited condensed consolidated statement of earnings (loss) and comprehensive earnings (loss).

 

In conjunction with the extinguishment of the $105 million Credit Agreement, Lakes’ related interest rate swap agreement was also terminated. The termination of the interest rate swap agreement resulted in additional interest expense of approximately $0.5 million which was recorded in the first quarter of fiscal 2007.

 

Pursuant to the terms and conditions of a financing agreement dated as of February 15, 2006 among Lakes, PLKS Funding, LLC and various subsidiaries of Lakes, PLKS Holdings, LLC (“PLKS”) was granted a warrant to purchase 1,250,000 common shares of Lakes at $7.50 per share (“Warrant”). During April 2007, PLKS exercised and purchased 102,500 shares underlying the Warrant at $7.50 per share and paid Lakes $0.8 million.

 

On May 4, 2007, Lakes and PLKS amended the exercise price of the Warrant (“Amendment”). The Amendment reduced the exercise price of the Warrant from $7.50 per share to $6.50 per share for the remaining 1,147,500 shares underlying the Warrant. In consideration for the reduced exercise price, PLKS agreed to exercise and purchase the remaining 1,147,500 shares underlying the Warrant for an aggregate exercise price of $7.5 million, which was paid to Lakes on May 7, 2007. Lakes is currently evaluating the potential effect this Amendment will have on its financial position and results of operations during the second quarter of 2007.

 

Our agreements with our tribal partners require that we provide certain financing for project development in the form of loans. These loans are interest bearing; however, the loans and related interest are not due until the casino is built and has established profitable operations. In the event that the casinos are not built, our only recourse is to attempt to liquidate assets of the development, if any, excluding any land in trust.

 

We believe that our casino development projects currently in progress and included in the table below will be constructed and achieve profitable operations; however, no assurance can be made that this will occur. If this does not occur, it is likely that we would incur substantial or complete losses on our notes receivable from Indian tribes and related intangible assets associated with the acquisition of the management, development, consulting and financing contracts. In addition, if our current casino development projects are not completed or, upon completion, fail to successfully compete in the highly competitive market for gaming activities, we may lack the funds to compete for and develop future gaming or other business opportunities and our business could be adversely affected to the extent that we may be forced to cease our operations entirely.

 

Following is a table summarizing remaining contractual obligations as of April 1, 2007 (in millions):

 

 

 

 

 

We have incurred cumulative development and land development costs of approximately $6.4 million and $1.9 million, respectively, relating to the development of a Company-owned non-Indian casino in Vicksburg, Mississippi. These costs are included in property and equipment as construction in progress and land, respectively. We have received various regulatory approvals to develop our own casino near Vicksburg, Mississippi. Lakes does not expect to pursue further development of this project until 2008.

 

Our major use of cash over the past three years has been pre-construction financing provided to our tribal partners and on-going corporate costs. We may be required to pay taxes up to approximately $12 million plus interest and fees in fiscal 2007 related to two tax matters. We anticipate that our operational and development needs may require us to obtain additional sources of financing. Therefore, we will explore additional financing alternatives as needed, which may include debt, equity or a combination thereof.

 

If the financing is in the form of equity financing it will be dilutive to our shareholders, and any debt financing may involve additional restrictive covenants. We may raise additional capital through either public or private financings or the sale of some or all of our shares of WPTE, although it is not currently our intent to sell all of our interest in WPTE. An inability to raise such funds when needed might require us to delay, scale back or eliminate some of our expansion and development goals.

 

Our cash requirements do not include construction-related costs that will be incurred when any of the projects begin construction. The construction of our Indian casino projects will depend on the ability of the tribes to obtain financing for the projects. If such financing cannot be obtained on acceptable terms, it may not be possible to complete these projects, which could have a material adverse effect on our results of operations and financial condition. In order to assist the tribes, we may be required to guarantee the tribes’ debt financing or otherwise provide support for the tribes’ obligations. Guarantees by us, if any, will increase our potential exposure in the event of a default by any of these tribes.

 

Critical Accounting Policies and Estimates

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our unaudited condensed consolidated financial statements which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the balance sheet date and reported amounts of revenue and expenses during the reporting period. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue recognition, long-term assets related to Indian casino projects, deferred television costs, investments, litigation costs, income taxes, share-based compensation and derivative financial instruments. We base our estimates and judgments on historical experience and on various other factors that are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

 

We believe the following critical accounting policies involve the more significant judgments and estimates used in the preparation of our unaudited condensed consolidated financial statements.

 

Revenue recognition:  Revenue from the management of Indian-owned casino gaming facilities is recognized in accordance with our policy described below under the caption “Accounting for long-term assets related to Indian casino projects.”

 

Revenue from the domestic and international distribution of WPTE television series is recognized as earned under the following criteria established by the American Institute of Certified Public Accountants Statement of Position (SOP) No. 00-2, Accounting by Producers or Distributors of Films (SOP 00-2):

 

 

In accordance with the terms of the WPT Agreement, WPTE recognize domestic television license revenues upon the receipt and acceptance of completed episodes. However, due to restrictions and practical limitations applicable to WPTE’s operating relationships with foreign networks, WPTE currently does not consider collectibility of international television license revenues to be reasonably assured, and accordingly, WPTE does not recognize such revenue until the distributor has received payment. Additionally, WPTE presents international distribution license fee revenues net of the distributor’s fees, as the distributor is the primary obligor in the transaction with the ultimate customer pursuant to Emerging Issues Task Force (EITF) 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent (EITF 99-19).

 

Product licensing revenues are recognized when the underlying royalties from the sales of the related products are earned. WPTE recognizes minimum revenue guarantees ratably over the term of the license or as earned royalties based on actual sales of the related products, if greater. WPTE presents product licensing fees gross of licensing commissions, which are recorded as selling and administrative expenses because WPTE is the primary obligor in the transaction with the ultimate customer pursuant to EITF 99-19.

 

Online gaming revenues are recognized monthly based on detailed statements received from WagerWorks, WPTE’s online gaming service provider, for online poker and casino activity during the previous month. In accordance with EITF 99-19, WPTE presents online gaming revenues gross of WagerWorks costs, including WagerWorks management fee, royalties, credit card processing and chargebacks that are recorded as cost of revenues, because WPTE has the ability to adjust price and specifications of the online gaming site, WPTE bears the majority of the credit risk and WPTE is responsible for the sales and marketing of the gaming site. WPTE includes certain promotional expenses related to free bets and deposit bonuses along with customer chargebacks as deductions of revenue. All other promotional expenses are generally recorded as sales and marketing expenses.

 

Event hosting fees are paid by host casinos for the privilege of hosting the events and are recognized as the episodes that feature the host casino are aired. Sponsorship revenues are recognized as the episodes that feature the sponsor are aired. Licensing advances and guaranteed payments collected, but not yet earned, by WPTE, as well as casino host fees and sponsorship receipts collected prior to the airing of episodes, are classified as deferred revenue in the accompanying balance sheets.

 

Deferred television costs:  WPTE accounts for deferred television costs in accordance with SOP 00-2. Deferred television costs include capitalizable direct costs, production overhead and development costs and are stated at the lower of cost or net realizable value based on anticipated revenue. WPTE has not currently anticipated any revenues in excess of those subject to existing contractual relationships, because WPTE has insufficient operating history to enable such anticipation. Marketing, distribution and general and administrative costs are expensed as incurred. Capitalized television production costs for each episode are expensed as revenues are recognized upon delivery and acceptance by TRV of the completed episode. WPTE’s management currently estimates that 100% of the approximately $2.0 million in capitalized deferred television costs at April 1, 2007 are expected to be expensed in connection with episode deliveries by the end of fiscal 2007.

 

Share-Based Compensation Expense:  We measure share-based compensation expense pursuant to the Financial Accounting Standards Board (“FASB”) SFAS No. 123^®, which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee and director stock options and employee and director stock purchases based on estimated fair values. In March 2005, the SEC issued Staff Accounting Bulletin (“SAB”) No. 107 relating to SFAS No. 123(R) and we have applied certain provisions of SAB 107 in our adoption of SFAS 123(R).

 

SFAS No. 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our consolidated statement of earnings (loss) and comprehensive earnings (loss). SFAS No. 123(R)supersedes our previous accounting under the provisions of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”). As permitted by SFAS No. 123, we measured compensation cost for options granted prior to January 2, 2006, in accordance with Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees and related interpretations. Accordingly, no accounting recognition is given to stock options granted at fair market value until they are exercised. Upon exercise, net proceeds, including tax benefits realized, are credited to equity.

 

Pursuant to SFAS No. 123(R), we use the Black-Scholes option pricing method to establish fair value of options. Our determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to our expected stock price volatility and actual and projected employee stock option exercise behaviors. Any changes in these assumptions may materially affect the estimated fair value of the share-based award.

 

Income taxes:  In accordance with SFAS No. 109, Accounting for Income Taxes, (“SFAS 109”) we evaluated the ability to utilize deferred tax assets arising from net operating loss carryforwards, and other ordinary items and determined that a valuation allowance was appropriate at April 1, 2007 and December 31, 2006. We evaluated all evidence and determined net losses (excluding net realized and unrealized gains and losses on notes receivable) generated over the past five years outweighed the current positive evidence that we believe exists surrounding our ability to generate significant income from our long-term assets related to Indian casino projects. Therefore, we have recorded a 100% valuation allowance against these items at April 1, 2007, and December 31, 2006.

 

We have recorded deferred tax assets related to capital losses. The realization of these benefits is dependent on the generation of capital gains during the applicable carryforward periods. We believe we will have sufficient capital gains in the foreseeable future to utilize these benefits due to significant appreciation in our investment in WPTE, which has a minimal cost basis and could be sold at a substantial gain. We own approximately 12.5 million shares of WPTE common stock valued at approximately $64 million as of April 1, 2007 based upon the closing stock price as reported by NASDAQ on March 30, 2007 of $5.14.

 

WPTE’s current growth plans potentially may include international expansion primarily related to WPTE’s online gaming business, expansion of television and product licensing businesses, industry consolidation and acquisitions and entry into new branded gaming businesses. Although WPTE anticipates that all potential strategies will be accretive to earnings, WPTE is aware of the risks involved with an aggressive growth strategy. Therefore, based on WPTE’s limited and volatile earnings history combined with WPTE’s cautious optimism, WPTE has determined that a valuation allowance is necessary to the extent that management currently believes it is more likely than not that tax benefits related to stock option exercises will not be realized.

 

See Note 6 to the unaudited condensed consolidated financial statements included in Item 1 of this Quarterly Report Form 10-Q above, for a discussion of the effects of adopting FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”) in the first quarter of fiscal 2007.

 

Accounting for long-term assets related to Indian casino projects:

 

Notes receivable.  We have formal procedures governing our evaluation of opportunities for potential development projects that we follow before entering into agreements to provide financial support for the development of these Indian owned casino projects. We determine whether there is probable future economic benefit prior to recording any asset related to the Indian casino project. We initially evaluate the following factors involving critical milestones that affect the probability of developing and operating a casino:

 

 

We account for our notes receivable from and service contracts with the tribes as separate assets. The estimated fair value of the advances made to the tribes are accounted for as in-substance structured notes in accordance with the guidance contained in Emerging Issues Task Force Consensus No. 96-12, Recognition of Interest Income and Balance Sheet Classification of Structured Notes (“EITF No. 96-12”). . Under their terms, the notes do not become due and payable unless and until the projects are completed and operational. However, in the event our development activity is terminated prior to completion, we generally retain the right to collect in the event of completion by another developer. Because the stated rate of the notes receivable alone is not commensurate with the risk inherent in these projects (at least prior to commencement of operations), the estimated fair value of the notes receivable is generally less than the amount advanced. Costs incurred related to Indian casino projects are not considered

advanced to the tribe until actually paid by us. At the date of each advance, the difference between the estimated fair value of the note receivable and the actual amount advanced is recorded as an intangible asset.

 

Subsequent to its initial recording at estimated fair value, the note receivable portion of the advance is adjusted to its current estimated fair value at each balance sheet date using then current assumptions including typical market discount rates, and expected repayment terms as may be affected by estimated future interest rates and opening dates, with the latter affected by changes in project-specific circumstances such as ongoing litigation, the status of regulatory approvals and other factors previously noted. The notes receivable are not adjusted to a fair value estimate that exceeds the face value of the note plus accrued interest, if any. Due to uncertainties surrounding the projects, no interest income is recognized during the development period, but changes in estimated fair value of the notes receivable still held as of the balance sheet date are recorded as unrealized gains or losses in our unaudited condensed statement of earnings (loss) and comprehensive earnings (loss).

 

Upon opening of the casino, any difference between the then estimated fair value of the notes receivable and the amount contractually due under the notes will be amortized into income using the effective interest method over the remaining term of the note. Such notes would then be evaluated for impairment pursuant to Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan.

 

Intangible assets related to Indian casino projects.  Intangible assets related to the acquisition of the management, development, consulting or financing contracts are accounted for using the guidance in SFAS No. 142 Goodwill and Other Intangible Assets (“SFAS No. 142”). Pursuant to that guidance, the assets are periodically evaluated for impairment based on the estimated cash flows from the contract on an undiscounted basis. In the event the carrying value of the intangible assets, in combination with the carrying value of land held for development and other assets associated with the Indian casino projects described below, were to exceed the undiscounted cash flow, an impairment would be recorded. Such an impairment would be measured based on the difference between the fair value and carrying value of the assets. In accordance with SFAS No. 142, we will amortize the intangible assets related to the acquisition of the management, development, consulting or financing contracts under the straight-line method over the lives of the contracts which will commence when the related casinos open. In addition to the intangible asset associated with the cash advances to tribes described above, these assets include actual costs incurred to acquire our interest in the projects from third parties.

 

Land held for development.  Included in land held for development is land held for possible transfer to Indian tribes for use in certain of the future casino resort projects. In the event that this land is not transferred to the tribes, we can sell it. We evaluate these assets for impairment in combination with intangible assets related to acquisition of management, development, consulting or financing contracts and other assets related to the Indian casino projects as discussed above.

 

Other.  Included in this category are costs incurred related to the Indian casino projects, which have not yet been included as part of the notes receivable because of timing of the payment of these costs. When paid, these amounts will be allocated between notes receivable and intangible assets related to the acquisition of management, development, consulting or financing contracts and will be evaluated for changes in fair value or impairment, respectively, as described above. These amounts vary from period to period due to timing of payment of these costs. Also included in this category are receivables from related parties that are directly related to the development and opening of Lakes’ Indian casino projects.

 

In addition, we incur certain costs related to the projects that are not included in notes receivable, which are expensed as incurred. These costs include salaries, travel and certain legal costs.

 

As of April 1, 2007 and December 31, 2006, the consolidated balance sheets include long-term assets related to Indian casino projects of $147.7 million and $243.8 million, respectively. The amounts are as follows by project (in thousands):

 

 

 

The key assumptions and criteria used in the determination of the estimated fair value of the notes receivable are estimated casino opening date, projected interest rates, discount rates and probability of projects opening. The estimated casino opening date used in the valuation reflects the weighted-average of three scenarios: a base case (which is based on our forecasted casino opening date) and one and two years out from the base case. The projected interest rates are based upon the one year U.S. Treasury Bill spot yield curve per Bloomberg and the specific assumptions on contract term, stated interest rate and casino opening date. The discount rate for the projects is based on the yields available on certain financial instruments at the valuation date, the risk level of equity investments in general, and the specific operating risks associated with open and operating gaming enterprises similar to each of the projects. In estimating this discount rate, market data of other public gaming related companies is considered. The probability applied to each project is based upon a weighting of four different scenarios with the fourth scenario assuming the casino never opens. The first three scenarios assume the casino opens but applies different opening dates as discussed above. The probability weighting applied to each scenario captures the element of risk in these projects and is based upon the status of each project, review of the critical milestones and likelihood of achieving the milestones.

 

The following table provides the key assumptions used to value the notes receivable at estimated fair value (dollars in thousands):

 

Shingle Springs Tribe:

 

 

 

 

See discussion included below under “Description of each Indian casino project and evaluation of critical milestones — Shingle Springs.”

 

Jamul Tribe:

 

 

See discussion below included under the caption “Description of each Indian casino project and evaluation of critical milestones — Jamul Tribe”.

 

The following table represents a sensitivity analysis prepared by us of the notes receivable from the Jamul Tribe and Shingle Springs Tribe, based upon a change in the probability rate of the casino opening by five

percentage points and the estimated casino opening date by one year (probability will not be adjusted in excess of 100%):