GOLDEN ENTERTAINMENT, INC. - Quarter Report: 2009 June (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 has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o

 

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

 

 

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 August 4, 2009, there were 26,328,045 shares of Common Stock, $0.01 par value per share, outstanding.

 

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

INDEX

 

 

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Consolidated Balance Sheets

 

 

See notes to unaudited consolidated financial statements.

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

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

 

 

See notes to unaudited consolidated financial statements.

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Consolidated Statements of Cash Flows

 

 

See notes to unaudited consolidated financial statements.

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Consolidated Financial Statements

 

 

The unaudited 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 and/or omitted. Lakes owned approximately 61% of the outstanding common stock of WPT Enterprises, Inc. (“WPTE”), a separate publicly-held media and entertainment company until November 21, 2008 when all of these shares were distributed to Lakes’ shareholders through a noncash dividend. Operations of WPTE after the date of distribution are not included in Lakes’ consolidated results of operations, and historical operating results of WPTE up to that date are presented as discontinued operations (see Note 4). Lakes has evaluated the financial statements for subsequent events through August 5, 2009, which was the date this Form 10-Q was filed with the SEC. 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 28, 2008, previously filed with the SEC, 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. The results for the current interim period are not necessarily indicative of the results to be expected for the full year.

 

Certain reclassifications to amounts previously reported have been made to conform to the current period presentation.

 

 

In July 2009, the FASB issued SFAS 168, FASB Accounting Standards Codification (“SFAS 168”), as the single source of authoritative non-governmental U.S. generally accepted accounting principles. SFAS 168 is effective for interim and annual periods ending after September 15, 2009. All existing accounting standards will be superseded by the codification. All other accounting literature not included in the codification is non-authoritative. The implementation of this standard is not expected to have a material impact on our future financial position, results of operations or cash flows.

 

In May 2009, the FASB issued SFAS 165, Subsequent Events (“SFAS 165”), which provides guidance to establish general standards of accounting for and disclosures of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. SFAS 165 is effective for interim or fiscal periods ending after June 15, 2009. The implementation of this standard did not have a material impact on our financial position, results of operations or cash flows.

 

In April 2009, the FASB issued FASB Staff Position 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (“FSP 157-4”), which provides additional guidance for estimating fair value in accordance with SFAS 157, when the volume and level of activity for the asset or liability have significantly decreased. FSP 157-4 is effective for interim and annual reporting periods ending after June 15, 2009. The implementation of this standard did not have a material impact on our financial position, results of operations or cash flows.

 

In April 2009, the FASB issued FASB Staff Position 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments (“FSP 107-1”), which requires additional disclosures about fair value of financial instruments for interim reporting periods. FSP 107-1 is effective for interim and annual reporting periods ending after June 15, 2009. The implementation of this standard did not have a material impact on our financial position, results of operations or cash flows. In April 2009, the FASB also issued FASB Staff Positions FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (“FSP FAS 115-2 and FAS 124-2”), which amends the other-than-temporary impairment guidance in U.S. Generally Accepted Accounting Principles for debt securities to make the guidance more operational and to improve the presentation

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Consolidated Financial Statements — (Continued)

 

and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements. FSP FAS 115-2 and FAS 124-2 is effective for interim and annual reporting periods ending after June 15, 2009. The implementation of these three standards did not have a material impact on our financial position, results of operations or cash flows.

 

 

The Company’s financial instruments consist of cash and cash equivalents, accounts receivable, investments in securities, notes receivable from Indian tribes, accounts payable, contract acquisition costs payable, and lines of credit.

 

For the Company’s cash equivalents, accounts receivable, accounts payable and lines of credit, the carrying amounts approximate fair value because of the short duration of these financial instruments. The Company’s other classes of financial instruments include primarily investments in auction rate securities (“ARS”) (Note 5 and Note 6), notes receivable from Indian Tribes, primarily with the Shingle Springs Band of Miwok Indians (the “Shingle Springs Tribe”) (Note 6 and Note 7) and contract acquisition costs payable (Note 10). The methods used in estimating the fair value of each is discussed in the related notes to the consolidated financial statements.

 

 

On October 1, 2008, Lakes’ Board of Directors declared a noncash dividend consisting of all of the shares of WPTE then owned by Lakes. Lakes previously owned 12,480,000 or approximately 61% of the outstanding common stock of WPTE, a separate publicly-held media and entertainment company. The record date for the dividend was October 24, 2008, which established the shareholders of record entitled to the dividend, thereby allowing the determination of the ratio of WPTE shares to be distributed per Lakes share. The dividend ratio for shareholders of record on the record date was approximately 0.479 shares of WPTE common stock for each share of Lakes common stock. The date of distribution was November 21, 2008. Operations of WPTE after the date of distribution are not included in Lakes’ consolidated results of operations, and historical operating results of WPTE up to that date are presented as discontinued operations.

 

Revenues, net loss before income taxes and income taxes, related to WPTE, for the three months and six months ended June 29, 2008, have been derived from historical financial information and reported in discontinued operations as follows (in thousands, unaudited):

 

 

 

The Company’s investment portfolio is comprised of investments in ARS. The types of ARS that the Company owns are backed by student loans, the majority of which are guaranteed under the Federal Family Education Loan Program (“FFELP”). As a result of the liquidity issues surrounding the Company’s ARS, the Company’s ARS have been classified as long-term investments in securities. See also Note 9 for a discussion of Lakes’ credit line agreement with UBS Financial Services, Inc (“UBS”).

 

In November 2008, the Company accepted an offer from UBS granting nontransferable rights (the “Rights”) to sell the Company’s ARS held by UBS at par value to UBS at any time during the period of June 30, 2010, through

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Consolidated Financial Statements — (Continued)

 

July 2, 2012. The Rights represent a free standing asset separate from the ARS. UBS’ obligations under the Rights are not secured by its assets and do not require UBS to obtain any financing to support its performance obligations under the Rights. UBS has disclaimed any assurance that it will have sufficient financial resources to satisfy its obligations under the Rights.

 

The estimated fair value of the Rights was $3.0 million and $4.3 million as of June 28, 2009 and December 28, 2008, respectively. The $1.3 million decrease in the estimated fair value of the Rights is reflected as a reduction in interest income in the unaudited consolidated statement of earnings (loss) and comprehensive earnings (loss) for the six months ended June 28, 2009. The Rights do not meet the definition of a derivative instrument under Statement of Financial Accounting Standards (“SFAS”) SFAS 133, Accounting for Derivative Instruments and Hedging Activities. Therefore, the Company has elected to measure the Rights at estimated fair value under SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”), which permits the Company to elect the fair value option for recognized financial assets, to match the changes in the estimated fair value of the ARS. The Company expects that future changes in the estimated fair value of the Rights will approximate fair value movements in the related ARS.

 

The Company classifies its ARS as trading securities pursuant to SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, which reflects management’s intent to exercise its Rights during the period June 30, 2010 to July 3, 2012. As of June 28, 2009 and December 28, 2008, investments in securities with original maturity dates beyond three months consist of the following (in thousands):

 

 

The $1.5 million increase in the estimated fair value of the ARS is included in interest income in the unaudited consolidated statement of earnings (loss) and comprehensive earnings (loss) for the six months ended June 28, 2009.

 

 

The Company utilizes the methods of estimating fair value as described in SFAS 157, Fair Value Measurements (“SFAS 157”), to value certain of its financial assets. Financial Accounting Standards Board (“FASB”) Staff Position FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (“FSP FAS 157-4”), was issued in April 2009, and was effective for the quarter ended June 28, 2009. The implementation of FSP FAS 157-4 did not have a material impact on the Company’s valuation techniques, financial position, results of operations or cash flows.

 

The Company’s financial instruments that are measured at estimated fair value use inputs from among the three levels of the fair value hierarchy set forth in SFAS 157, however, none of the Company’s financial assets that are presented at their estimated fair value are measured using Level 1 or Level 2 inputs. Level 3 inputs are unobservable inputs that reflect management’s estimates about the assumptions that market participants would use in pricing the asset or liability. Management develops these inputs based on the best information available, including internally-developed data.

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Consolidated Financial Statements — (Continued)

 

The Company’s financial assets that are carried at estimated fair value are summarized below (in thousands):

 

 

 

 

The Company utilizes valuation models based on management’s estimates of expected cash flow streams and discount rates to value these assets.

 

The following is a list of the most significant factors affecting the Company’s cash flows and discount rate estimates by financial asset type:

 

 

The following table summarizes the activity for the Company’s financial instruments that are reported at estimated fair value utilizing Level 3 inputs (in thousands):

 

 

 

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Consolidated Financial Statements — (Continued)

 

 

 

The majority of the assets related to Indian casino projects are in the form of notes receivable due from the Indian tribes pursuant to the Company’s development, financing, consulting and management agreements. The repayment terms of the loans are specific to each Indian tribe and are dependent upon the successful development and operating performance of each gaming facility. Repayment of the loans is required only if distributable profits are available from the operation of the related casinos. In addition, repayment of the loans and the development, financing, consulting and management fees under contracts are subordinated to certain other financial obligations of the respective operations. Generally, the order of priority of payments from the casinos’ cash flows is as follows: a certain minimum monthly priority payment to the Indian tribe; repayment of senior debt associated with construction and equipping of the casino with interest accrued thereon; repayment of various debt with interest accrued thereon due to Lakes; development, financing, consulting and management fees to Lakes, with the remaining funds distributed to the Indian tribe.

 

Information with respect to the notes receivable activity is summarized in the following table (in thousands):

 

 

 

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Consolidated Financial Statements — (Continued)

 

 

Shingle Springs Tribe.  The terms and assumptions used to value Lakes’ notes receivable from the Shingle Springs Tribe at estimated fair value at December 17, 2008 are as follows (dollars in thousands):

 

 

The carrying value of Lakes’ notes receivable from the Shingle Springs Tribe was $52.6 million as of June 28, 2009. Management estimates the fair value of this financial instrument as of June 28, 2009 to be approximately $53.0 million using a discount rate of 17.00% and a remaining term of 78 months.

 

Jamul Tribe.  The terms and assumptions used to value Lakes’ notes receivable from the Jamul Tribe at estimated fair value are as follows (dollars in thousands):

 

 

 

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Consolidated Financial Statements — (Continued)

 

 

Iowa Tribe.  The terms and assumptions used to value Lakes’ notes receivable from the Iowa Tribe at estimated fair value are as follows (dollars in thousands):

 

 

 

 

 

Intangible assets.  Intangible assets consist of costs associated with the acquisition of the management, development, consulting or financing contracts related to tribal gaming projects and are periodically evaluated for impairment after they are initially recorded.

 

Information with respect to the intangible assets related to the acquisition of management, development, consulting or financing contracts by project is summarized as follows (in thousands):

 

 

 

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Consolidated Financial Statements — (Continued)

 

 

 

Land held for development.  Land held for development is comprised of 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, the Company has the right to sell it. As of June 28, 2009, land held for development related to Indian casino projects was $1.8 million. Lakes currently owns approximately 96 acres of land held for development located adjacent to the Jamul Casino project location, which is carried at $1.0 million as of June 28, 2009.

 

As of June 28, 2009, Lakes owns approximately 139 acres of land held for development located adjacent to the Ioway Casino Resort project location. Lakes has invested $0.8 million in land held for development, which is being held for future transfer to the Iowa Tribe.

 

Other.  As of June 28, 2009 and December 28, 2008 these assets consist primarily of amounts due from Mr. Kevin M. Kean, a partner in the KAR Entities that were advanced in connection with the acquisition of contracts rights related to the Red Hawk Casino and the proposed Jamul Casino. Primarily as a result of a decrease in estimated collateral value related to these and other advances, Lakes recorded an impairment loss of approximately $1.2 million on other long-term assets related to Indian casino projects during the second quarter of 2009. Also see the discussion of these arrangements below in Part I, Item 2 of this Quarterly Report on Form 10-Q, included under the captions “Description of each Indian casino project and evaluation of critical milestones” — Shingle Springs Tribe and Jamul Tribe.

 

 

Line of Credit.  During 2008, Lakes entered into a client agreement (the “Credit Line”) with UBS, collateralized by Lakes’ ARS held at UBS (Note 5) and is due and payable on demand with interest at 30-day LIBOR plus one percent. As of June 28, 2009, approximately $18.0 million was outstanding under the Credit Line.

 

Non-revolving line of credit.  Also during 2008, Lakes closed on a two-year interest only $8.0 million non-revolving line of credit loan agreement (the “Loan Agreement”) with First State Bank. Amounts borrowed under the Loan Agreement are collateralized by real property in Minnetonka, Minnesota and bear interest at 8.95%. As of June 28, 2009, Lakes had drawn $2 million under the Loan Agreement.

 

 

The Company is obligated to pay approximately $11 million to an unrelated third party as part of an agreement associated with the Company obtaining the management contract with the Pokagon Band. The obligation is payable quarterly over the term of the five-year management agreement for the Four Winds Casino Resort. The Company is also obligated to pay approximately $3 million over 24 months to a separate unrelated third party on behalf of the Pokagon Band in accordance with the management contract. As of June 28, 2009, the remaining carrying amounts owed under these agreements were $6.1 million, net of a $1.9 million discount. Management estimated the fair value of this obligation to be approximately $6.1 million as of June 28, 2009 using a discount rate of approximately 18% and a remaining term of 38 months.

 

During 2006, the Lyle Berman Family Partnership (the “Partnership”) purchased a portion of the $11 million obligation discussed above from an unrelated third party. The Partnership receives approximately $0.3 million per year of the payment stream related to this obligation during the five-year term of the management contract of the Four Winds Casino Resort. Lyle Berman, Lakes’ Chairman and Chief Executive Officer, does not have an ownership or any other beneficial interest in the Partnership. Neil I. Sell, a director of Lakes, is one of the trustees of the irrevocable trusts for the benefit of Lyle Berman’s children who are the partners in and sole beneficiaries of the Partnership.

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Consolidated Financial Statements — (Continued)

 

Effective June 2009, the Company became obligated to pay Mr. Argovitz $1 million per year (prorated based on a 365 day year) during the remainder of the seven-year initial term of the management contract which commenced in December 2008 between the Company and the Shingle Springs Tribe, subject to certain conditions. This obligation does not have a stated interest rate and has payments terms which extend beyond one fiscal year. As a result, this obligation has been recorded at its net present value with an effective interest rate of approximately 18%, and the difference between the face amount and the net present value of the obligation is recorded as a discount, which is amortized to interest expense over the contract term using the effective interest method. As of June 28, 2009, the remaining carrying amount of the liability was $3.7 million, net of a $2.7 million discount.

 

 

Share-based compensation expense, which includes stock options and restricted stock units, for the three months and six months ended June 28, 2009 and June 29, 2008, respectively, were as follows:

 

 

See Note 13 for a discussion of the income tax benefits related to share-based compensation.

 

Stock options.  The Company uses the Black Scholes option pricing model to estimate the fair value and compensation cost associated with employee incentive stock options which requires the consideration of historical employee exercise behavior data and the use of a number of assumptions including volatility of the Company’s stock price, the weighted average risk-free interest rate and the weighted average expected life of the options.

 

The following values represent the average per grant for the indicated variables used to value options granted during the three months and six months ended June 28, 2009 and June 29, 2008, respectively. There have been no significant changes to the assumptions thus far in 2009 and none are expected during the remainder of 2009.

 

 

 

 

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Consolidated Financial Statements — (Continued)

 

 

 

The following table summarizes Lakes’ stock option activity during the three months and six months ended June 28, 2009 and June 29, 2008 (unaudited):

 

 

 

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Consolidated Financial Statements — (Continued)

 

 

The following table summarizes significant ranges of Lakes’ outstanding and exercisable options as of June 28, 2009 (unaudited):

 

 

The aggregate intrinsic value in the preceding table represents the total pre-tax intrinsic value, based on Lakes’ closing stock price of $3.58 on June 26, 2009, which would have been received by the option holders had all option holders exercised their options as of that date. There were no options exercised during the three months ended June 28, 2009. Options exercised during the six months ended June 28, 2009 and the three months and six months ended June 29, 2008, respectively, did not have a significant intrinsic value. As of June 28, 2009, Lakes’ unrecognized share-based compensation was approximately $1.1 million, which is expected to be recognized over a weighted-average period of 2.3 years.

 

Lakes issues new shares of common stock upon the exercise of options.

 

Restricted stock units.  The following table summarizes Lakes’ restricted stock unit activity during the three months and six months ended June 28, 2009 (unaudited):

 

 

As of June 28, 2009, Lakes’ unrecognized share-based compensation was approximately $0.3 million related to non-vested shares, which is expected to be recognized over a weighted-average of 2.1 years. No restricted stock units vested during the three months or six months ended June 28, 2009.

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Consolidated Financial Statements — (Continued)

 

 

 

For all periods, basic earnings (loss) applicable to Lakes Entertainment, Inc. per share (“EPS”) is calculated by dividing net earnings (loss) applicable to Lakes Entertainment, Inc. by the weighted-average common shares outstanding. Diluted EPS in profitable years reflects the effect of all potentially dilutive common shares outstanding by dividing net earnings (loss) applicable to Lakes Entertainment, Inc. by the weighted-average of all common and potentially dilutive shares outstanding. Potentially dilutive stock options applicable to Lakes Entertainment, Inc. of 416,953 and 529,150 shares for the three months and six months ended June 29, 2008, were not used to compute diluted loss per share applicable to Lakes Entertainment, Inc. because the effects would have been anti-dilutive.

 

 

Our effective tax rates were 9.2% and 16.3% for the six months ended June 28, 2009 and the corresponding 2008 period, respectively. The effective tax rate differs from the federal tax rate of 35% due to state income taxes, release of valuation allowance, stock based compensation deductions included in net operating loss carryforwards, and provisions for interest charges on uncertain tax positions. At December 28, 2008, the Company had recorded a 100% valuation allowance against the remaining deferred tax assets arising from net operating loss and capital loss carryforwards. Management has evaluated all evidence and has determined that cumulative net losses generated over the past three years outweigh 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. However, the Company has released approximately $1.9 million of deferred taxes related to net operating loss carryforwards and management currently expects to release a total of $3.3 million of deferred tax assets related to net operating loss carryforwards that will offset current book income for 2009, of which approximately $1.4 million will be credited to additional paid-in capital relating to the release of valuation allowances against tax windfall benefits related to share-based compensation from prior years.

 

The Company recorded $0.2 million and $0.4 million of interest related to the uncertain tax positions to income tax expense for the three months and six months ended June 28, 2009, respectively.

 

 

General.  The recent decline in general economic conditions in the United States may negatively impact the local economic conditions near the casinos Lakes’ manages and may negatively impact Lakes’ management fees and the availability of credit to finance Lakes development projects.

 

Louisiana Department of Revenue litigation tax matter.  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. This determination is the result of an audit of Louisiana tax returns filed by Lakes for the tax periods at issue and relates to the reporting of income earned by Lakes in connection with the managing of two Louisiana-based casinos. On December 20, 2004, the Secretary of the Department of Revenue of the State of Louisiana filed a petition to collect taxes in the amount of $8.6 million, plus interest, against Lakes for the taxable periods set forth above. Lakes maintains that it remitted the proper Louisiana corporation income tax and Louisiana corporation franchise tax for the taxable periods at issue. On February 14, 2005, Lakes filed an answer to the petition to collect taxes asserting all proper defenses and maintaining that no additional taxes were owed and that the petition to collect taxes should be dismissed. Management intends to continue to vigorously contest this action by the Louisiana Department of Revenue. However, Lakes may be required to pay up to the $8.6 million assessment plus interest if Lakes is not successful in this matter. Lakes has recorded an estimated liability related to this examination including accrued interest and fees, which is included as part of income taxes payable on the accompanying consolidated balance sheets.

 

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Notes to Unaudited Consolidated Financial Statements — (Continued)

 

Red Hawk Casino.  Lakes may be required to pay Mr. Kean a consulting fee based on the management fees to be received by the Company in connection with management of the Red Hawk Casino or acquire all of his remaining rights in connection with the Shingle Springs project. See the discussion in Part I, Item 2 of this Quarterly Report on Form 10-Q below included under the caption “Description of each Indian casino project and evaluation of critical milestones — Shingle Springs Tribe”.

 

Miscellaneous legal matters.  Lakes and its subsidiaries 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 likelihood of an unfavorable outcome is remote, and is not likely to have a material adverse effect upon Lakes’ unaudited consolidated financial statements. Accordingly, no provision has been made with regard to these matters.

 

 

On April 1, 2009, the Company submitted an application to the Kansas Lottery Commission for a Gaming Facility Manager license to develop and operate a casino in the South Central Kansas Gaming Zone. Lakes has not yet been notified whether or not it will receive this license.

 

Overview

 

We develop, finance and manage Indian-owned casino properties. We currently have development and management or financing agreements with four separate tribes for casino operations in Michigan, California, and Oklahoma for a total of five separate casino projects as follows:

 

 

We have also explored, and continue to explore, other development projects with Indian tribes. We also explore other non-Indian casino development projects and other business activities.

 

On October 1, 2008, Lakes’ Board of Directors declared a noncash dividend consisting of all of the shares of WPTE then owned by Lakes. Lakes previously owned 12,480,000 or approximately 61% of the outstanding common stock of WPTE, a separate publicly-held media and entertainment company. The record date for the dividend was October 24, 2008, which established the shareholders of record entitled to the dividend, thereby allowing the determination of the ratio of WPTE shares to be distributed per Lakes share. The date of distribution was November 21, 2008. Operations of WPTE after the date of distribution are not included in Lakes’ consolidated

results of operations, and historical operating results of WPTE up to that date are presented as discontinued operations.

 

Results of Operations

 

The following discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q for the three months and six months ended June 28, 2009.

 

Three months ended June 28, 2009 compared to the three months ended June 29, 2008

 

Revenues.  Total revenues for the second quarter of 2009 were $7.1 million, a 20% increase in comparison to prior year period revenues of $5.9 million. The increase was primarily due to fees from the Red Hawk Casino, which opened in December 2008.

 

Selling, general and administrative expenses.  Selling, general and administrative expenses were $3.8 million in the second quarter of 2009 compared to $3.6 million for the second quarter of 2008. For the second quarter of 2009, Lakes’ selling, general and administrative expenses consisted primarily of payroll and related expenses of $2.1 million, including share-based compensation, travel expenses of $0.8 million, professional fees of $0.5 million, and costs associated with the application for a gaming site in the State of Kansas of $0.3 million. For the second quarter of 2008, Lakes’ selling, general and administrative expenses consisted primarily of payroll and related expenses of $2.1 million, including share-based compensation, travel expenses of $0.7 million, and professional fees of $0.5 million.

 

Ohio initiative costs.  Development costs associated with the Ohio casino resort initiative, which was terminated after the November 2008 election, were $4.0 million during the second quarter of 2008.

 

Impairment losses.  Impairment losses were $1.7 million in the second quarter of 2009. There were no impairment losses during the second quarter of 2008. The 2009 impairment losses related primarily to continued uncertainty surrounding the Jamul Casino project as well as the determination that certain amounts due to Lakes from former business partners were not likely to be collected due primarily to a decrease in estimated collateral values associated with these advances.

 

Amortization of intangible assets related to Indian casino projects.  Amortization of intangible assets related to Indian casino projects for the second quarter of 2009 was $2.5 million compared to $1.7 million for the second quarter of 2008. The increase of $0.8 million related to the amortization of intangible assets associated with the Red Hawk Casino, which began when it opened in December 2008. Amortization for the second quarter of 2008 related primarily to the intangible assets associated with the Four Winds Casino Resort.

 

Net unrealized gains on notes receivable.  Net unrealized gains on notes receivable relate primarily to our notes receivable from Indian tribes for casino projects that are not yet open, which are adjusted to estimated fair value, based upon the current status of the related tribal casino projects and evolving market conditions. In the second quarter of 2009, net unrealized gains on notes receivable were $2.5 million, compared to net unrealized gains of $1.1 million in the prior year period. The net unrealized gains in the second quarter of 2009 consisted of $2.2 million related to the Jamul Casino project with the Jamul Tribe and $0.3 million related to the Iowa Tribe’s Ioway Casino project due primarily to improvement in the credit markets, which resulted in lower required rates of return. Net unrealized gains in the second quarter of 2008 were related primarily to the notes receivable related to the Red Hawk Casino project with the Shingle Springs Tribe due to the decrease in number of months until opening of the project.

 

Other income (expense), net.  Other income (expense), net for the second quarter of 2009 was $1.3 million compared to less than $0.1 million for the second quarter of 2008. The increase was due primarily to interest earned on the notes receivable from the Shingle Springs Tribe.

 

Income Taxes.  The income tax provision for the second quarter of 2009 was less than $0.1 million compared to $0.4 million for the second quarter of 2008. Our effective tax rates were 0.1% and 18.0% for the second quarter of 2009 and the second quarter of 2008, respectively. The effective tax rate differs from the federal tax rate of 35% due

to state income taxes, release of valuation allowance, stock based compensation deductions included in net operating loss carryforwards, and provisions for interest charges on uncertain tax positions. Lakes’ income tax provision in the current year period consists primarily of current income tax of $0.7 million, and approximately $0.2 million of interest on a Louisiana tax audit matter (Note 14 to the unaudited consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q), which were offset by an additional paid-in capital adjustment of $0.9 million. In the prior year period, the income tax provision was primarily related to a valuation allowance against deferred tax assets related to capital losses for the portion that were not expected to be realized, and approximately $0.3 million of interest on a Louisiana tax audit matter.

 

Six months ended June 28, 2009 compared to the three months ended June 29, 2008

 

Revenues.  Total revenues for the six months ended June 28, 2009 were $14.3 million, up 37% from prior year period revenues of $10.5 million. This increase was primarily due to improved results from the Four Winds Casino Resort during the current year, and fees from the Red hawk Casino which opened in December 2008.

 

Selling, general and administrative expenses.  Selling, general and administrative expenses for the six months ended June 28, 2009 were $7.8 million compared to $7.5 million in the prior year period. For the first six months of 2009, Lakes’ selling, general and administrative expenses consisted primarily of payroll and related expenses of $4.0 million, including share-based compensation, travel expenses of $1.7 million, professional fees of $1.1 million, and costs associated with the application for a gaming site in the State of Kansas of $0.3 million. For the first six months of 2008, Lakes’ selling, general and administrative expenses consisted primarily of payroll and related expenses of $4.3 million, including share-based compensation, travel expenses of $1.3 million, and professional fees of $1.1 million.

 

Ohio initiative costs.  Development costs associated with the Ohio casino resort initiative, which was terminated after the November 2008 election, were $5.7 million during the first six months of 2008.

 

Impairment losses.  Impairment losses were $2.3 million for the six months ended June 28, 2009. There were no impairment losses during the first six months of 2008. The 2009 impairment losses related primarily to continued uncertainty surrounding the Jamul Casino project as well as the determination that certain amounts due to Lakes from former business partners were not likely to be collected due primarily to a decrease in estimated collateral values associated with these advances.

 

Amortization of intangible assets related to Indian casino projects.  Amortization of intangible assets related to Indian casino projects for the six months ended June 28, 2009 was $5.0 million compared to $3.4 million in the prior year period. The increase related to the amortization of intangible assets associated with the Red Hawk Casino, which began when it opened in December 2008. Amortization for the first six months of 2008 related primarily to the intangible assets associated with the Four Winds Casino Resort.

 

Net unrealized gains (losses) on notes receivable.  Net unrealized gains (losses) on notes receivable relate primarily to our notes receivable from Indian tribes for casino projects that are not yet open, which are adjusted to estimated fair value, based upon the current status of the related tribal casino projects and evolving market conditions. In the first six months of 2009, net unrealized gains were notes receivable of $2.3 million, compared to net unrealized losses of $0.9 million in the prior year period. The net unrealized gains for the six months ended June 28, 2009 consisted of $2.2 million related to the Jamul Casino project with the Jamul Tribe and $0.1 million related to the Iowa Tribe’s Ioway Casino project due primarily to improvement in the credit markets, which resulted in lower required rates of return. Net unrealized losses in the prior year period were due primarily to a decrease in projected interest rates, due to market conditions, for notes receivable related to the Jamul Tribe and the Red Hawk Casino project with the Shingle Springs Tribe, which offset gains related to the decrease in number of months until opening of the Red Hawk Casino.

 

Other income (expense), net.  Other income (expense), net for the six months ended June 28, 2009 was $2.8 million compared to $0.2 million in the prior year period. The increase was due primarily to interest earned on the notes receivable from the Shingle Springs Tribe.

 

Income Taxes.  The income tax provision was $0.4 million and $1.1 million for the six months ended June 28, 2009 and June 29, 2008, respectively. Our effective tax rates were 9.2% and 16.3% for the six months ended June 28,

2009 and the corresponding 2008 period, respectively. The effective tax rate differs from the federal tax rate of 35% due to state income taxes, release of valuation allowance, stock based compensation deductions included in net operating loss carryforwards, and provisions for interest charges on uncertain tax positions. Lakes’ income tax provision in the current year period consists primarily of current income tax of $0.9 million, and approximately $0.4 million of interest on a Louisiana tax audit matter (Note 14 to the unaudited consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q), which were offset by an additional paid-in capital adjustment of $0.9 million. In the prior year period, the income tax provision was primarily related to a valuation allowance against deferred tax assets related to capital losses for the portion that were not expected to be realized, and approximately $0.3 million of interest on a Louisiana tax audit matter.

 

Liquidity and Capital Resources

 

As of June 28, 2009, we had $10.8 million in cash and cash equivalents and $26.7 million of long-term investments in securities recorded at estimated fair value (including nontransferable rights to sell our auction rate securities (“ARS”) back to UBS Financial Services, Inc. (“UBS”) (“Rights”) of approximately $3.0 million). We currently believe that our cash and cash equivalents balance, our cash flows from operations and the financing sources discussed below will be sufficient to meet our working capital requirements during the next 12 months. However, our operating results and performance depend significantly on the current economic conditions and their impact on consumer spending in the casinos we manage. Declines in consumer spending may cause our revenue generated from the management of Indian casinos to be adversely impacted. The recent decline in general economic conditions in the United States may negatively impact the local economic conditions near the casinos Lakes’ manages and may negatively impact Lakes’ management fees and the availability of credit to finance Lakes development projects.

 

On October 1, 2008, Lakes’ Board of Directors declared a noncash dividend consisting of all of the shares of WPTE then owned by Lakes. The date of distribution was November 21, 2008. WPTE cash and investments have not been used in our business. The exclusion of WPTE from our consolidated financial statements does not have an impact on Lakes’ cash position.

 

All of our investments in securities are ARS, held by UBS and are classified as trading securities as of June 28, 2009. The types of ARS that we own are backed by student loans, the majority of which are guaranteed under the Federal Family Education Loan Program (“FFELP”). None of our investments in ARS qualify, or have ever been classified in our consolidated financial statements, as cash or cash equivalents.

 

In November 2008, we accepted an offer from UBS granting Rights to sell our ARS held by UBS at par value to UBS at any time during the period of June 30, 2010, through July 2, 2012. We expect to sell our ARS under the Rights. However, if the Rights are not exercised before July 2, 2012 they will expire and UBS will have no further rights or obligation to buy our ARS. UBS’s obligation under the Rights are not secured by its assets and do not require UBS to obtain any financing to support its performance obligations under the Rights. UBS has disclaimed any assurance that it will have sufficient financial resources to satisfy its obligations under the Rights. As a result, our ARS are classified as long-term investments in securities as of June 28, 2009 and December 28, 2008.

 

During 2008, we entered into a credit agreement with UBS (the “Credit Line”) which is due and payable on demand with interest at 30-day LIBOR plus one percent. As of June 28, 2009, approximately $18.0 million was outstanding under the Credit Line.

 

Also during 2008, we closed on a two-year interest only $8.0 million non-revolving line of credit loan agreement (the “Loan Agreement”) with First State Bank. Amounts borrowed under the Loan Agreement bear interest at 8.95%. As of June 28, 2009, Lakes has drawn $2 million under the Loan Agreement.

 

During the first six months of 2009, Lakes has recognized significant revenues from the management of Indian casino properties, and going forward Lakes expects this trend to continue as Lakes is managing the Cimarron Casino, the Four Winds Casino Resort and the Red Hawk Casino. However, because of the relatively short operating history of the casinos we manage, and the uncertainty in the economic environment, no assurance can be given that this trend will occur. Lakes’ agreements with tribal partners require that we provide certain financing for project development in the form of loans, which has been a major use of cash over the past three years, in addition to on-

going corporate costs and costs incurred during 2008 for the Ohio casino resort initiative. These loans to our tribal partners 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.

 

Our cash forecast requirements do not include construction-related costs that will be incurred when pending and future development projects begin construction. The construction of our pending casino projects will depend on the ability of the tribes and/or Lakes to obtain additional financing for the projects, which based on the general economic environment, is subject to considerable uncertainty. 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 future results of operations, cash flows 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 to losses and other adverse consequences in the event of a default by any of these tribes.

 

If our casino development projects with the Iowa Tribe and the Jamul Tribe are not constructed or if constructed, do not achieve profitable operations in the highly competitive market for gaming activities, it is likely that we would incur substantial or complete losses on our related notes receivable and intangible assets associated with those projects. In addition, 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.

 

We have received various regulatory approvals to develop our own casino near Vicksburg, Mississippi. However, uncertainty exists surrounding the development of this project due primarily to changes in the economic environment and credit markets. As a result, the assets associated with the Vicksburg project are recorded at their estimated fair value of $5.4 million as of June 28, 2009.

 

The following table summarizes our contractual obligations as of June 28, 2009 (in millions):

 

 

 

 

Critical Accounting Policies and Estimates

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles. The preparation of these financial statements requires us to make estimates 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, share-based compensation, income taxes, and long-term assets related to Indian casino projects. 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 consolidated financial statements.

 

Revenue recognition.  Revenue from the management, development, and financing of, and consulting with, Indian-owned casino gaming facilities is recognized as it is earned pursuant to each respective agreement. See further discussion below under the caption “Long-term assets related to Indian casino projects.”

 

Share-based compensation.  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. We determine the estimated fair value per share of restricted stock units as the closing stock price on the date of grant, as reported by the Nasdaq Global Market.

 

Income taxes.  We account for income taxes under the provisions of SFAS 109, Accounting for Income Taxes.  The determination of our income tax-related account balances requires the exercise of significant judgment by management. Accordingly, in estimating the annual effective income tax rate for interim financial reporting purposes, we assess the likelihood that deferred tax assets will be recovered from future taxable income and establish an appropriate valuation allowance when management believes recovery it is not more likely than not.

 

We also account for income tax uncertainties under the provisions of Financial Accounting Standards Board (“FASB”) Interpretation 48, Accounting for Uncertainty in Income Taxes and record estimated penalties and interest related to income tax matters, including uncertain tax positions, as a component of income tax expense.

 

Long-term assets related to Indian casino projects:

 

Notes receivable.  We have formal procedures governing our evaluation of opportunities for potential Indian-owned casino development projects that we follow before entering into agreements to provide financial support for the development of these 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 the tribes as in-substance structured notes in accordance with the guidance contained in Emerging Issues Task Force 96-12, Recognition of Interest Income and Balance Sheet Classification of Structured Notes. Under their terms, the notes do not become due and payable unless the projects are completed and operational, and distributable profits are available from the operations. 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. 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, and the two assets are accounted for separately.

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 approval 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 consolidated statement of earnings (loss) and comprehensive earnings (loss).

 

Upon opening of the casino, any difference between the then estimated fair value of the notes receivables and the amount contractually due under the notes is 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 SFAS 114 Accounting by Creditors for Impairment of a Loan (“SFAS 114”).

 

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 142, Goodwill and Other Intangible Assets (“SFAS 142”) and FASB Staff Position 142-3, Determination of the Useful Life of Intangible Assets (“FSP 142-3”). Pursuant to SFAS 142, 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 FSP 142-3, we amortize the intangible assets related to the acquisition of the management, development, consulting or financing contracts under the straight-line method over the term of the contracts which 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 have the right to 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 are 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 non-reimbursable 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.

The consolidated balance sheets as of June 28, 2009 and December 28, 2008 include long-term assets related to Indian casino projects of $109.2 million and $108.9 million, respectively. The amounts are as follows by project (in thousands):