GOLDEN ENTERTAINMENT, INC. - Quarter Report: 2010 July (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):

 

(Do not check if a smaller reporting company)

 

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 9, 2010, there were 26,369,377 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 consolidated financial statements.

 

 

See notes to consolidated financial statements.

LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES

 

Consolidated Statements of Cash Flows

 

 

See notes to consolidated financial statements.

 

 

The unaudited consolidated financial statements of Lakes Entertainment, Inc., a Minnesota corporation, and Subsidiaries (individually and collectively “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.

 

Management has evaluated the consolidated financial statements for subsequent events (Notes 8 and 15) through the date this Quarterly Report on 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 January 3, 2010, 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.

 

 

In January 2010, the Financial Accounting Standards Board issued Accounting Standards Update (“ASU”) 2010-6, Improving Disclosures About Fair Value Measurements, which requires reporting entities to make new disclosures about recurring or nonrecurring fair-value measurements including significant transfers into and out of Level 1 and Level 2 fair-value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair value measurements. ASU 2010-6 was effective for Lakes’ fiscal year beginning January 4, 2010, except for Level 3 reconciliation disclosures which will be effective for the fiscal year beginning January 3, 2011. The adoption of ASU 2010-6 did not have a material impact on Lakes’ financial statements for the three months ended July 4, 2010 and the adoption of Level 3 reconciliation disclosures is not expected to have a material impact on Lakes’ financial statements for the fiscal year beginning January 3, 2011.

 

 

At January 3, 2010, the Company’s investment portfolio was comprised of investments in auction rate securities (“ARS”), all held by UBS Financial Services, Inc. (“UBS”). See also Note 8 for a discussion of Lakes’ credit line agreement with UBS. At January 3, 2010, the Company also had the nontransferable right to sell the ARS (the “Rights”), at par value to UBS at any time during the period of June 30, 2010, through July 2, 2012. The par value of the Company’s ARS was $24.3 million as of January 3, 2010.

 

During the three months ended July 4, 2010, the Company exercised the Rights and the remaining ARS were purchased by UBS (Note 4). There were no remaining ARS investments as of July 4, 2010.

 

 

Financial instruments.  The Company’s financial instruments consist of cash and equivalents, accounts receivable, investments in securities, notes receivable and other long-term assets related to Indian casino projects, equity and cost method investments, accounts payable, contract acquisition costs payable and lines of credit. Cash equivalents consist of highly-liquid investments with an original maturity of three months or less.

 

For the Company’s cash and equivalents, accounts receivable, accounts payable and lines of credit payable, the carrying amounts approximate fair value because of the short duration of these financial instruments. The methods used in estimating the fair value of Company’s notes receivable from the Shingle Springs Tribe and Iowa Tribe of Oklahoma (Note 5), investment in unconsolidated investees (Note 7), other long-term assets related to Indian casino projects (Note 6) and contract acquisition costs payable (Note 9) are discussed in the referenced notes to the unaudited consolidated financial statements.

 

Investments in ARS, Rights, and in notes receivable from Indian Tribes for projects under development are measured at estimated fair value on a recurring basis using unobservable (Level 3) inputs that reflect management’s estimates about the assumptions that market participants would use in pricing the asset or liability, including estimated cash flows and valuation metrics. The determination of fair value for these items is described below.

 

Fair value measurements.  The following is a list of the most significant factors affecting the estimated cash flows and discount rates used in the Company’s valuation models by asset type:

 

 

The Company’s financial assets that are carried at estimated fair value based on level 3 inputs are summarized below (in thousands):

 

 

Changes in the carrying value of these asset types follows (in thousands):

 

 

To value the Company’s ARS portfolio, the Company utilized valuation models based on management’s estimates of expected cash flow streams and collateral values, default risk underlying the security, discount rates and overall capital market liquidity. The valuation of the Company’s ARS portfolio was subject to uncertainties and evolving market conditions that were difficult to predict. Factors that may have impacted the estimated fair value included changes to credit ratings of the ARS as well as to the assets collateralizing the securities, rates of default of the underlying assets, underlying collateral value, discount rates, and evolving market conditions affecting the liquidity of the ARS.

 

The Rights were a free standing asset separate from the ARS, and represented the Company’s contractual right to require UBS to purchase the Company’s ARS at par value during the period of June 30, 2010 through July 2, 2012. In order to determine the estimated fair value of the Rights, the Company utilized valuation models based on management’s estimates of expected cash flow streams, intrinsic value, and the credit worthiness of UBS.

 

To value the Company’s notes receivable from Indian tribes, the Company utilizes valuation models based on management’s estimates of expected cash flow streams, discount rates, and as applicable, probabilities of casinos opening and the expected opening dates, projected pre- and post-opening date interest rates. 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 similar financial instruments. In estimating this discount rate, market data of other public gaming related companies is also considered. The estimated casino opening date used in the valuations of the notes receivable related to Indian casino projects that are not yet under construction and in the development phase reflects the weighted-average of three scenarios: a base case (which is based on the Company’s forecasted casino opening date) and one and two years out from the base case. Once a casino project is under construction, the weighted-average scenarios are no longer used and only the planned opening date is used in the valuation. The projected pre- and post-opening 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 probability applied to each project is based upon a weighting of various possible scenarios with one scenario assuming the casino never opens. The other scenarios assume the casino opens but apply different opening dates. The probability-weighting applied to each scenario is intended to effectively capture 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.

 

During May 2010, a subsidiary of Lakes entered into a termination agreement with the Iowa Tribe of Oklahoma (“Termination Agreement with the Iowa Tribe”) terminating all contracts and agreements between them including the Management Agreement for the Cimarron Casino and the Consulting Agreement and Note Agreements for the Ioway Casino Resort. As a result, the note receivable from the Iowa Tribe of Oklahoma is no longer adjusted to its estimated fair value on a quarterly basis, but rather they are evaluated periodically for impairment pursuant to Accounting Standards Codification (“ASC”) 310.

 

Land held for development is measured at estimated fair value on a nonrecurring basis using unobservable (Level 3) inputs that utilize the market approach technique and reflect management’s estimates about the assumptions that market participants would use in pricing the asset. Significant inputs include recent transactions of comparable properties as well as consideration of its highest and best use.

 

 

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 long-term notes receivable activity is summarized in the following table (in thousands):

 

 

 

 

Shingle Springs Tribe.  The carrying value of Lakes’ notes receivable from the Shingle Springs Tribe was $52.4 million, including current portion, as of July 4, 2010. Management estimates the fair value of this financial instrument as of July 4, 2010 to be approximately $50.3 million using a discount rate of 19% and a remaining term of 66 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):

 

 

Iowa Tribe.  During the three months ended April 4, 2010, the Iowa Tribe decided not to pursue the proposed Ioway Casino Resort with Lakes. During May 2010, a subsidiary of Lakes entered into a Termination Agreement with the Iowa Tribe whereby the Iowa Tribe agreed to pay Lakes a total of $4.5 million of which $1.0 million was paid in May 2010 and the remaining $3.5 million is being paid in 15 equal monthly installments.

 

As a result of the Termination Agreement with the Iowa Tribe, the carrying value of the notes receivable was adjusted to its estimated fair value of as of April 4, 2010 and the difference between the then estimated fair value and the amount contractually due under the Termination Agreement with the Iowa Tribe is being amortized into interest income using the effective interest method over the remaining term. The note receivable is no longer adjusted to estimated fair value, but rather it is evaluated periodically for impairment pursuant to ASC 310. The payment terms of the Termination Agreement with the Iowa Tribe and a discount rate of 6.0% were used as the assumptions for the determination of estimated fair value as of April 4, 2010.

 

Lakes recorded an unrealized gain of zero and $0.9 million for the three and six months ended July 4, 2010, respectively, which is included in net unrealized gains (losses) from notes receivable in the unaudited consolidated statements of earnings (loss). At July 4, 2010, the carrying value of the note receivable is $3.2 million, including current portion, which approximates fair value.

 

The terms and assumptions used to value Lakes’ notes receivable from the Iowa Tribe at estimated fair value as of January 3, 2010 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 by project is summarized as follows (in thousands):

 

 

 

 

Land held for development.  Land held for development in this category is 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. 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 July 4, 2010 and January 3, 2010.

 

As of July 4, 2010 and January 3, 2010, Lakes also owns approximately 114 acres of land held for development located in Oklahoma. As of January 3, 2010, Lakes had invested $0.8 million in land held for development, which was being held for future transfer to the Iowa Tribe. As a result of the Iowa Tribe’s decision on April 2, 2010 not to move forward with Lakes on the Ioway Casino Resort, management performed an assessment of the land fair value and has deemed the land impaired. As a result, Lakes adjusted the carrying value of this land to its estimated fair value of $0.2 million, recorded an impairment of $0.7 million during the six months ended July 4, 2010, and has reclassified the land to Land held for development (not related to Indian casino projects). No impairment losses related to Land held for development were recognized during the three months ended July 4, 2010.

 

Other.  As of July 4, 2010 and January 3, 2010 these assets included amounts due from Mr. Kevin M. Kean. Financial instruments related to Mr. Kean have a carrying value of $2.1 million and $2.3 million, net of current portion, as of July 4, 2010 and January 3, 2010, respectively. In addition other long-term assets include financial instruments related to the Shingle Springs Tribe of $2.4 million and $1.5 million as of July 4, 2010 and January 3, 2010, respectively. Management estimates the fair value of the financial instruments related to Mr. Kean and the Shingle Springs Tribe to be $3.7 million as of July 4, 2010 using a discount rate of 19.00%.

 

 

Equity method investment.  At January 3, 2010, the Company had a 16.67% ownership interest in Kansas Gaming Partners, LLC (“Kansas Partners”) which wholly owns Chisholm Creek Casino Resort, LLC (“Chisholm Creek”), an entity formed to develop and manage a casino in south central Kansas. Lakes entered into an agreement to perform certain management and development services related to this potential casino. As of January 3, 2010, Lakes had invested approximately $8.4 million in Kansas Partners which is included in the Investment in Unconsolidated Investees in the Consolidated Balance Sheets. During April 2010, Chisholm Creek withdrew its application to be the Lottery Facility Gaming Manager in the South Central Gaming Zone in Kansas, and as a

 

result, Lakes also terminated its involvement with this project. Accordingly, Lakes received approximately $8.3 million representing a refund of Lakes’ 2009 capital contribution related to the deposit of a privilege fee with the State of Kansas for the Chisholm Creek project. As of July 4, 2010, the Company has no amounts recorded in the Consolidated Balance Sheets related to an ownership interest in Kansas Partners.

 

Cost method investments.  Lakes has an investment in Rock Ohio Ventures for the potential development of two casinos in Ohio. This investment is accounted for using the cost method since Lakes does not have the ability to significantly influence the operating and financial decisions of the entity. At July 4, 2010 and January 3, 2010, Lakes had invested a total of approximately $2.4 million in Rock Ohio Ventures, which is included in the Investment in Unconsolidated Investees in the Consolidated Balance Sheets. Lakes has the right, but not the obligation, to make additional investments up to 10% of equity required by Rock Ohio Ventures to develop the potential casinos in Ohio in return for a corresponding equity interest in those casinos (Note 13). The fair value of the Company’s investment in Rock Ohio Ventures was not estimated as of July 4, 2010, as there were no events or changes in circumstances that may have a significant adverse effect on the fair value of the investment, and Lakes’ management determined that it was not practicable to estimate the fair value of the investments.

 

At July 4, 2010 and January 3, 2010, Lakes also has an investment of approximately $1.9 million in an entity to be formed in collaboration with Penn Ventures, LLC for the potential development of two casinos in Ohio. This investment is included in the Investment in Unconsolidated Investees in the Consolidated Balance Sheets and accounted for using the cost method since Lakes does not have the ability to significantly influence the operating and financial decisions of the entity. The fair value of the Company’s investment in the entity to be formed in collaboration with was not estimated as of July 4, 2010, as there were no events or changes in circumstances that may have a significant adverse effect on the fair value of the investment. During July 2010, the Company entered into a Termination Agreement with Penn Ventures, LLC (Note 15) in which the Company divested its interest in the entity to be formed in collaboration with Penn Ventures, LLC.

 

 

Line of credit payable.  During 2008, Lakes entered into a client agreement (the “Credit Line”) with UBS under which any borrowings are secured by Lakes’ ARS held at UBS. As of January 3, 2010, approximately $16.3 million was outstanding under the Credit Line. During the three months ended July 4, 2010, a portion of the proceeds from the sale of ARS were used to repay the remaining balance of the Credit Line at that time. The Credit Line was closed upon repayment and no additional amounts are available.

 

Non-revolving line of credit payable.  Also during 2008, Lakes entered into a two-year interest only $8.0 million non-revolving line of credit loan agreement (the “Loan Agreement”) with Centennial Bank (formerly First State Bank). The Loan Agreement is collateralized by primarily all of Lakes’ interest in the real property it owns in Minnetonka, Minnesota. Amounts borrowed under the Loan Agreement bear interest at 8.95% and are due in October 2010. Lakes’ Chief Executive Officer, Lyle Berman, personally guaranteed the Loan Agreement on behalf of Lakes. As of July 4, 2010, and January 3, 2010, Lakes owed $2 million under the Loan Agreement. Subsequently on July 27, 2010, the $2 million in advances on the Loan Agreement were repaid.

 

 

The Company is obligated 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. As of July 4, 2010 and January 3, 2010, the remaining carrying amount of the liability, which approximates its estimated fair value, was $4.5 million and $5.3 million, net of a discount of $1.1 million and $1.5 million, respectively. Amounts payable during the next 12 fiscal months totaling $1.7 million are included in current contract acquisition costs payable as of July 4, 2010.

 

During 2006, the Lyle Berman Family Partnership (the “Partnership”) purchased a portion of the 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. However, 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 partners in the Partnership.

 

During 2009, the Company became obligated to pay Mr. Jerry Argovitz and Mr. Kevin Kean each $1 million per year (prorated based on a 365 day year) during the remainder of the seven-year initial term of the Red Hawk Casino management contract, which commenced in December 2008. These obligations resulted from Mr. Argovitz’s and Mr. Kean’s elections under existing agreements with Lakes to relinquish their respective other rights related to the Red Hawk Casino project. As of July 4, 2010 and January 3, 2010, the remaining carrying amount of the liability, which approximates its estimated fair value, was $6.9 million and $7.2 million, net of a $4.1 million and $4.8 million discount, respectively. Amounts payable during the next 12 fiscal months totaling $0.8 million, net of related discount, are included in current contract acquisition costs payable as of July 4, 2010.

 

 

Share-based compensation expense, which includes stock options and restricted stock units, for the three and six months ended July 4, 2010 and June 28, 2009, respectively, were as follows (unaudited):

 

 

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.

 

There were no options granted during the three and six months ended July 4, 2010 and the three months ended June 28, 2009. The weighted-average grant-date fair value of options granted during the six months ended June 28, 2009 was $2.46, which was calculated using the following assumptions: 0% expected dividend yield, 2.52% risk-free interest rate, expected term of 7.7 years, expected volatility of 79.82% and no forfeiture rate.

 

 

 

The following table summarizes Lakes’ stock option activity during the three and six months ended July 4, 2010 and June 28, 2009 (unaudited):

 

 

 

 

As of July 4, 2010, the options outstanding had a weighted-average remaining contractual life of 7.3 years, weighted-average exercise price of $3.46 and aggregate intrinsic value of zero. The options exercisable have a weighted-average exercise price of $3.47, a weighted-average remaining contractual life of 2.7 years and aggregate intrinsic value of zero as of July 4, 2010.

 

The total intrinsic value of options exercised during the three and six months ended June 28, 2009 was immaterial. There were no options exercised during the three and six months ended July 4, 2010. Lakes’ unrecognized share-based compensation related to stock options was approximately $0.7 million, as of July 4, 2010, which is expected to be recognized over a weighted-average period of 2.7 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 and six months ended July 4, 2010 and June 28, 2009 (unaudited):

 

 

During the three and six months ended July 4, 2010, 41,332 common shares were issued upon the vesting of restricted stock units, net of common shares redeemed at the election of the grantee for payroll tax payment. As of July 4, 2010, Lakes’ unrecognized share-based compensation was approximately $0.2 million related to non-vested shares, which is expected to be recognized over a weighted-average of 1.6 years.

 

 

For all periods, basic earnings (loss) per share (“EPS”) is calculated by dividing net earnings (loss) applicable to common shareholders 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 applicable to common shareholders by the weighted-average of all common and potentially dilutive shares outstanding. Potentially dilutive stock options applicable to common shareholders of 1,601,082 and 2,693,175 shares for the three months ended July 4, 2010 and June 28, 2009, respectively, and 1,601,082 and 2,787,726 shares for the six months ended July 4, 2010 and June 28, 2009, respectively, were not used to compute diluted earnings per share applicable to common shareholders because the effects would have been anti-dilutive.

 

 

The Company’s effective tax rates were (278%) and 9.2% for the six months ended July 4, 2010 and June 28, 2009, respectively. For the six months ended July 4, 2010, the effective tax rate differs from the federal tax rate of 35% primarily due to discrete items recognized and additional valuation allowance recorded due to projected 2010 timing differences. As of July 4, 2010 and January 3, 2010, the Company has recorded a $1.9 million deferred tax asset related to federal and state net operating loss carryforwards and the AMT carryforwards. The Company continues to provide a valuation allowance against its other deferred tax assets because management has evaluated all available evidence and has determined that cumulative net losses generated over the past three years outweigh existing positive evidence.

 

As of July 4, 2010, Lakes has recorded a liability of $6.9 million for uncertain tax positions plus an additional $10.3 million for the possible payment of interest and fees related to these tax liabilities (Note 13). These tax

 

liabilities are considered unrecognized tax benefits which would affect Lakes’ effective tax rate if recognized. There were no changes in the components of the liability related to uncertain tax positions during the six months ended July 4, 2010 and June 28, 2009. The Company recorded $0.2 million and $0.3 million of interest related to the uncertain tax positions as income tax expense for the three and six months ended July 4, 2010, respectively.

 

 

General.  The decline in general economic conditions in the United States may continue to have a negative impact on 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.

 

Rock Ohio Ventures, LLC.  Lakes’ initial capital requirement for a 10% ownership in Rock Ohio Ventures, LLC was $2.4 million. If Lakes chooses not to fund any additional amounts, it will maintain an ownership position in Rock Ohio Ventures, LLC in a pro rata amount of what its $2.4 million payment is to the total amount funded to develop casino operations. As of July 4, 2010, Lakes has contributed approximately $2.4 million as required as of that date (Note 7).

 

Quest Media Group, LLC.  During March and April 2010, Lakes entered into an agreement and amendment, respectively, with Quest Media Group, LLC (“Quest”), wherein Lakes agreed to pay a fee to Quest for assisting Lakes in partnering with Rock Ohio Ventures, LLC, and Penn Ventures, LLC during 2009 and with MYOHIONOW.COM, LLC in 2008 (collectively the “Project Companies”). Pursuant to the agreement, Lakes shall pay Quest a fee equal to 18.5% of gross distributions from the Project Companies (less certain amounts set forth in the agreement), capped at $0.5 million for the first five years or until Lakes recovers prior expenditures, as set forth in the agreement. The April 2010 amendment increased the fee from 18.0% to 18.5% in exchange for a payment from Quest to Lakes of $0.5 million.

 

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. Lakes expects to have motion hearings this year and a trial shortly thereafter. 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.

 

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, and although unable to estimate the minimum costs, if any, to be incurred in connection with these matters, 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.

 

 

Lakes’ segments reported below 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 Indian Casino Projects segment includes operations and assets related to the development, financing and management of gaming-related properties for the Shingle Springs Tribe, Pokagon Band, Jamul Tribe and Iowa Tribe. The Non-Indian Casino Projects segment includes operations and assets related to the development, financing and management of gaming-related properties in Mississippi and Ohio. The total assets in “Corporate and Eliminations” below primarily relate to Lakes’ short-term investments, deferred tax assets, and the Lakes’ corporate office building. 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.

 

 

 

 

 

On July 13, 2010, Lakes entered into a Termination Agreement with Penn Ventures, LLC whereby in exchange for a $25 million payment from Penn Ventures, LLC to Lakes, Lakes agreed to relinquish all rights, title and interest in the entity that was to be formed in collaboration with Penn Ventures, LLC for the development of casinos in Toledo and Columbus, Ohio (Note 7). The proceeds, net of the previously contributed capital of $1.9 million, will be recognized as a Gain on divestiture of cost method investment of approximately $23 million in the Consolidated Statement of Earnings during the three months ended October 3, 2010.

 

On July 19, 2010, in accordance with the agreement with Quest (Note 13) Lakes paid Quest $500,000 as a result of the payment received from the Termination Agreement with Penn Ventures, LLC. The payment to Quest is expected to be recognized in the Consolidated Statement of Earnings during the three months ended October 3, 2010.

 

Overview

 

Lakes Entertainment, Inc. and subsidiaries (“Lakes”, “we, or “our”) primarily develops, finances and manages casino properties with a historical emphasis on those that are Indian-owned. We currently have development and management or financing agreements with three separate tribes for casino operations in Michigan and California, for a total of three separate casino projects as follows:

 

 

During May 2010, a subsidiary of Lakes entered into a termination agreement with the Iowa Tribe of Oklahoma, its governmental components and instrumentalities (collectively, the “Iowa Tribe”) (“Termination Agreement with the Iowa Tribe”), whereby, in consideration of the parties terminating all contracts and agreements between them (including the Management Agreement under which Lakes was managing the Cimarron Casino, the Consulting Agreement for the Ioway Casino Resort, and the Amended and Restated Ioway Note under which approximately $5.0 million was advanced), the Iowa Tribe agreed to pay to Lakes a total of $4.5 million in the following manner: $1 million to be paid within two days of execution of the Termination Agreement with the Iowa Tribe and the sum of $3.5 million to be paid in 15 equal monthly installments commencing on June 15, 2010 and on the 15th day of each of the next 14 months. The Iowa Tribe is permitted to make prepayments on the outstanding amount at a 6% discount during the first twelve months after the execution of the Termination Agreement with the Iowa Tribe.

 

We have also explored, and continue to explore, other casino development projects. An overview of our non-Indian projects are as follows:

 

 

 

 

In August 2009, Lakes entered into a joint venture with the Chisholm Creek Casino Resort, LLC (“Chisholm Creek”) relating to an application to the Kansas Lottery to develop and operate a casino project in south central Kansas. On April 9, 2010, Chisholm Creek withdrew its application for the potential casino due to unresolved issues related to the project’s location and uncertainties in the competitive market. Chisholm Creek is a wholly-owned subsidiary of Kansas Gaming Partners, LLC. Lakes Kansas Casino Management, LLC, an indirect wholly-owned consolidated subsidiary of Lakes, has a 16.67% ownership in Kansas Gaming Partners, LLC. As a result of the withdrawal of the application Lakes also terminated its involvement with this project.

 

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 and six months ended July 4, 2010.

 

Three months ended July 4, 2010 compared to the three months ended June 28, 2009

 

Revenues.  Total revenues were $4.8 million for the second quarter of 2010 compared to $7.1 million for the second quarter of 2009. This decrease was primarily related to a reduction in management fees earned from the Four Winds Casino Resort due in part to an unusually low table games hold during the second quarter of 2010 and also due to new competition that entered the Four Winds Casino Resort market during the third quarter of 2009. Also contributing to the decline in Lakes’ second quarter 2010 revenues were a decrease in management fees earned related to the Cimarron Casino project, due to the termination of that agreement in May 2010 as well as a decrease in management fees from the Red Hawk Casino.

 

Selling, general and administrative expenses.  Selling, general and administrative expenses were $3.3 million in the second quarter of 2010 compared to $3.8 million for the second quarter of 2009. For the second quarter of 2010, Lakes’ selling, general and administrative expenses consisted primarily of payroll and related expenses of $1.7 million, including share-based compensation, travel expenses of $0.6 million, and professional fees of $0.5 million. The decrease was primarily due to decreases in payroll and related expenses and travel expenses. 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.

Impairment losses.  Impairment losses were $0.7 million in the second quarter of 2010 compared to $1.7 million in the second quarter of 2009. The 2010 impairment losses related primarily to continued uncertainty surrounding the Jamul Casino.

 

Amortization of intangible assets related to Indian casino projects.  Amortization of intangible assets related to Indian casino projects for the second quarter of 2010 was $2.8 million compared to $2.5 million for the second quarter of 2009.

 

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 second quarter of 2010, net unrealized losses on notes receivable were $1.5 million, compared to net unrealized gains of $2.5 million in the prior year period. The net unrealized losses in the second quarter of 2010 consisted of losses related to the Jamul Indian Village (“Jamul Tribe”) near San Diego, California due primarily to ongoing issues in the credit markets. The net unrealized gains in the second quarter of 2009 were related to the project with the Jamul Tribe and the Iowa Tribe of Oklahoma (“Iowa Tribe”) due primarily to improvements in the credit markets during that quarter.

 

Other income (expense), net.  Other income (expense), net for the second quarter of 2010 was $1.8 million compared to $1.3 million for the second quarter of 2009. The increase was primarily due to the receipt of $0.5 million from Quest Media Group, LLC in April 2010 for an increase in the percentage from 18.0% to 18.5% of gross distributions from Rock Ohio Ventures, LLC and Penn Ventures, LLC (Note 13 to the unaudited consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q).

 

Income Taxes.  The income tax benefit for the three months ended was $5.6 million compared to an income tax provision of less than $0.1 million for the second quarter of 2009. Our effective tax rates were 338.0% and 0.1% for the second quarter of 2010 and the second quarter of 2009, respectively. The effective tax rate differs from the federal tax rate of 35% due to state income taxes, valuation allowance, and provisions for interest charges on uncertain tax positions. Lakes’ income tax provision in the current year period consists primarily of current income tax benefit of $5.7 million and a current provision of approximately $0.1 million of interest on a Louisiana tax audit matter (Note 13 to the unaudited consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q). As a result of changes in estimated annual income, including a payment from Penn Ventures, LLC, which will be recognized as income in the third quarter of 2010, the majority of Lakes’ estimated annual income is now expected to be recognized during the second half of 2010. Therefore, the current period tax benefit primarily represents the adjustment needed to reflect the appropriate year-to-date provision for the six months ended July 4, 2010.

 

Six months ended July 4, 2010 compared to the six months ended June 28, 2009

 

Revenues.  Total revenues for the six months ended July 4, 2010 were $11.8 million compared to $14.3 million for the six months ended June 28, 2009. This decrease was primarily due to a reduction in management fees earned from the Four Winds Casino Resort due to new competition that entered the Four Winds Casino Resort market during the third quarter of 2009 in addition to an unusually low table games hold during the second quarter of 2010. Also contributing to the decline in Lakes’ 2010 revenues were a decrease in management fees earned related to the Cimarron Casino project, due to the termination of that agreement in May 2010 as well as a decrease in management fees from the Red Hawk Casino.

 

Selling, general and administrative expenses.  Selling, general and administrative expenses for the six months ended July 4, 2010, were $6.5 million compared to $7.8 million in the prior year period. For the first six months of 2010, Lakes’ selling, general and administrative expenses consisted primarily of payroll and related expenses of $3.6 million, including share-based compensation, travel expenses of $1.2 million, and professional fees of $1.0 million. For the first six months of 2009, Lakes’ selling, general and administrative expenses consisted primarily of payroll and related expenses of $4.2 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.

Impairment losses.  Impairment losses were $3.4 million for the six months ended July 4, 2010 compared to $2.3 million for the six months ended June 28, 2009. Due to the Iowa Tribe’s decision not to move forward with Lakes for the development and management of the Ioway Casino Resort impairment losses of $2.1 million were recognized during the first six months of 2010 in connection with land and intangible assets related to the Ioway Casino Project. In addition, due to the continued uncertainty surrounding the Jamul Casino project associated with delays in progress as well as ongoing issues in the credit markets and general economic uncertainties, we recognized impairment losses of $1.3 million during the first six months of 2010.

 

Amortization of intangible assets related to Indian casino projects.  Amortization of intangible assets related to Indian casino projects for the six months ended July 4, 2010 was $5.6 million compared to $5.0 million in the prior year period.

 

Net unrealized gains (losses) on notes receivable.  In the first six months of 2010, net unrealized gains were notes receivable of $0.3 million, compared to net unrealized gains of $2.3 million in the prior year period. The net unrealized gains in the current year period included losses related to the Jamul Tribe of $0.6 million, due primarily to ongoing issues in the credit markets. Also contributing to the current year gains were gains related to the Iowa Tribe of $0.9 million which resulted from the previously announced Termination Agreement with the Iowa Tribe in May 2010. The net unrealized gains in the prior year period were related to the project with the Jamul Tribe and the Iowa Tribe due primarily to improvements in the credit markets during that period.

 

Other income (expense), net.  Other income (expense), net for the six months ended July 4, 2010 was $3.3 million compared to $2.8 million in the prior year period. The increase was primarily due to the receipt of $0.5 million from Quest Media Group, LLC in April 2010 for an increase in the percentage from 18.0% to 18.5% of gross distributions from Rock Ohio Ventures, LLC and Penn Ventures, LLC (Note 13 to the unaudited consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q).

 

Income Taxes.  The income tax provision was $0.6 million and $0.4 million for the six months ended July 4, 2010 and June 28, 2009, respectively. Our effective tax rates were (278%) and 9.2% for the six months ended July 4, 2010 and the corresponding 2009 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 benefit of $0.1 million offset by approximately $0.2 million of interest on a Louisiana tax audit matter (Note 13 to the unaudited consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q), and an additional paid-in capital adjustment of $0.4 million.

 

Liquidity and Capital Resources

 

As of July 4, 2010, we had $24.3 million in cash and cash equivalents. We currently believe that our cash and cash equivalents balance and our cash flows from operations will be sufficient to meet our working capital requirements during the next 12 months. Lakes currently expects to be able to obtain funds in order to fulfill its potential future capital needs. However, such financing may not be available at all, or at acceptable terms, or it may be dilutive to our stockholders.

 

Our operating results and performance depend significantly on economic conditions and their effects on consumer spending in the casinos we manage. Declines in consumer spending cause our revenue generated from the management of these casinos to be adversely affected.

 

During the quarter ended July 4, 2010, UBS Financial Services (“UBS”) purchased our remaining Auction Rate Securities at their par value of $21.9 million. A portion of the proceeds were used to repay the remaining balance of $14.7 million on our related line of credit with UBS, which was subsequently closed upon repayment. These transactions resulted in a net additional liquidity of $7.2 million to Lakes, and Lakes has no remaining Auction Rate Securities investments and no remaining outstanding balance on the related line of credit.

 

On April 9, 2010, Chisholm Creek withdrew its application to be the Lottery Facility Gaming Manager in the South Central Gaming Zone in Kansas. As a result, Lakes received approximately $8.3 million from Kansas

Gaming Partners, LLC on April 14, 2010 representing Lakes’ previous capital contribution for the deposit of a privilege fee with the State of Kansas.

 

During 2008, we closed on a two-year interest only $8.0 million non-revolving line of credit loan agreement (the “Loan Agreement”) with Centennial Bank (formerly First State Bank). Amounts borrowed under the Loan Agreement bear interest at 8.95%. As of July 4, 2010, Lakes has drawn $2.0 million under the Loan Agreement. These advances were repaid on July 27, 2010. There are currently no advances outstanding under the Loan Agreement.

 

Per our agreement with Rock Ohio Ventures related to two potential Ohio casinos, Lakes expects to invest additional funds in those projects. As a result Lakes may need to obtain additional financing.

 

Lakes derived its revenues from the management of the Cimarron Casino, the Four Winds Casino Resort and the Red Hawk Casino. Due to the Termination Agreement with the Iowa Tribe, Lakes will no longer receive management fees for the Cimarron Casino subsequent to May 2010. Our management contracts with the Four Winds Casino Resort and the Red Hawk Casino extend through fiscal July 2012 and December 2015, respectively. Because of the relatively short operating history of the casinos we manage, and the uncertainty in the economic environment, the amount of our ongoing management fees is uncertain.

 

During May 2010, Lakes entered into the Termination Agreement with the Iowa Tribe whereby the Iowa Tribe agreed to pay to Lakes a total of $4.5 million of which $1 million was received within two days of execution of the Termination Agreement with the Iowa Tribe and the sum of $3.5 million is to be paid in 15 equal monthly installments commencing on June 15, 2010, and on the 15th day of the next 14 months.

 

On July 13, 2010, Lakes entered into a Termination Agreement with Penn Ventures, LLC whereby, in consideration of the parties terminating the Funding and Option Agreement entered into during October 2009, Penn Ventures, LLC paid Lakes $25 million. Accordingly, Lakes no longer has any rights, obligations or interest in the entity that was to be formed in collaboration with Penn Ventures for the development of casinos in Toledo and Columbus, Ohio. On July 19, 2010, in accordance with the agreement with Quest Media Group, LLC, Lakes paid Quest $500,000 as a result of the payment received from the Termination Agreement with Penn Ventures, LLC.

 

Lakes’ forecasted operating cash requirements do not include construction-related costs that will be incurred when pending and future development projects begin construction because the construction of our pending casino projects will depend on the ability of the tribes and/or Lakes or its partners 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. If our casino development project with the Jamul Tribe is not constructed or if constructed, does not achieve profitable operations in the highly competitive market for gaming activities, our only recourse is to attempt to liquidate assets of the development, if any, excluding any land in trust and it is likely that we would incur complete losses on our notes receivable and any related intangible assets.

 

In order to assist the tribes, we may elect 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. 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.

 

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, long-term assets related to Indian casino projects, investment securities, litigation costs, income taxes, and share-based compensation. 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, 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 expense:  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 Accounting Standards Codification (“ASC”) 740, Income Taxes.  The determination of our income tax-related account balances requires the exercise of significant judgment by management. Accordingly, we determine deferred tax assets and liabilities based upon the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. We assess the likelihood that deferred tax assets will be recovered from future taxable income and establish a valuation allowance when management believes recovery is not likely.

 

We 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 ASC 320, Investments — Debt and Equity Securities. 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 consolidated statement of 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 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 ASC 310, Receivables (“ASC 310”).

 

Additionally, upon significant changes in the development activity prior to the opening of a casino, including termination of the project, notes receivable would be evaluated for impairment pursuant to ASC 310 and any necessary decline in the carrying amount will be recorded as unrealized losses in our consolidated statement of earnings (loss). Subsequent to the initial impairment evaluation, we continue to monitor the note receivable for any changes in expected cash flows and recognize those changes in accordance with ASC 310.

 

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 ASC 350, Intangibles — Goodwill and Other (“ASC 350”). 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 ASC 350, 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.

 

Long-term asset related to Indian Casino projects The consolidated balance sheets as of July 4, 2010 and January 3, 2010 include long-term assets related to Indian casino projects of $102.4 million and $110.6 million, respectively, which primarily related to four separate projects. The amounts are as follows by project (in thousands):

 

 

 

 

 

 

The key assumptions, estimates and criteria used in the determination of the estimated fair value of the notes receivable are primarily unobservable level three inputs, which are casino opening dates, pre- and post-opening date interest rates, discount rates and probabilities of projects opening. The estimated casino opening dates used in the valuations of the notes receivable related to Indian casino projects that are not yet under construction reflect 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. Once a casino project is under construction, the weighted-average scenarios are no longer used and only the planned opening date is used in the valuation. The 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 various possible scenarios with one scenario assuming the casino never opens. The other scenarios assume the casino opens but apply different opening dates. The probability-weighting applied to each scenario is intended to effectively capture 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.

 

Jamul Tribe

 

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

 

 

The following table represents a sensitivity analysis prepared by Lakes as of July 4, 2010 on the notes receivable from the Jamul Tribe, based upon changes in the probability rate of the casino opening by five percentage points and the estimated casino opening date by one year:

 

The assumption changes used in the sensitivity analysis above are hypothetical. The effect of the variation in the probability assumption and estimated opening date on the estimated fair value of the notes receivable from Indian tribes was calculated without changing any other assumptions; however, in reality, changes in these factors may result in changes in another. For example, the change in probability could be associated with a change in discount rate, which might magnify or counteract the sensitivities.

 

The following represents the nature of the advances to the tribes for Jamul project under development, which represent the principal amount of the notes receivable, as of July 4, 2010 and January 3, 2010 (in thousands).

 

 

 

 

The notes receivable pre-construction advances consist of the following principal amounts advanced to the Jamul Tribe as of July 4, 2010 and January 3, 2010 (in thousands):

 

 

Iowa Tribe

 

As a result of the Termination Agreement with the Iowa Tribe, the carrying value of the notes receivable was adjusted to its estimated fair value of as of April 4, 2010 and the difference between the then estimated fair value and the amount contractually due under the Termination Agreement with the Iowa Tribe is being amortized into income using the effective interest method over the remaining term. The note receivable is no longer adjusted to estimated fair value, but rather it is evaluated periodically for impairment pursuant to ASC 310. The payment terms of the Termination Agreement with the Iowa Tribe and a discount rate of 6.0% were used as the assumptions for the determination of estimated fair value as of April 4, 2010.

 

Lakes recorded an unrealized gain of zero and $0.9 million for the three and six months ended July 4, 2010, which is included in net unrealized gains (losses) from notes receivable in the unaudited consolidated statements of earnings (loss). At July 4, 2010, the carrying value of the note receivable is $3.2 million, including current portion, which approximates fair value.

The following table provides the key assumptions used to value the notes receivable from the Iowa Tribe at estimated fair value as of January 3, 2010 (dollars in thousands):

 

 

Evaluation of impairment related to long-term assets related to Indian casino projects, excluding the notes receivable.

 

Management periodically evaluates the intangible assets, land held for development and other costs associated with each of the projects for impairment based on the estimated undiscounted cash flows from the applicable management 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 were to exceed the undiscounted cash flow, an impairment loss would be recorded, based on the difference between the estimated fair value and carrying value of the assets.

 

The financial models prepared by management for each project are based upon the scope of each of the projects, which are supported by a feasibility study as well as a market analysis where the casino will be built. We (as predecessor to Grand Casinos Inc.) began developing Indian casino projects in 1990 and demonstrated success from the day the first Indian casino opened in 1991 through the expiration of the Coushatta management contract in 2002. Additionally, we have been managing the Cimarron Casino since 2006, the Four Winds Casino Resort since August of 2007, and the Red Hawk Casino since December of 2008. Our successful history legitimizes many of the key assumptions supporting the financial models. Forecasts for each applicable casino development were developed based on analysis of published information pertaining to the particular markets in which our Indian casinos will be located and are updated quarterly based on evolving events and market conditions. In addition, we have many years of casino operations experience, which provides an additional resource on which to base our revenue expectations. The forecasts were prepared by us not for purposes of the valuation at hand but rather for purposes of our and the tribes’ business planning.

 

The primary assumptions included within management’s financial model for the Jamul Casino project are as follows:

 

Jamul Tribe

 

Lakes and the Jamul Tribe have consulted with third party advisors as to the architectural feasibility of a plan to build a casino with related amenities such as parking on the six acres of reservation land held by the Jamul Tribe and have concluded that such a project could be successfully built assuming adequate financing can be obtained. The gaming facility is currently planned to be a class II electronic gaming device facility which will not require a compact. The agreement between Lakes and the Jamul Tribe will also be modified to reflect the new economics of the revised casino plan but is not currently believed to require approval by the State or the NIGC.

 

 

The Jamul Casino project has been significantly delayed due to various political and regulatory issues. Significant risk exists related to this project moving forward to completion, and historically, we have recorded significant impairment charges against our investment in this project. However, the Jamul Tribe has the two basic requirements to eventually build a successful project — federal recognition as an Indian Tribe and Indian land eligible for gaming and Lakes currently expects to continue its involvement with this project.

 

Iowa Tribe

 

On April 2, 2010, the Iowa Tribe decided not to pursue the proposed Ioway Casino Resort with Lakes. At January 3, 2010, long-term assets included intangibles assets of $1.4 million and land held for development of $0.9 million. As a result of the Iowa Tribe’s decision on April 2, 2010 not to move forward with Lakes on the Ioway Casino Resort, management performed an assessment of the land fair value and has deemed the land impaired as of April 4, 2010. As a result, Lakes adjusted the carrying value of this land to its estimated fair value of $0.2 million as of that date, recorded an impairment of $0.7 million during the three months ended April 4, 2010, respectively, and has reclassified the land to Land held for development (not related to Indian casino projects). No impairment losses were recognized during the three months ended July 4, 2010.

 

Description of each Indian casino project and evaluation of critical milestones:

 

Pokagon Band

 

Business arrangement.  On August 2, 2007, the Four Winds Casino Resort in New Buffalo, Michigan opened to the public. We receive approximately 24% of net income up to a certain level and 19% of net income over that level, as a management fee. The term of the management contract is five years, which began on August 2, 2007. Payment of our management fee is subordinated to the Pokagon Gaming Authority’s senior indebtedness relating to the Four Winds Casino Resort. The Pokagon Band may also buy out the management contract. The buy-out amount is calculated based upon the previous 12 months of management fees earned multiplied by the remaining number of years under the management contract, discounted back to the present value at the time the buy-out occurs. The NIGC approved the management contract in March 2006.

 

Shingle Springs

 

Business arrangement.  On December 17, 2008, the Red Hawk Casino opened to the public. We receive a management fee equal to 30% of net income (as defined by the management contract) of the operations annually for the first five years, with a declining percentage in years six and seven. Payment of our management fee is subordinated to the repayment of $450 million senior note financing of an affiliate of the Shingle Springs Tribe, the repayment of $53.7 million furniture, furnishings and equipment financing as of July 4, 2010 and a minimum priority payment to the Shingle Springs Tribe. Generally, the order of priority of payments from the Red Hawk Casino’s cash flows is as follows: a certain minimum monthly guaranteed payment to the Shingle Springs Tribe, repayment of various debt with interest accrued thereon, management fee to Lakes, and other obligations, with the remaining funds distributed to the Shingle Springs Tribe. The management contract includes provisions that allow the Shingle Springs Tribe to buy out the management contract after four years from the opening date. The buy-out amount is based upon the previous 12 months of management fees earned multiplied by the remaining number of years under the contract, discounted back to the present value at the time the buy-out occurs. If the Shingle Springs

Tribe elects to buy out the contract, all outstanding amounts owed to Lakes immediately become due and payable. The NIGC approved the management contract in July 2004, which was subsequently amended in April 2007.

 

We acquired our initial interest in the development and management contracts for the Shingle Springs Casino from KAR — Shingle Springs in 1999 and formed a joint venture, in which the contracts were held, between us and KAR — Shingle Springs. On January 30, 2003, we purchased the remaining KAR — Shingle Springs’ partnership interest in the joint venture. In connection with the purchase transaction, we entered into separate agreements with the two individual owners of KAR — Shingle Springs (Kevin M. Kean and Jerry A. Argovitz).

 

During 2009, Lakes 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 Lakes and the Shingle Springs Tribe, as a result of Mr. Argovitz’s election under an existing agreement related to this project. Also as a result of this election, Mr. Argovitz will not be entitled to obtain a 15% equity interest in the Lakes’ entity that holds the rights to the management fees earned by Lakes from the Red Hawk Casino operations.

 

During 2009, Lakes became obligated to pay to Mr. Kean $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 Lakes and the Shingle Springs Tribe, as a result of Mr. Kean’s election under an existing agreement related to this project. Also as a result of this election, Mr. Kean will not be entitled to receive consulting fees equal to 15% of the management fees earned by Lakes from the Red Hawk Casino operations.

 

See Note 9 to the consolidated unaudited financial statements for further discussion.

 

Jamul Tribe

 

The Jamul Casino project has been delayed due to various political and regulatory issues related to access from State Highway 94 to the proposed casino site. The Jamul Tribe first requested approval on a driveway road connection to State Highway 94, but was denied a permit by San Diego County (the “County”).

 

In September 2008, the BIA notified the Jamul Tribe that an access road on its land had been approved as an Indian Reservation Road (“IRR”), which would allow the Jamul Tribe to construct a second potential access point to the reservation without the need for a permit from the County. The Jamul Tribe notified CalTrans of this additional access option but CalTrans viewed this access point no differently than the proposed driveway road connection to State Highway 94. The Jamul Tribe filed a federal complaint requesting the Federal Court to order CalTrans to cease its efforts to impede the Jamul Tribe from using its lands for economic development purposes. After losing a motion to dismiss, CalTrans denied the allegations. The parties subsequently reached an agreement whereby the Jamul Tribe dismissed its lawsuit and CalTrans removed its contention that it could restrict access to the reservation, and agreed to work positively with the Jamul Tribe to expeditiously process the encroachment permit application. Traffic, environmental, engineering and other required studies are now underway as the Jamul Tribe works toward completing the environmental analysis necessary for the encroachment permit application.

 

Business arrangement.  The Jamul Tribe has an approximate six-acre reservation on which the casino project is currently planned to be built. The reservation is located near San Diego, California. Under the current compact that the Jamul Tribe has with the State of California (the “State”) and based upon requirements in other compacts approved by the State in 2004, the Jamul Tribe completed a Tribal Environmental Impact Statement/Report that was approved by the Jamul Tribe’s General Council with a record of decision issued by the Jamul Tribe on December 16, 2006. Since that time, the Jamul Tribe has received comments from various state agencies including the representative from the California Governor’s office. The Jamul Tribe and the State have met on several occasions in an attempt to address the State’s comments related to compact requirements. Throughout 2007, Lakes and the Jamul Tribe were evaluating the Jamul Tribe’s alternatives of pursuing a new compact, complying with certain requirements in their existing compact or building and operating a casino based solely on class II electronic gaming devices. The proposed gaming facility has been reduced in size and scope because the State’s comments on the Jamul Tribe’s existing compact or a proposed new contract is expected to take more time than is currently acceptable to the Jamul Tribe. The current plan is for a smaller scale gaming facility that will become a solely class II electronic gaming device facility which will not require a compact. The agreement between Lakes and the Jamul Tribe (discussed below) will also be modified to reflect the new economics of the revised casino plan but is not currently believed to require approval by the State or the NIGC.

Effective March 30, 2006, Lakes entered into a development financing and services agreement with the Jamul Tribe to assist the Jamul Tribe in developing the Jamul Casino which the Jamul Tribe will manage. As part of the current agreement, Lakes will use its best efforts to obtain financing of up to $350 million, from which advances will be made to the Jamul Tribe to pay for the design and construction of the Jamul Casino. Under the current development financing and services agreement, Lakes is entitled to receive a flat fee of $15 million for its development design services and a flat fee of $15 million for its construction oversight services, payable evenly over the first five years after the opening date of the Jamul Casino. In connection with Lakes’ financing of the Jamul Casino, the Jamul Tribe is required to pay interest over a ten-year period on sums advanced by Lakes equal to the rate charged to Lakes for obtaining the necessary funds plus five percent. Amounts previously advanced by Lakes to the Jamul Tribe in connection with the Jamul Tribe’s proposed casino resort are included in the development financing and services agreement financing amount. However, as discussed above, this agreement is planned to be modified with resulting lower fees to Lakes. There is also no assurance that third party financing will be available with acceptable terms. If Lakes is unable to obtain the appropriate amount of financing for this project, the project may not be completed as planned.