ICAHN ENTERPRISES L.P. - Quarter Report: 2005 June (Form 10-Q)

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

COMMISSION FILE NUMBER 1-9516

AMERICAN REAL ESTATE PARTNERS, L.P.

(Exact name of registrant as specified in its charter)

(914) 242-7700

(Registrant’s telephone number, including area code)

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

      Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)     Yes þ          No o

      As of August 1, 2005, there were 61,856,830 depositary units and 10,800,577 preferred units outstanding.

INDEX

AMERICAN REAL ESTATE PARTNERS, L.P. AND SUBSIDIARIES

FORM 10-Q, JUNE 30, 2005

Part I. Financial Information

Item 1. Financial Statements

CONSOLIDATED BALANCE SHEETS

See notes to consolidated financial statements.

AMERICAN REAL ESTATE PARTNERS, L.P. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF EARNINGS

See notes to consolidated financial statements.

AMERICAN REAL ESTATE PARTNERS, L.P. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF EARNINGS

See notes to consolidated financial statements.

AMERICAN REAL ESTATE PARTNERS, L.P. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES

IN PARTNERS’ EQUITY AND COMPREHENSIVE INCOME

SIX MONTHS ENDED JUNE 30, 2005

Accumulated other comprehensive loss at June 30, 2005 was $5.8 million.

See notes to consolidated financial statements.

AMERICAN REAL ESTATE PARTNERS, L.P. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS

AMERICAN REAL ESTATE PARTNERS, L.P. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS — (Continued)

See notes to consolidated financial statements.

AMERICAN REAL ESTATE PARTNERS, L.P.

FORM 10-Q JUNE 30, 2005

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

      American Real Estate Partners, L.P. (“AREP” or the “Company”) is a master limited partnership formed in Delaware on February 17, 1987. Our general partner is American Property Investors, Inc. (“API” or “the General Partner”). The Company owns a 99% limited partner interest in American Real Estate Holdings Limited Partnership (“AREH”), the operating partnership formed to hold the investments of and conduct the business operations of the Company. The accompanying consolidated financial statements and related notes should be read in conjunction with the consolidated financial statements and related notes contained in the Company’s annual report on Form 10-K for the year ended December 31, 2004, and the supplemental consolidated financial statements and related notes contained in the Company’s current report on Form 8-K filed on May 9, 2005 to reflect the inclusion in the Company’s consolidated financial statements of TransTexas Gas Corporation as a result of its acquisition on April 6, 2005 (see note 2 below).

      The financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission related to interim financial statements. The financial information contained herein is unaudited; however, all adjustments which, in the opinion of management, are necessary to present fairly the results for the interim periods, have been made. All such adjustments are of a normal and recurring nature. Certain prior year amounts have been reclassified in order to conform to the current year presentation.

      The consolidated financial statements include the accounts of the Company and its wholly and majority owned subsidiaries in which control can be exercised. The Company is considered to have control if it has a direct or indirect ability to make decisions about an entity’s activities through voting or similar rights. All material intercompany accounts and transactions have been eliminated in consolidation.

      The results of operations for the three and six months ended June 30, 2005 are not necessarily indicative of the results to be expected for the full year. In particular, hotel, casino and resort operations are highly seasonal.

      The Company’s historical financial statements herein have been restated to reflect the five entities acquired in the second quarter of 2005 as discussed in note 2. In accordance with generally accepted accounting principles, assets transferred between entities under common control are accounted for at historical cost similar to a pooling of interests, and the financial statements of previously separate companies for periods prior to the acquisition are restated on a combined basis.

      As a result of the restatements arising from the acquisitions that occurred in the second quarter of 2005, the financial statements of the Company now include additional entities. Some of these entities, principally the oil and gas entities, prepare financial statements based on accounting policies that were not described in the Company’s annual report on Form 10-K for the year ended December 31, 2004. Accordingly, certain required additional information is included in this Form 10-Q in such a manner as to supplement disclosures already included in the Company’s annual report on Form 10-K.

      The new accounting policies, which relate to oil and gas accounting, are set out in note 3. Additional disclosures related to the oil and gas acquisitions are included in notes 12, 16 and 17.

      On June 29, 2005, the Company issued unit options to its Chief Executive Officer (see note 4). No other options or equity related awards have been made to directors, officers or employees. Coincident with the issuance of the unit options the Company adopted the provisions of Financial Accounting Standards Board

AMERICAN REAL ESTATE PARTNERS, L.P.

FORM 10-Q JUNE 30, 2005

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123R”) under which compensation expense for options issued to employees is accounted for using a fair-value-based method with the (non-cash) compensation expense being recorded in the financial statements over the vesting period. The Company uses the Black-Scholes option-pricing model to value options. The amount recorded in the Company’s income statement for the three and six months ended June 30, 2005 related to the options was not significant. The adoption of SFAS 123R did not have an impact on any prior period.

      The Company classifies its marketable securities as either held-for-sale or trading based upon whether it intends to hold the investment for the foreseeable future. Securities that are classified as held-for-sale are reported at fair value with unrealized gains and losses reported as a separate component of partners’ equity. Trading securities are carried at fair value with unrealized losses being including in net earnings.

      Each of National Energy Group, Inc. (“NEG”) and Atlantic Coast Entertainment Holdings, Inc. (“Atlantic Holdings”), are reporting companies under the Securities Exchange Act of 1934. In addition, American Casino & Entertainment Properties LLC (“American Casino”) files annual, quarterly and current reports. Each of these reports is separately filed with the Securities and Exchange Commission.

      During the second quarter of 2005, the Company acquired the following five companies:

      Each of these companies was acquired from entities affiliated with Mr. Icahn. The acquisition of entities under common control is required to be accounted for under the “as if pooling” method during the period of common control. As a result of this method of accounting, the assets and liabilities of NEG Holdings, TransTexas, Panaco, GBH and Atlantic Holdings are included in the consolidated financial statements at historical cost. All prior period financial statements of the Company included herein have been restated to include the consolidated results of operations and cash flows of the acquired entities.

      TransTexas: On April 6, 2005, the Company acquired 100% of the equity of TransTexas, an oil and gas exploration and production company, for a purchase price of $180.0 million in cash from affiliates of Mr. Icahn. The period of common control for TransTexas began on September 1, 2003. For financial reporting purposes, earnings, capital contributions and distributions prior to the acquisition have been allocated to the General Partner.

      NEG Holdings: On June 30, 2005, the Company completed the acquisition of the managing membership interest in NEG Holdings from an affiliate of Mr. Icahn in consideration for 11,034,408 of our depositary units representing limited partner interests in American Real Estate Partners, L.P. The depositary units issued in consideration for the acquisition were valued at approximately $320 million. The membership interest

AMERICAN REAL ESTATE PARTNERS, L.P.

FORM 10-Q JUNE 30, 2005

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

acquired constitutes all of the membership interests other than the membership interest already owned by National Energy Group, Inc., (“NEG”) which is itself 50.01% owned by us. NEG Holdings owns 100% of NEG Operating LLC, (“NEG Operating” or “Operating LLC”) which is engaged in the exploration and production of oil and gas, primarily in Arkansas, Louisiana, Texas and Oklahoma. As a result of the acquisition of the additional direct interest in NEG Holdings, the Company is now the primary beneficiary of NEG Holdings in accordance with FASB Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities”, and now consolidates the financial results of NEG Holdings. The consolidated financial statements give retroactive effect to the consolidation of the acquired 50% interest in NEG Holdings, together with our 50% interest owned through NEG. Our investment in NEG Holdings, which was previously accounted for as a preferred investment has been eliminated with the consolidation of NEG Holdings. The period of common control for NEG Holdings began on September 1, 2001. For financial reporting purposes, earnings, capital contributions and distributions prior to the acquisition have been allocated to the General Partner.

      Panaco: On June 30, 2005, the Company acquired 100% of the equity of Panaco from affiliates of Mr. Icahn for 4,310,345 depositary units. The depositary units issued in consideration for the acquisition were valued at approximately $125 million. Panaco is engaged in the exploration and production of oil and gas, primarily in the Gulf of Mexico and the Gulf Coast Region and owns interests in 123 wells. The period of common control for Panaco began on November 16, 2004 when Panaco emerged from bankruptcy. The six weeks of operations from that date to the end of the fiscal year were not material and accordingly the acquisition of Panaco has been recorded effective December 31, 2004. For financial reporting purposes, earnings, capital contributions and distributions prior to the acquisition have been allocated to the General Partner.

      GBH and Atlantic Holdings: On June 30, 2005, the Company completed the purchase of 4,121,033 shares of common stock of GBH and 1,133,284 shares of common stock of Atlantic Holdings from affiliates of Mr. Icahn in consideration for 413,793 of our depositary units. Up to an additional 206,897 depositary units may be issued if Atlantic Holdings meets certain earnings targets during 2005 and 2006. The depositary units issued in consideration for the acquisitions were valued at approximately $12 million. Atlantic Holdings owns ACE Gaming LLC (“ACE”) which owns and operates the Sands Hotel and Casino in Atlantic City, New Jersey. The period of common control for GBH and Atlantic Holding began prior to January 1, 2002. Earnings, capital contributions and distributions prior to the acquisition have been allocated to the General Partner.

      On May 17, 2005, the Company (1) converted $28.8 million in principal amount of 3% notes due 2008 issued by Atlantic Holdings into 1,898,181 shares of Atlantic Holdings common stock and (2) exercised warrants to acquire 997,620 shares of Atlantic Holdings common stock. Also on May 17, 2005, affiliates of Mr. Icahn exercised warrants to acquire 1,133,284 shares of Atlantic Holdings common stock. Prior to May 17, 2005 GBH owned 100% of the outstanding capital stock of Atlantic Holdings.

      After the acquisitions from affiliates of Mr. Icahn, the Company owns 77.5% of the common stock of GBH and 58.3% of the common stock of Atlantic Holdings. Atlantic Holdings owns 100% of ACE. As a result of the acquisition, the Company obtained control of GBH and Atlantic Holdings. The consolidated financial statements give retroactive effect to the consolidation of GBH and Atlantic Holdings. The Company had previously accounted for GBH on the equity method.

      On June 30, 2005, in connection with issuances of depositary units in the NEG Holdings, Panaco, GBH and Atlantic Holdings transactions, AREP entered into a registration rights agreement with Highcrest Investors Corp., Arnos Corp., Cyprus, LLC and Gascon Partners, all affiliates of Mr. Icahn.

AMERICAN REAL ESTATE PARTNERS, L.P.

FORM 10-Q JUNE 30, 2005

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

      Summary financial data for the acquired entities for the six months ended June 30, 2005 and 2004 are as follows:

As a result of the restatement discussed above, NEG Holdings and GBH/ Atlantic Holdings have been consolidated for all periods included in the accompanying statements of earnings. However, the Company’s financial statements prior to the restatement included certain income statement amounts for these entities. Specifically:

      The above table also reflects the impact of unrealized losses on oil and gas derivatives which totaled $31.8 million and $13.8 million for the six months ended June 30, 2005 and 2004, respectively.

      In 1997, the Company entered into a license agreement with an affiliate of API for office space. Pursuant to the license agreement, the Company has the non-exclusive use of approximately 2,275 square feet for which it pays monthly rent of $11,185 plus 10.77% of certain “additional rent.” The terms of such license agreement were reviewed and approved by the Audit Committee of the Board of Directors of the General Partner (the “Audit Committee”). The agreement, which expired in May 2004, has been extended on a month-to-month basis. In the three months ended June 30, 2005 and 2004, the Company paid rent of approximately $39,000 and $26,000, respectively. In the six months ended June 30, 2005 and 2004, the Company paid rent of approximately $78,000 and $65,000, respectively.

      In the three months ended June 30, 2005 and 2004, the Company paid approximately $340,000 and $59,000 to an affiliate of the General Partner for telecommunication services, respectively. In the six months ended June 30, 2005 and 2004, the Company paid approximately $567,000 and $120,000 to an affiliate of the General Partner for telecommunication services, respectively.

      An affiliate of the General Partner provided certain administrative services to the Company which paid to such affiliate approximately $22,000 and $20,000 in the three months ended June 30, 2005 and 2004, respectively and $43,000 and $41,000 in the six months ended June 30, 2005 and 2004.

AMERICAN REAL ESTATE PARTNERS, L.P.

FORM 10-Q JUNE 30, 2005

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

      The Company provided certain administrative services to affiliate of the General Partner and was paid $18,000 in the three and six months ended 2005, and $27,000 in the three and six months ended June 30, 2004.

      As of August 1, 2005, affiliates of Mr. Icahn owned 9,346,044 preferred units and 55,655,382 depositary units which represent 86.5% and 90.0% of the outstanding preferred units and depositary units, respectively.

      The Company utilizes the full cost method of accounting for its crude oil and natural gas properties. Under the full cost method, all productive and nonproductive costs incurred in connection with the acquisition, exploration and development of crude oil and natural gas reserves are capitalized and amortized on the units-of-production method based upon total proved reserves. The costs of unproven properties are excluded from the amortization calculation until the individual properties are evaluated and a determination is made as to whether reserves exist. Conveyances of properties, including gains or losses on abandonments of properties, are treated as adjustments to the cost of crude oil and natural gas properties, with no gain or loss recognized.

      Under the full cost method, the net book value of oil and natural gas properties, less related deferred income taxes, may not exceed the estimated after-tax future net revenues from proved oil and natural gas properties, discounted at 10% per year (the ceiling limitation). In arriving at estimated future net revenues, estimated lease operating expenses, development costs, abandonment costs, and certain production related and ad-valorem taxes are deducted. In calculating future net revenues, prices and costs in effect at the time of the calculation are held constant indefinitely, except for changes, which are fixed and determinable by existing contracts. The net book value of oil and gas properties is compared to the ceiling limitation on a quarterly basis.

      The Company has capitalized internal costs of $.5 million for the six months ended June 30, 2004 and 2005, respectively with respect to its oil and gas activities. The Company has not capitalized interest expense.

      The Company is subject to extensive federal, state, and local environmental laws and regulations. These laws, which are constantly changing, regulate the discharge of materials into the environment and may require the Company to remove or mitigate the environment effects of the disposal or release of petroleum or chemical substances at various sites. Environmental expenditures are expensed or capitalized depending on their future economic benefit. Expenditures that relate to an existing condition caused by past operations and that have no future economic benefits are expensed. Liabilities for expenditures of a non-capital nature are recorded when environmental assessment and/or remediation is probable, and the costs can be reasonably estimated.

      The Company’s oil and gas operations are subject to all of the risks inherent in oil and natural gas exploration, drilling, and production. These hazards can result in substantial losses to the Company due to personal injury and loss of life, severe damage to and destruction of property and equipment, pollution or environmental damage, or suspension of operations. The Company maintains insurance of various types customary in the industry to cover its operations and believes it is insured prudently against certain of these risks. In addition, the Company maintains operator’s extra expense coverage that provides coverage for the care, custody and controls of wells drilled by the Company. The Company’s insurance does not cover every potential risk associated with the drilling and production of oil and natural gas. As a prudent operator, the Company does maintain levels of insurance customary in the industry to limit its financial exposure in the event of a substantial environmental claim resulting from sudden and accidental discharges. However, 100%

AMERICAN REAL ESTATE PARTNERS, L.P.

FORM 10-Q JUNE 30, 2005

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

coverage is not maintained. The occurrence of a significant adverse event, the risks of which are not fully covered by insurance, could have a material adverse effect on the Company’s financial condition and results of operations. Moreover, no assurance can be given that the Company will be able to maintain adequate insurance in the future at rates it considers reasonable. The Company believes that, in all material respects, it operates in compliance with government regulations and in accordance with safety standards which meet or exceed industry standards.

      The Company accounts for natural gas production imbalances using the sales method, whereby the Company recognizes revenue on all natural gas sold to its customers notwithstanding that its ownership may be less than 100% of the natural gas sold. Liabilities are recorded by the Company for imbalances greater than the Company’s proportionate share of remaining natural gas reserves. The Company had $.9 million in gas balancing liabilities as of June 30, 2005 (unaudited) and December 31, 2004, respectively.

      From time to time, the Company enters into derivative contracts, principally commodity price collar agreements to reduce its exposure to price risk in the spot market for natural gas and oil. The Company follows Statement of Financial Accounting Standards No. 133 (“SFAS 133”), “Accounting for Derivative Instruments and Hedging Activities”, which was amended by Statement of Financial Accounting Standards No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities.” These pronouncements established accounting and reporting standards for derivative instruments and for hedging activities, which generally require recognition of all derivatives as either assets or liabilities in the balance sheet at their fair value. The accounting for changes in fair value depends on the intended use of the derivative and its resulting designation. (See note 17).

      Provision has been made for federal, state or local income taxes on the results of operations generated by the Company’s corporate subsidiaries. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

      No provision has been made for federal, state or local income taxes on the results of operations generated by partnership activities, as such taxes are the responsibility of the partners.

      The Company accounts for its asset retirement obligations under Statement of Financial Accounting Standards No. 143 (“SFAS 143”), “Accounting for Asset Retirement Obligations”. SFAS 143 provides accounting requirements for costs associated with legal obligations to retire tangible, long-lived assets. Under SFAS 143, an asset retirement obligation is recorded at fair value in the period in which it is incurred by increasing the carrying amount for the related long-lived asset. In each subsequent period, the liability is accreted to its present value and the capitalized cost is depreciated over the useful life of the related asset. (See note 16).

AMERICAN REAL ESTATE PARTNERS, L.P.

FORM 10-Q JUNE 30, 2005

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

      The following disclosures are required annual disclosures. As the Company’s annual report on Form 10-K has not been restated to include the results of operations for the oil and gas entities that were acquired recently, the following disclosures are provided in this Form 10-Q.

      Capitalized costs as of December 31, 2004 relating to oil and gas producing activities are as follows (in $000s):

      Cost incurred in connection with property acquisition, exploration and development activities for the year ended December 31, 2004 were as follows (in $000s, except depletion rate):

      As of December 31, 2004 all capitalized costs relating to oil and gas activities have been included in the full cost pool.

      The accompanying tables present information concerning the Company’s oil and natural gas producing activities during the year ended December 31, 2004 and are prepared in accordance with Statement of Financial Accounting Standards No. 69, “Disclosures about Oil and Gas Producing Activities.”

      Estimates of the Company’s proved reserves and proved developed reserves were prepared by independent firms of petroleum engineers, based on data supplied by them to the Company. Estimates relating to oil and gas reserves are inherently imprecise and may be subject to substantial revisions due to changing prices and new information, such as reservoir performance, production data, additional drilling and other factors becomes available.

      Proved reserves are estimated quantities of oil, natural gas, condensate and natural gas liquids which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Natural gas liquids and condensate are included in oil reserves. Proved developed reserves are those proved reserves that can be expected to be recovered through existing wells with existing equipment and operating methods. Natural gas quantities represent gas volumes which include amounts that will be extracted as natural gas liquids. The Company’s

AMERICAN REAL ESTATE PARTNERS, L.P.

FORM 10-Q JUNE 30, 2005

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

estimated net proved reserves and proved developed reserves of oil and condensate and natural gas for the year ended December 31, 2004 were as follows:

      The calculation of estimated future net cash flows in the following table assumes the continuation of existing economic conditions and applied year-end prices (except for future price changes as allowed by contract) of oil and gas to the expected future production of such reserves, less estimated future expenditures (based on current costs) to be incurred in developing and producing those reserves.

      The standardized measure of discounted future net cash flows does not purport, nor should it be interpreted, to present the fair market value of the Company’s oil and gas reserves. These estimates reflect proved reserves only and ignore, among other things, changes in prices and costs, revenues that could result from probable reserves which could become proved reserves in later years and the risks inherent in reserve estimates. The standardized measure of discounted future net cash flows relating to proved oil and gas reserves as of December 31, 2004 is as follows:

AMERICAN REAL ESTATE PARTNERS, L.P.

FORM 10-Q JUNE 30, 2005

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

      Principal sources of change in the standardized measure of discounted future net cash flows for the year ended December 31, 2004 was:

      During recent years, there have been significant fluctuations in the prices paid for crude oil in the world markets. This situation has had a destabilizing effect on crude oil posted prices in the United States, including the posted prices paid by purchasers of the Company’s crude oil. The net weighted average prices of crude oil and natural gas as of December 31, 2004 was $41.80 per barrel of crude oil and $5.93 per thousand cubic feet of natural gas.

      The Company sells crude oil and natural gas to various customers. In addition, the Company’s oil and gas operations participate with other parties in the operation of crude oil and natural gas wells. Substantially all of these accounts receivable are due from either purchasers of crude oil and natural gas or participants in crude oil and natural gas wells for which the Company serves as the operator. Generally, operators of crude oil and natural gas properties have the right to offset future revenues against unpaid charges related to operated wells. Crude oil and natural gas sales are generally unsecured.

      On September 28, 2004, the SEC released Staff Accounting Bulletin 106 (“SAB 106”) regarding the application of SFAS 143, “Accounting for Asset Retirement Obligations (“AROs”),” by oil and gas producing companies following the full cost accounting method. Pursuant to SAB 106, oil and gas producing companies that have adopted SFAS 143 should exclude the future cash outflows associated with settling AROs (ARO liabilities) from the computation of the present value of estimated future net revenues for the purposes of the full cost ceiling calculation. In addition, estimated dismantlement and abandonment costs, net of estimated salvage values, that have been capitalized (ARO assets) should be included in the amortization base for computing depreciation, depletion and amortization expense. Disclosures are required to include discussion of how a company’s ceiling test and depreciation, depletion and amortization calculations are impacted by the adoption-of SFAS 143. The Company does not expect that the adoption of SAB 106 will have a material impact on either its ceiling test calculation or its depreciation, depletion and amortization.

AMERICAN REAL ESTATE PARTNERS, L.P.

FORM 10-Q JUNE 30, 2005

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

      On June 29, 2005, the Company granted 700,000 nonqualified unit options (the “Options”) to its Chief Executive Officer (the “CEO”). The option agreement permits the CEO to purchase up to 700,000 Depositary Units of AREP at an exercise price of $35 per unit. The Options vest at a rate of 100,000 units on each of the first seven anniversaries of the date of grant. The Options expire as to 600,000 of the vested units on the seventh anniversary of the date of grant. The Options for the remaining 100,000 vested units expire on the eighth anniversary of the date of grant.

      The fair value of the Options on the grant date was estimated using the Black-Scholes option-pricing model. The assumptions used in the model were as follows:

      As of June 30, 2005, the options had a weighted-average remaining contractual term of 7.1 years. The weighted-average grant-date fair value of the options was $9.65.

      As of June 30, 2005, there was $6.8 million of total unrecognized compensation cost related to non-vested options. That cost is expected to be recognized over a period of seven years. For the six months ended June 30, 2005, the amount of expense recognized for options was not significant. No amount of expense related to options was recognized in any period prior to 2005.

      The Company, either directly or through its consolidated subsidiaries, conducts business in three principal areas: oil and gas, gaming and real estate.

      We own and operate gaming properties in Las Vegas and Atlantic City. We operate three gaming and entertainment properties in the Las Vegas metropolitan area through our subsidiary American Casino and Entertainment Properties LLC (“American Casino”). The three properties are the Stratosphere Casino Hotel and Tower, which is located on the Las Vegas Strip and caters to visitors to Las Vegas, and two off-Strip casinos, Arizona Charlie’s Decatur and Arizona Charlie’s Boulder, which cater primarily to residents of Las Vegas and the surrounding communities. The Stratosphere is one of the most recognized landmarks in Las Vegas and our two Arizona Charlie’s properties are well-recognized casinos in their respective marketplaces. We also own and operate the Sands Hotel and Casino in Atlantic City, New Jersey through our majority ownership of Atlantic Holdings.

AMERICAN REAL ESTATE PARTNERS, L.P.

FORM 10-Q JUNE 30, 2005

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

      A summary balance sheet for gaming as of June 30, 2005 and December 31, 2004, included in the consolidated balance sheet, is as follows:

      Summarized income statement information for the three and six month periods ended June 30, 2005 and 2004, is as follows:

      The Company conducts oil and gas operations through its wholly-owned subsidiary, AREP Oil and Gas LLC (“AREP Oil and Gas”). AREP Oil and Gas includes its 50.01% ownership interest in NEG, its 50% membership interest in NEG Holdings, its indirect 50% membership interest (through NEG) in NEG Holdings, and its 100% ownership interest in TransTexas and Panaco, which are now known as National Onshore, LP and National Offshore, LP, respectively. The Company’s oil and gas operations consist of exploration,

AMERICAN REAL ESTATE PARTNERS, L.P.

FORM 10-Q JUNE 30, 2005

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

development, and production operations principally in Texas, Oklahoma, Louisiana and Arkansas and offshore in the Gulf of Mexico.

      A summary balance sheet for AREP Oil and Gas as of June 30, 2005 and December 31, 2004, included in the consolidated balance sheet, is as follows:

      Summarized income statement information for the three and six month periods ended June 30, 2005 and 2004 is as follows:

      Oil and gas operating expenses comprise expenses that are directly attributable to exploration, development and production operations including lease operating expenses, transportation expenses, gas plant operating expenses, ad valorem and production taxes.

      For the three and six months ended June 30, 2005 natural gas comprised 71% and 70% of revenues, respectively.

      Included in revenue is the impact of unrealized gains and losses on derivatives. For the three months ended June 30, 2005 there was an unrealized gain of $6.9 million as compared to a loss of $14.5 million in the comparable period of the prior year. For the six months ended June 30, 2005 and 2004, net losses of $31.8 million and $13.8 million, respectively, were recognized.

AMERICAN REAL ESTATE PARTNERS, L.P.

FORM 10-Q JUNE 30, 2005

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

      The Company’s real estate operations consist of (1) rental real estate, (2) residential developments and (3) associated resort activities.

      Rental Real Estate. As of June 30, 2005, the Company owned 58 rental real estate properties. These primarily consist of fee and leasehold interests and, to a limited extent, interests in real estate mortgages in 23 states. Most of these properties are net-leased to single corporate tenants. Approximately 74% of these properties are currently net-leased, 2% are operating properties, 10% are vacant and 14% are held for sale.

      Property Development and Associated Resort Activities. The Company owns, primarily through its Bayswater and other subsidiaries, residential development properties. Bayswater, a real estate investment, management and development company, focuses primarily on the construction and sale of single-family houses, multi-family homes and lots in subdivisions and planned communities and raw land for residential development. Our New Seabury development property in Cape Cod, Massachusetts, and our Grand Harbor and Oak Harbor development property in Vero Beach, Florida each include land for future residential development of more than 450 and 980 units of residential housing, respectively. Both developments operate golf and resort activities.

      A summary of real estate assets as of June 30, 2005 and December 31, 2004, included in the consolidated balance sheet, is as follows:

      In addition to the above are properties held for sale. The amount included in other current assets related to such properties was $38.8 million and $58.0 million at June 30, 2005 and December 31, 2004, respectively.

AMERICAN REAL ESTATE PARTNERS, L.P.

FORM 10-Q JUNE 30, 2005

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

      Summarized income statement information attributable to rental properties, residential development and resorts is summarized as follows:

      The Company markets portions of its commercial real estate portfolio. For the three and six months ended, sale activity was as follows:

      During the three months ended June 30, 2005, the Company designated certain securities as trading securities based on its intent with respect to the securities. As of June 30, 2005, the relevant securities had a market value of $48.0 million. The securities had been designated as available for sale in prior quarters. Accordingly, an unrealized loss of $.5 million that had been recorded as a component of other comprehensive

AMERICAN REAL ESTATE PARTNERS, L.P.

FORM 10-Q JUNE 30, 2005

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) — (Continued)

income was transferred to unrealized loss in the accompanying consolidated statement of earnings for the three months ended June 30, 2005.

      No securities were designated as trading securities as of December 31, 2004.

      The largest component of receivables was amounts due from brokers. As of June 30, 2005 (unaudited) and December 31, 2004 amounts due from broker was $145.5 million and $123.0 million, respectively.

      Property, plant and equipment (“P,P&E”) consist of the following: