UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 --------------------------- FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 30, 2003 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ___________________ to __________________ Commission File No. 0-24993 LAKES ENTERTAINMENT, INC. ------------------------- (Exact name of registrant as specified in its charter) Minnesota 41-1913991 --------- ---------- (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 130 Cheshire Lane Minnetonka, Minnesota 55305 --------------------- ----- (Address of principal executive offices) (Zip Code) (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 [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act. Yes [ ] No [X] As of May 8, 2003, there were 10,638,320 shares of Common Stock, $0.01 par value per share, outstanding.
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES INDEX <TABLE> <CAPTION> PAGE OF FORM 10-Q --------- <S> <C> PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS Condensed Consolidated Balance Sheets as of March 30, 2003 and 3 December 29, 2002 Condensed Consolidated Statements of Earnings for the three months 4 ended March 30, 2003 and March 31, 2002 Condensed Consolidated Statements of Comprehensive Earnings for the three months ended March 30, 2003 and March 31, 2002 5 Condensed Consolidated Statements of Cash Flows for the three months 6 ended March 30, 2003 and March 31, 2002 Notes to Condensed Consolidated Financial Statements 7 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION 19 AND RESULTS OF OPERATIONS ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 31 ITEM 4. CONTROLS AND PROCEDURES 32 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS 33 ITEM 5. OTHER INFORMATION 35 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 36 </TABLE> 2
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) (UNAUDITED) <TABLE> <CAPTION> MARCH 30, 2003 DECEMBER 29, 2002 - -------------------------------------------------------------------------------------------------------- <S> <C> <C> ASSETS Current Assets: Cash and cash equivalents $ 5,500 $ 14,106 Accounts receivable, net 764 116 Deferred tax asset 6,771 6,771 Other current assets 1,116 547 - -------------------------------------------------------------------------------------------------------- Total Current Assets 14,151 21,540 - -------------------------------------------------------------------------------------------------------- Property and Equipment-Net 6,825 6,962 - -------------------------------------------------------------------------------------------------------- Other Assets: Land held under contract for sale 29,053 28,832 Land held for development 29,224 27,791 Notes receivable 72,470 70,955 Cash and cash equivalents-restricted 8,313 8,300 Investments in and notes from unconsolidated affiliates 1,248 1,013 Deferred tax asset 4,165 3,835 Other long-term assets 8,754 6,657 - -------------------------------------------------------------------------------------------------------- Total Other Assets 153,227 147,383 - -------------------------------------------------------------------------------------------------------- TOTAL ASSETS $ 174,203 $ 175,885 ======================================================================================================== LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities: Accounts payable $ 108 $ 226 Income taxes payable 5,517 5,564 Litigation and claims accrual 5,809 5,847 Accrued payroll and related 343 252 Other accrued expenses 3,242 3,486 - -------------------------------------------------------------------------------------------------------- Total Current Liabilities 15,019 15,375 - -------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES 15,019 15,375 - -------------------------------------------------------------------------------------------------------- COMMITMENTS AND CONTINGENCIES Shareholders' Equity: Capital stock, $.01 par value; authorized 100,000 shares; 10,638 common shares issued and outstanding at March 30, 2003, and December 29, 2002 106 106 Additional paid-in-capital 131,526 131,525 Retained Earnings 27,552 28,879 - -------------------------------------------------------------------------------------------------------- Total Shareholders' Equity 159,184 160,510 - -------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 174,203 $ 175,885 ======================================================================================================== </TABLE> THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 3
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF EARNINGS (IN THOUSANDS, EXCEPT EARNINGS PER SHARE) <TABLE> <CAPTION> (UNAUDITED) THREE MONTHS ENDED ------------------ MARCH 30, 2003 MARCH 31, 2002 -------------- -------------- <S> <C> <C> REVENUES: Management fee income $ - $ 1,502 License fee income 550 - - ---------------------------------------------------------------------------------------------------- Total Revenues 550 1,502 - ---------------------------------------------------------------------------------------------------- COSTS AND EXPENSES: Selling, general and administrative 2,979 2,100 Depreciation and amortization 128 99 - ---------------------------------------------------------------------------------------------------- Total Costs and Expenses 3,107 2,199 - ---------------------------------------------------------------------------------------------------- LOSS FROM OPERATIONS (2,557) (697) - ---------------------------------------------------------------------------------------------------- OTHER INCOME (EXPENSE): Interest income 237 736 Interest expense - (23) Equity in loss of unconsolidated affiliates (87) (123) Other 159 - - ---------------------------------------------------------------------------------------------------- Total other income, net 309 590 - ---------------------------------------------------------------------------------------------------- Loss before income taxes (2,248) (107) Benefit for income taxes (921) (44) - ---------------------------------------------------------------------------------------------------- NET LOSS ($ 1,327) ($ 63) ==================================================================================================== BASIC LOSS PER SHARE ($ 0.12) ($ 0.01) ==================================================================================================== DILUTED LOSS PER SHARE ($ 0.12) ($ 0.01) ==================================================================================================== WEIGHTED AVERAGE COMMON SHARES OUTSTANDING 10,638 10,638 DILUTIVE EFFECT OF STOCK COMPENSATION PROGRAMS - - - ---------------------------------------------------------------------------------------------------- WEIGHTED AVERAGE COMMON AND DILUTED SHARES OUTSTANDING 10,638 10,638 ==================================================================================================== </TABLE> THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 4
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE EARNINGS (IN THOUSANDS) <TABLE> <CAPTION> (UNAUDITED) THREE MONTHS ENDED ---------------------------------- MARCH 30, 2003 MARCH 31, 2002 ---------------------------------- <S> <C> <C> NET LOSS ($ 1,327) ($ 63) OTHER COMPREHENSIVE LOSS, NET OF TAX: Unrealized losses on securities: Unrealized holding losses during the period - (8) ------------------------------ COMPREHENSIVE LOSS ($ 1,327) ($ 71) ============================== </TABLE> THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 5
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) <TABLE> <CAPTION> (UNAUDITED) THREE MONTHS ENDED ------------------ MARCH 30, 2003 MARCH 31, 2002 -------------- -------------- <S> <C> <C> OPERATING ACTIVITIES: Net loss ($ 1,327) ($ 63) Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation and amortization 128 99 Equity in loss of unconsolidated affiliates 87 123 Changes in operating assets and liabilities: Accounts receivable (648) 3,529 Income taxes (47) 338 Accounts payable (118) 47 Accrued expenses (191) 1,008 Other (899) (127) - --------------------------------------------------------------------------------------------------------- Net Cash Provided by (Used in) Operating Activities (3,015) 4,954 - --------------------------------------------------------------------------------------------------------- INVESTING ACTIVITIES: Payments for land held under contract for sale (221) (291) Payments for land held for development (1,433) (265) Advances on notes receivable (3,492) (4,557) Proceeds from repayment of notes receivable - 67 Investment in and notes receivable from unconsolidated affiliates (285) (160) Increase in restricted cash, net (13) (27) Increase in other long-term assets (156) (851) Reduction of (payments for) property and equipment, net 9 (832) - --------------------------------------------------------------------------------------------------------- Net Cash Used in Investing Activities (5,591) (6,916) - --------------------------------------------------------------------------------------------------------- FINANCING ACTIVITIES: Payments on capital lease obligations - (5,714) - --------------------------------------------------------------------------------------------------------- Net Cash Used in Financing Activities - (5,714) - --------------------------------------------------------------------------------------------------------- Net decrease in cash and cash equivalents (8,606) (7,676) Cash and cash equivalents - beginning of period 14,106 42,638 - --------------------------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS - END OF PERIOD $ 5,500 $ 34,962 ========================================================================================================= SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the period for: Interest $ - $ 25 Income taxes 5 5 </TABLE> THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 6
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. BUSINESS Lakes Entertainment, Inc., a Minnesota corporation ("Lakes" or the "Company") was established as a public corporation on December 31, 1998, via a distribution (the "Distribution") of its common stock, par value $.01 per share (the "Common Stock") to the shareholders of Grand Casinos, Inc. ("Grand"). Lakes currently has development and management agreements with four separate tribes for four new casino operations, one in Michigan, two in California and one with the Nipmuc Nation on the east coast. The Company also has agreements for the development of one additional casino on Indian owned land in California through a joint venture which is currently being disputed by the tribe. Each of these projects is currently in the development phase. The Company has also formed a joint venture with a producer to launch the World Poker Tour ("WPT") and establish poker as the next significant televised mainstream sport. During March of 2003, the WPT signed an agreement with the Travel Channel, LLC (TRV), granting TRV the right to broadcast the first season of the WPT series. WPT receives a series of fixed license payments from TRV, subject in each case to satisfaction of production milestones and other conditions. Revenue is recognized ratably as production milestones and other conditions are met. The license fees are expected to cover substantially all anticipated first year production costs. LAND HELD UNDER CONTRACT FOR SALE On December 28, 2001, the Company transferred title and ownership obligations of the Polo Plaza shopping center property to Metroflag Polo, LLC. In conjunction with this transaction, Lakes transferred to Metroflag BP, LLC, rights to and obligations of the adjacent Travelodge property consisting of a long-term land lease and a motel operation. This transaction was accounted for under the deposit method of accounting under the requirements of Statement of Financial Accounting Standards No. 66, Accounting for Sales of Real Estate, rather than as a sale. Therefore, the property is included as land held under contract for sale on the accompanying balance sheets as of March 30, 2003 and December 29, 2002. The total price for this combined transaction was approximately $30.9 million. Terms of the transaction included a $1.0 million down payment, which was received in January 2002, a contractual commitment to pay Lakes $23.3 million by December 29, 2002, and a second contractual agreement to pay Lakes $7.5 million on June 30, 2004. A $0.5 million payment on the notes receivable was received during 2002. During 2002, Lakes and Metroflag restructured the terms of the Polo Plaza and Travelodge property transactions due to deteriorating economic conditions. The parties reduced the purchase price for the Polo Plaza property from $23.8 million to $21.8 million. On the payment date, which was scheduled to be no later than January 31, 2003, $16.8 million of the purchase price was to be payable to Lakes in cash and $4.0 million was to be payable through the issuance to Lakes of a preferred membership interest in Metroflag. Effective June 30, 2002, Lakes recorded a $3.0 million impairment charge for these properties relating to the adjustment in the purchase price and the potential discount on the return of Lakes' preferred interest. This real estate is reported at its adjusted carrying value in Land Held Under Contract for Sale. Lakes' collateral is the property and lease rights described above which would revert back to Lakes in the event of default by Metroflag. 7
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) During March of 2003, Lakes and Metroflag agreed to additional revisions to the terms of the Polo Plaza and Travelodge property transactions. The parties have increased the price of the Polo Plaza property from $21.8 million to $25.8 million. On the payment date, which the parties have agreed shall be extended to no later than May 15, 2003, $16.8 million of the purchase price is payable to Lakes in cash, $4.0 million is payable through the issuance to Lakes of a preferred membership interest in Metroflag and $4.0 million is payable through the issuance to Lakes of a subordinated membership interest in Metroflag. On or before April 30, 2004, Metroflag Polo may elect to distribute to Lakes $3.0 million plus interest in cash as full return of Lakes' preferred interest. If paid after April 30, 2004, and in no event later than December 24, 2006, the entire $4.0 million plus interest will be payable. The subordinated interest must be repurchased for $4.0 million at the time of repayment of an outstanding $3.5 million contractual commitment in connection with the Travelodge property, which is scheduled on or before December 28, 2004. In March of 2003, the parties decreased the sale price of the Travelodge property from $7.5 million to $3.5 million. At that time, the contractual commitment to pay Lakes was also decreased from $7.5 million to $3.5 million. If the Travelodge commitment is not repaid by December 28, 2004, ownership of the Travelodge lease rights would revert back to Lakes. If at any time the Polo Plaza property is sold and the Travelodge commitment has not been repaid, Metroflag is required to repurchase the subordinated interest for the lesser of $4.0 million or any portion of the net cash proceeds from such sale or refinancing that exceeds $60.0 million. LAND HELD FOR DEVELOPMENT Lakes continues to own the Shark Club property, which is an approximate 3.5 acre undeveloped site adjacent to the Polo Plaza shopping center and Travelodge sites. During August 2002, Lakes formed a joint venture with Diamond Resorts, LLC, a Nevada limited liability company and time-share developer for the purpose of developing the Shark Club parcel as an upscale time-share project. The terms of this joint venture agreement require that Diamond and Lakes each make an initial working capital contribution of $250,000. Subject to Diamond obtaining a financing commitment for a construction loan sufficient to fund at least the first phase of the building improvements contemplated by the time-share project, the joint venture agreement will require Lakes to contribute the relevant portion of the Shark Club parcel, which was originally valued at $16 million. During December of 2002, the Shark Club parcel was adjusted to its revised estimated market value of $15 million, resulting in an impairment charge of approximately $1.0 million, which was reflected in impairment losses in the consolidated statement of loss for the year ended December 29, 2002. Diamond has agreed to perform sales, marketing, administrative and managerial services for the project. The terms of the joint venture agreement provide for the repayment to Lakes of its contribution of property in cash based on the joint venture's cash flow and time-share unit sales. It is contemplated that Lakes will be required to make no other material contributions of cash or property to the project. It is possible that Lakes may sell the Shark Club property or its interest in the joint venture prior to or during construction in order to monetize this investment. See Note 10 for current status. 8
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) On October 2, 2002, Lakes loaned $1.0 million to the joint venture. Interest will accrue at a rate of 10.0% per annum. The loan is due and payable from first available cash flow of the joint venture (excluding any required capital contribution from a member) and no later than October 1, 2004. Also included in land held for development is land held for possible transfer to Indian tribes for use in future casino resort projects in the amount of $14.2 million and $12.8 million as of March 30, 2003 and December 29, 2002, respectively. RECENT ACCOUNTING PRONOUNCEMENTS The FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" in November 2002. This interpretation elaborates on the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of this interpretation are applicable to all guarantees and modification to guarantees made after December 31, 2002. The Company's disclosure of the indemnification and guarantee agreements of the Company is in compliance with the interpretation. The disclosure requirements in this interpretation are effective for financial statements of interim or annual periods ended after December 15, 2002. The adoption of the interpretation did not have a material impact on the Company's results of operations, financial position and cash flows. The Company does have an indemnification agreement with Grand Casinos which is fully described in Note 8 Commitments and Contingencies. In January 2003, the FASB issued Interpretation No. 46 (FIN46), "Consolidation of Variable Interest Entities", which addresses the consolidation of variable interest entities. The interpretation applicable immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which a Company obtains an interest after that date. For variable interests in variable interest entities acquired before February 1, 2003, the interpretation applicable applies in the first interim period beginning after June 15, 2003. The Company is in the process of evaluating all of its investments and other interests in entities that may be deemed variable interest entities under the provisions of FIN 46. If the Company's interests were deemed to constitute variable interest entities, there would be no material impact because amounts are already included as notes receivable on the accompanying condensed consolidated balance sheets. The Company cannot make any definitive conclusion until it completes its evaluation. In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations". SFAS No. 143 supersedes previous guidance for financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The statement applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or the normal operation of a long-lived asset. This statement was effective January 1, 2003. 9
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities". SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. SFAS No. 146 eliminates the definition and requirement for recognition of exit costs in Emerging Issues Task Force Issue No. 94-3 where a liability for an exit is recognized at the date of an entity's commitment to an exit plan. This statement is effective for exit or disposal activities initiated after December 31, 2002. The adoption of SFAS No. 143 and 146 did not have a material impact on the results of operations, financial position and cash flows of the Company. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment of FASB Statement No. 123". SFAS No. 148 provides alternative transition methods for companies that make a voluntary change to the fair-value-based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company has adopted the disclosure provisions of SFAS No. 148 and its adoption had no impact on the Company's consolidated financial position or results of operations. 2. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements include the accounts of Lakes and its wholly-owned and majority-owned subsidiaries. Investments in unconsolidated affiliates representing 50% or less of voting interests are accounted for on the equity method. All significant intercompany balances and transactions have been eliminated in consolidation. Lakes' investments in unconsolidated affiliates include a 50 percent ownership interest in PCG Santa Rosa, LLC, a joint venture formed to develop a casino on Indian-owned land in California and a 49 percent voting interest in the Chateaux, LLC, a joint venture formed to develop the Shark Club parcel in Las Vegas, Nevada, into an upscale timeshare project. See Note 9 for current status. The condensed consolidated financial statements have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America for interim financial information, in accordance with the rules and regulations of the Securities and Exchange Commission. Pursuant to such rules and regulations, certain financial information and footnote disclosures normally included in the condensed consolidated financial statements have been condensed or omitted. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for fair presentation have been included. Operating results for the three months ended March 30, 2003 are not necessarily indicative of the results that may be expected for the year ending December 28, 2003. The condensed consolidated financial statements should be read in conjunction with the condensed consolidated financial statements and notes thereto included in the Company's annual report on Form 10-K for the year ended December 29, 2002. 10
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 3. STOCK-BASED COMPENSATION At March 30, 2003, the Company has two stock-based employee compensation plans. The Company accounts for those plans under the recognition and measurement principles of APB Option No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation. <TABLE> <CAPTION> FIRST QUARTER FIRST QUARTER 2003 2002 ---- ---- <S> <C> <C> Net loss: As reported $ (1,327) $ (63) Less: Total stock-based compensation expense determined under the fair value method, net of related tax effects (383) (423) Pro forma (1,710) (486) Net loss per share: As reported -- Basic $ ( 0.12) $ ( 0.01) Pro forma -- Basic ( 0.16) ( 0.05) As reported -- Diluted ( 0.12) ( 0.01) Pro forma -- Diluted ( 0.16) ( 0.05) </TABLE> 4. MANAGEMENT CONTRACTS FOR INDIAN-OWNED CASINOS The ownership, management and operation of gaming facilities are subject to extensive federal, state, provincial, tribal and/or local laws, regulation, and ordinances, which are administered by the relevant regulatory agency or agencies in each jurisdiction. These laws, regulations and ordinances vary from jurisdiction to jurisdiction, but generally concern the responsibility, financial stability and character of the owners and managers of gaming operations as well as persons financially interested or involved in gaming operations. The Company is prohibited by the Indian Gaming Regulatory Act ("IGRA") from having an ownership interest in any casino it manages for Indian tribes. The management contract for Grand Casino Coushatta expired January 16, 2002, which is seven years from the date the casino opened, and was not renewed. This non-renewal has resulted in the loss of revenues to the Company derived from such contract, which has had a material adverse effect on the Company's results of operations. As of March 30, 2003, the Company has no other management contracts from which it will derive revenues in 2003. 11
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) The management contracts govern the relationship between the Company and the tribes with respect to the construction and management of the casinos. The construction or remodeling portion of the agreements commenced with the signing of the respective contracts and continued until the casinos opened for business; thereafter, the management portion of the respective management contracts continues for a period up to seven years. Under the terms of the contracts, the Company, as manager of the casino, receives a percentage of the distributable profits (as defined in the contract) of the operations as a management fee after payment of certain priority distributions, a cash contingency reserve, and guaranteed minimum payments to the tribes. Lakes has a contract to be the exclusive developer and manager of an Indian-owned gaming resort near New Buffalo, Michigan with the Pokagon Band of Potawatomi Indians. The Company has formed partnerships that hold contracts to develop and manage two casinos to be owned by Indian tribes in California, one near San Diego with the Jamul Indian Village, and the other near Sacramento with the Shingle Springs Band of Miwok Indians. Lakes and another company have formed a partnership with a contract to finance the construction of an Indian-owned casino 60 miles north of San Francisco, California for the Cloverdale Rancheria of Pomo Indians. The Rancheria is currently disputing the agreement with the partnership and has notified the partnership that it wishes to terminate the contract. The Company has also signed contracts with the Nipmuc Nation of Massachusetts for development and management of a potential future gaming resort in the eastern United States; however, this tribe has received a negative finding regarding federal recognition from the Bureau of Indian Affairs (BIA). The tribe has submitted additional information for reconsideration. 5. NOTES RECEIVABLE The notes receivable from Indian Tribes are generally for the development of gaming properties to be managed by the Company. The repayment terms are specific to each tribe and are largely dependent upon the operating performance of each gaming property. Repayments of the aforementioned notes receivable are required to be made only if distributable profits are available from the operation of the related casinos. Repayments are also the subject of certain distribution priorities specified in the management contracts. In addition, repayment of the notes receivable and the manager's fees under the management contracts are subordinated to certain other financial obligations of the respective tribes. Through March 30, 2003, no amounts have been withheld under these provisions. 12
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) Notes receivable consist of the following (in thousands): <TABLE> <CAPTION> March 30, 2003 December 29, 2002 -------------- ----------------- <S> <C> <C> Properties under development: Notes from the Pokagon Band of Potawatomi Indians with variable interest rates (not to exceed 10%) (5.25% at March 30, 2003), receivable in 60 monthly installments subsequent to commencement date $ 39,978 $ 39,470 Notes from the Shingle Springs Band of Miwok Indians with variable interest rates (6.25% at March 30, 2003), receivable in varying monthly installments based on contract terms subsequent to commencement date 15,886 14,035 Notes from Jamul Indian Village with variable interest rates (6.25% at March 30, 2003), receivable in 12 monthly installments subsequent to commencement date 10,148 9,492 Notes from the Nipmuc Nation with variable interest rates (6.25% at March 30, 2003) receivable in varying installments based on contract terms subsequent to commencement date 3,973 3,814 Other 2,485 4,144 ---------- ---------- Total notes receivable 72,470 70,955 Less - current installments of notes receivable - - ---------- ---------- Notes receivable, less current installments $ 72,470 $ 70,955 ========== ========== </TABLE> Interest income on notes receivable from Indian Tribes related to casino development projects is deferred because realizability of the interest is contingent upon the completion and positive cash flow from operation of the casino. Interest deferred during the development period is recognized over the remaining life of the note using the effective interest method. As of March 30, 2003 and December 29, 2002, $10.9 million and $10.1 million of interest on notes related to properties under development has been deferred. Management periodically evaluates the recoverability of such notes receivable based on the current and projected operating results of the underlying facility and historical collection experience. No impairment losses on such notes receivable have been recognized through March 30, 2003. The terms of these notes require the casinos to be constructed and to generate positive cash flows prior to the Company receiving repayment. As such, an estimate of the fair value of these notes requires an assessment of the timing of the construction of the related casinos and the profitability of the related casinos. Due to the significant uncertainty involved in such an assessment, the Company does not believe that it is practicable to accurately estimate the fair value of these notes with the degree of precision necessary to make such information meaningful. 13
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 6. LONG-TERM DEBT During 2002, the Company had two notes payable with third parties. The first was collateralized by certificates of deposit, in the amount of $1.0 million and was repaid during the fourth quarter of 2002. The second, in the amount of $0.4 million, was repaid during the second quarter of 2002. 7. CAPITAL LEASE OBLIGATIONS Pursuant to the terms of the Distribution Agreement, Grand assigned to Lakes, and Lakes assumed, a lease agreement dated February 1, 1996 covering Lakes' current corporate office space of approximately 65,000 square feet with a lease term of fifteen years. The lease commenced on October 14, 1996. During 2001, also pursuant to the terms of the Distribution Agreement, Lakes entered into a capital lease arrangement for the corporate office space at which time the operating lease was cancelled. Accordingly, Lakes recorded a capital leased asset and liability in the amount of approximately $5.8 million. On January 2, 2002, the Company completed the purchase of its corporate office building for $6.4 million, including transaction expenses. This transaction resulted in the extinguishment of the Company's capital lease obligation related to the building. 8. COMMITMENTS AND CONTINGENCIES: LEASES The Company leases certain property and equipment, including an airplane, under a non-cancelable operating lease. The airplane lease expires May 1, 2003 and provides for two one-year renewal terms. Approximate future minimum lease payments, due under this lease as of March 30, 2003, assuming both one-year renewals are exercised, are as follows (in thousands): <TABLE> <CAPTION> Operating Leases ---------------- <S> <C> 2003 $ 450 2004 600 2005 200 ------- $ 1,250 ======= </TABLE> PURCHASE OPTIONS The Company has the right to purchase the airplane it leases during the base lease term and any renewal term for approximately $8 million. 14
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) INDEMNIFICATION AGREEMENT As a part of the transaction establishing Lakes as a separate public company on December 31, 1998, the Company has agreed to indemnify Grand against all costs, expenses and liabilities incurred in connection with or arising out of certain pending and threatened claims and legal proceedings to which Grand and certain of its subsidiaries are likely to be parties. The Company's indemnification obligations include the obligation to provide the defense of all claims made in proceedings against Grand and to pay all related settlements and judgments. As security to support Lakes' indemnification obligations to Grand, Lakes agreed to deposit, in trust for the benefit of Grand, as a wholly owned subsidiary of Park Place, an aggregate of $30 million, to cover various commitments and contingencies related to or arising out of, Grand's non-Mississippi business and assets (including by way of example, but not limitation, tribal loan guarantees, real property lease guarantees for Lakes' subsidiaries and director and executive officer indemnity obligations) consisting of four annual installments of $7.5 million, during the four-year period subsequent to December 31, 1998. Any surplus proceeds remaining in this trust after all the secured obligations are indefeasibly paid in full and discharged shall be paid over to Lakes. Lakes made the first deposit of $7.5 million on December 31, 1999 and in July 2000, Lakes deposited $18 million in an escrow account in partial satisfaction of the indemnification obligation. The $18 million deposit represented a settlement agreement which was reached in June 2000 regarding both the Stratosphere Shareholders' litigation and the Grand Casinos, Inc. Shareholders' litigation. On August 14, 2001, the Court issued an order giving final approval to the settlement. As such, the $18 million in restricted cash was removed from the Company's condensed consolidated balance sheet. In January 2001, Lakes also purchased the Shark Club property in Las Vegas for $10.1 million in settlement of another obligation that was subject to the indemnification obligations. As of March 30, 2003 and December 29, 2002, $7.5 million related to security to support Lakes' indemnification obligations to Grand is included as restricted cash in the accompanying condensed consolidated balance sheets. Lakes believes it has satisfied all potential obligations beyond the amounts provided for in the Company's financial statements. Lakes is seeking release of the restricted cash that was deposited into trust. See Note 10 Subsequent Events. As part of the indemnification agreement, Lakes has agreed that it will not declare or pay any dividends, make any distribution of Lakes' equity interests, or otherwise purchase, redeem, defease or retire for value any equity interests in Lakes without the written consent of Park Place. LEGAL PROCEEDINGS The following summaries describe certain known legal proceedings to which Grand is a party which Lakes has assumed, or with respect to which Lakes may have agreed to indemnify Grand, in connection with the Distribution. 15
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) STRATOSPHERE PREFERENCE ACTION In April 1998, Stratosphere served on Grand and Grand Media & Electronics Distributing, Inc., a wholly owned subsidiary of Grand ("Grand Media"), a complaint in the Stratosphere bankruptcy case seeking recovery of certain amounts paid by Stratosphere to (i) Grand Media for electronic equipment purchased by Stratosphere from Grand Media, and (ii) Grand as management fees and for costs and expenses under a management agreement between Stratosphere and Grand. Stratosphere claimed in its complaint that such amounts are recoverable by Stratosphere as preferential payments under bankruptcy law. In May 1998, Grand responded to Stratosphere's complaint denying that Stratosphere is entitled to recover the amounts described in the complaint. Discovery was completed on December 31, 2001 and the case proceeded to trial before the United States Bankruptcy Court for the District of Nevada on June 20, 2002. On December 31, 2002, the Bankruptcy Court issued its final judgment holding that: (i) payments to Grand Media for electronic equipment totaling approximately $3.3 million are not recoverable by Stratosphere as avoidable preferences, and (ii) payment to Grand for management services in the approximate amount of $2.3 million is recoverable by Stratosphere and an avoidable preference. On May 8, 2003, this judgment was satisfied out of amounts held as security to support Lakes' indemnification obligations to Grand. OTHER LITIGATION The Company has recorded a reserve assessment related to the Stratosphere Preference Action. The reserve is included in the litigation and claims accrual on the accompanying condensed consolidated balance sheets as of March 30, 2003 and December 29, 2002. Lakes is involved in various other inquiries, administrative proceedings, and litigation relating to contracts and other matters arising in the normal course of business. While any proceeding or litigation has an element of uncertainty, management currently believes that the final outcome of these matters is not likely to have a material adverse effect upon the Company's consolidated financial position or results of operations. 9. RELATED PARTY TRANSACTIONS During 2001 and 2000, Lakes made a total of $4.0 million in unsecured loans to ViatiCare Financial Services, LLC, which has since been acquired by Living Benefits Financial Services ("Living Benefits"). In March 2001, the Board of Directors of Lakes decided not to make further loans to ViatiCare. A $4.0 million impairment charge for this note was recorded during the quarter ended June 30, 2002, due to increased competition in the viatical insurance business and restrictions on ability to make further policy acquisitions. 16
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) Subsequent to the decision by the Lakes Board to make no further loans to ViatiCare, L. B. Acquisitions, LLC, which is owned by Lyle Berman, the Chief Executive Officer and a Director of Lakes, made loans to Living Benefits. As an incentive to make the loans, L. B. Acquisitions was granted an initial 9% voting interest in Living Benefits and was given the option to convert the loan balance into 45% of the voting interest in Living Benefits. Therefore, Lyle Berman, through L. B. Acquisitions, beneficially owns a total of approximately 55% of the voting interest of Living Benefits. Previously, Lakes formed two joint venture partnerships with Kean Argovitz Resorts, LLC ("KAR"), a limited liability company based in Houston, Texas for the purpose of developing and managing casino resort projects with the Shingle Springs Band of Miwok Indians and the Jamul Indian Village, both in California. On January 30, 2003, Lakes restructured a series of arrangements with KAR and its individual members such that Lakes has effectively acquired 100% ownership of the joint ventures in exchange for restructuring indebtedness of $1.8 million from the joint venture partnerships to Lakes and an agreement to make certain conditional payments to the individual KAR members from profits received under the respective management contracts. While these conditional payments could total up to $2 million per year for each project, Lakes believes these payments will be substantially less than KAR would have received under their original interest. The individual KAR members have options to repurchase their interest or obtain a comparable financial interest, in the event they are found suitable by relevant gaming regulatory authorities. During 2002, Lakes rented the use of Company equipment to another company that had a mutual Board member during a portion of 2001. The transaction was for full value of the associated use and all payments for such use have been received. 10. SUBSEQUENT EVENTS SHARK CLUB On April 7, 2003, Lakes announced that it has signed a Letter of Intent to sell the approximate 3.5 acre undeveloped site, known as the Shark Club Parcel, which had been previously designated for development of the Chateau time share project with Diamond Resorts in Las Vegas, Nevada. Under the terms of the Letter of Intent, Lakes will sell the property to an entity to be managed and operated by Marriott Ownership Resorts, Inc. for a purchase price of $15.0 million in cash. Certain terms and conditions of this Letter of Intent will need to be satisfied prior to the completion of this sale, which is also subject to negotiation of a definitive purchase agreement. In addition to the $15.0 million payment, Lakes will receive $1.0 million as repayment of a loan previously made to Chateau by Lakes. Subject to the satisfaction of the necessary terms and conditions, Lakes anticipates the closing will occur in the second quarter of 2003. 17
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) INDEMNIFICATION AGREEMENT On May 8, 2003, the trust account set up as security to support Lakes' indemnification obligations to Grand Casinos was terminated since Lakes has satisfied all known material indemnification obligations. Prior to the termination, the Stratosphere Preference Action Settlement of approximately $2.3 million was paid out of the trust to Stratosphere. Following such payment, the remaining restricted funds of approximately $5.9 million including interest, were released to Lakes and reclassified as unrestricted. Subsequent indemnification obligations to Grand Casinos, if any, would be paid directly by Lakes. The amount accrued for the Stratosphere Preference Action Litigation in excess of the amount paid totaled $3.2 million. Therefore, this amount will be reversed in the second quarter of 2003 resulting in a reduction in operating expenses of $3.2 million in the second quarter of 2003. 18
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (UNAUDITED) ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Lakes Entertainment, Inc., a Minnesota corporation ("Lakes" or the "Company") was established as a public corporation on December 31, 1998, via a distribution (the "Distribution") of its Common Stock, to the shareholders of Grand Casinos, Inc. ("Grand"). As a result of the Distribution, Lakes operates the Indian casino management business and holds various other assets previously owned by Grand. Lakes' main business is the development, construction and management of casinos and related hotel and entertainment facilities in emerging and established gaming jurisdictions. Lakes has entered into the following contracts for the development, management and/or financing of new casino operations, all of which are subject to various regulatory approvals before construction can begin: (1) Lakes has a contract to be the exclusive developer and manager of an Indian-owned gaming resort near New Buffalo, Michigan. (2) Lakes has entered into contracts to develop and manage two casinos to be owned by Indian tribes in California, one near San Diego with the Jamul Indian Village and the other near Sacramento with the Shingle Springs Band of Miwok Indians. (3) Lakes and another company have formed a partnership with a contract to finance the construction of an Indian-owned casino 60 miles north of San Francisco, California. The Cloverdale Rancheria has notified the partnership that the Rancheria wishes to terminate the relationship between the two parties. The partnership has advised the Rancheria that the partnership believes the contract is enforceable. The Rancheria acknowledges that the partnership has loaned the Rancheria money and that the Rancheria will endeavor to repay the money in a timely manner. (4) Lakes has also signed contracts with a Massachusetts Indian tribe for development and management of a potential future gaming resort in the eastern United States; however, this tribe has received a negative finding regarding federal recognition from the Bureau of Indian Affairs (BIA). The tribe has submitted additional information to the BIA for reconsideration. In addition, Lakes owns options to purchase various new casino games and is actively marketing these new games to the casino industry in an attempt to have a casino accept the games for use in their operations. Lakes has also formed a joint venture with another company to develop approximately 2,000 acres owned by the joint venture in eastern San Diego County in California. It is possible the land will be sold in lieu of a development by the joint venture. Lakes has also formed a joint venture with a producer to launch the World Poker Tour and establish poker as the next significant televised mainstream sport. The joint venture recently signed a three-year agreement with the Travel Channel for broadcast of the World Poker Tour series. Revenue is recognized ratably as production milestones and other conditions are met. During the first quarter of 2003, Lakes recognized approximately $0.6 million in revenue related to the World Poker Tour. 19
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) (UNAUDITED) Lakes' historical revenues have been derived almost exclusively from management fees. Through January 16, 2002, Lakes managed a land-based, Indian-owned casino, Grand Casino Coushatta, in Kinder, Louisiana ("Grand Casino Coushatta"). Pursuant to the Coushatta management contract, Lakes received a fee based on the net distributable profits (as defined in the contracts) generated by Grand Casino Coushatta. The management contract expired January 16, 2002, and was not renewed. This non-renewal has resulted in the loss of revenues to the Company derived from such contract, which has had a material adverse effect on the Company's results of operations. Lakes' limited operating history may not be indicative of Lakes' future performance. In addition, a comparison of results from year to year may not be meaningful due to the opening of new facilities and the buy-out and/or cessation of other casino management contracts. Lakes' growth strategy contemplates the development of existing projects, the pursuit of opportunities to develop and manage additional gaming facilities and the pursuit of new business opportunities. The successful implementation of this growth strategy is contingent upon the satisfaction of various conditions, including obtaining governmental approvals, the impact of increased competition, and the occurrence of certain events, many of which are beyond the control of Lakes. SIGNIFICANT ACCOUNTING POLICIES The significant accounting policies, which Lakes believes are the most critical to aid in fully understanding and evaluating its reported financial results, include the following: revenue recognition and realizability of notes receivable. REVENUE RECOGNITION: Revenue from the management of Indian-owned casino gaming facilities is recognized when earned according to the terms of the management contracts. Currently all of the Indian-owned casino projects that Lakes is involved with are in development stages and are not yet open. Therefore, until a project is open and operating, Lakes will not recognize revenue related to Indian casino management. Interest income on notes receivable for Indian tribes related to casino development projects is deferred because realizability of the interest is contingent upon the completion and generation of cash flow from the operation of the casino. Interest deferred during the development period is recognized over the remaining life of the note using the effective interest method. Revenue from the World Poker Tour series is recognized ratably as production milestones and other conditions are met. IMPAIRMENT OF LONG-TERM ASSETS: The Company's notes receivable from Indian Tribes are generally for the development of gaming properties to be managed by the Company. The repayment terms are specific to each tribe and are largely dependent upon the operating performance of each gaming property. Repayments of the notes receivable are required to be made only if distributable profits are available from the operation of the related casinos. Repayments are also the subject of certain distribution priorities specified in the management contracts. In addition, repayment of the notes receivable and the manager's fees under the management contracts may be subordinated to certain other financial obligations of the respective tribes. 20
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) (UNAUDITED) Through March 30, 2003, no impairments have been recorded under these provisions. Management periodically evaluates the recoverability of such notes receivable based on the current and projected operating results of the underlying facility and historical collection experience. The Company currently holds land held for development and land held under contract for sale. The Company periodically evaluates whether events and circumstances have occurred that may affect the recoverability of the net book value of these assets. If such events or circumstances indicate that the carrying amount of an asset may not be recoverable, the Company estimates the future cash flows expected to result from the use of the asset. If the sum of the expected future undiscounted cash flows does not exceed the carrying value of the asset, the Company will recognize an impairment loss. During 2002, the Company recognized an impairment loss of $3.0 million on land held under contract for sale and an impairment loss of $1.0 million on land held for development. The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and notes thereto and management's discussion and analysis included in the Company's Annual Report on Form 10-K for the year ended December 29, 2002. RECENT ACCOUNTING PRONOUNCEMENTS The FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" in November 2002. This interpretation elaborates on the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of this interpretation are applicable to all guarantees and modification to guarantees made after December 31, 2002. The Company's disclosure of the indemnification and guarantee agreements of the Company is in compliance with the interpretation. The disclosure requirements in this interpretation are effective for financial statements of interim or annual periods ended after December 15, 2002. The adoption of the interpretation did not have a material impact on the Company's results of operations, financial position and cash flows. The Company does have an indemnification agreement with Grand Casinos which is fully described in the Financial Condition section of this Management's Discussion and Analysis. In January 2003, the FASB issued Interpretation No. 46 (FIN46), "Consolidation of Variable Interest Entities", which addresses the consolidation of variable interest entities. The interpretation applicable immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which a Company obtains an interest after that date. For variable interests in variable interest entities acquired before February 1, 2003, the interpretation applicable applies in the first interim period beginning after June 15, 2003. 21
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) (UNAUDITED) The Company is in the process of evaluating all of its investments and other interests in entities that may be deemed variable interest entities under the provisions of FIN 46. If the Company's interests were deemed to constitute variable interest entities, there would be no material impact because amounts are already included as notes receivable on the accompanying condensed consolidated balance sheets. The Company cannot make any definitive conclusion until it completes its evaluation. In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations". SFAS No. 143 supersedes previous guidance for financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The statement applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or the normal operation of a long-lived asset. This statement was effective January 1, 2003. In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities". SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. SFAS No. 146 eliminates the definition and requirement for recognition of exit costs in Emerging Issues Task Force Issue No. 94-3 where a liability for an exit is recognized at the date of an entity's commitment to an exit plan. This statement is effective for exit or disposal activities initiated after December 31, 2002. The adoption of SFAS No. 143 and 146 did not have a material impact on the results of operations, financial position and cash flows of the Company. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment of FASB Statement No. 123". SFAS No. 148 provides alternative transition methods for companies that make a voluntary change to the fair-value-based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company has adopted the disclosure provisions of SFAS No. 148 and its adoption had no impact on the Company's consolidated financial position or results of operations. 22
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) (UNAUDITED) RESULTS OF OPERATIONS Revenues are calculated in accordance with accounting principles generally accepted in the United States of America and are presented in a manner consistent with industry practice. Historically, net distributable profits by the Indian casinos were computed using a modified cash basis of accounting in accordance with the management contracts to calculate management fees. Under this modified cash basis of accounting prescribed by the management contracts, the write-off of capital equipment and leased assets for the casino operations was accelerated, which thereby impacted the timing of net distributable profits. THREE MONTHS ENDED MARCH 30, 2003 COMPARED TO THE THREE MONTHS ENDED MARCH 31, 2002 Revenues Total revenues were $0.6 million for the three months ended March 30, 2003 compared to $1.5 million for the same period in the prior year. Revenues for the current year quarter were derived entirely from license fees related to the World Poker Tour series. Revenues for the prior year quarter were derived entirely from management fees from the management of Grand Casino Coushatta. The management contract with the Coushatta Tribe of Louisiana for Grand Casino Coushatta expired on January 16, 2002. The Company currently has no other management contracts from which it will derive revenues in 2003. Costs and Expenses Total costs and expenses were $3.1 million for the three months ended March 30, 2003, compared to $2.2 million for the same period in the prior year. Selling, general and administrative expenses increased from $2.1 million for the three months ended March 31, 2002 to $3.0 million for the three months ended March 30, 2003. This increase is primarily due to an increase in costs incurred associated with World Poker Tour. Other Interest income was $0.2 million for the three months ended March 30, 2003 compared to $0.7 million for the same period in the prior year. This decrease is primarily due to a decline in cash balances. Losses Per Common Share and Net Losses For the three months ended March 30, 2003, basic and diluted losses per common share were $0.12, compared to basic and diluted losses of $0.01, for the same period in the prior year. Losses for the period ended March 30, 2003 were $1.3 million compared to $0.1 million for the three months ended March 31, 2002. This increase in losses relates primarily to the expiration of the management contract for Grand Casino Coushatta on January 16, 2002. In addition, increases in costs incurred associated with World Poker Tour in excess of revenues related to World Poker Tour added to the increase in net losses for the three months ended March 30, 2003. 23
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) (UNAUDITED) Outlook It is currently contemplated that there will be no operating revenues for the remainder of 2003 from existing casino development projects. Revenue from the World Poker Tour is being recognized, however, this revenue is not expected to exceed production costs during the remainder of 2003. Although none of the existing casino development projects are expected to produce revenue in 2003, Lakes continues to evaluate potential new revenue-generating business opportunities. Lakes continues to closely monitor its operating expenses. In the second quarter of 2003, the Company will recognize a non-recurring reduction in operating expenses of approximately $3.2 million. This amount represents the excess of the amount previously accrued for the Stratosphere Preference Action Litigation over the amount of the final judgment paid by the Company in May 2003. The Company's cash position coupled with payment to be received on the sale of the Polo Plaza property, are considered adequate to cover expected 2003 operating expenses. FINANCIAL CONDITION At March 30, 2003, Lakes had $8.3 million in restricted cash and $5.5 million in unrestricted cash and cash equivalents. Subsequent to March 30, 2003, Lakes has received a $5.9 million cash distribution from the termination of a trust established as security for indemnification obligations to Grand Casinos, Inc. For the three months ended March 30, 2003, net cash used in operating activities totaled $3.0 million. For the three months ended March 31, 2002, net cash provided by operating activities totaled $5.0 million. For the same periods, net cash used in investing activities totaled $5.6 million and $6.9 million, respectively. Included in these investing activities for the periods ended March 30, 2003 and March 31, 2002 are advances on notes receivable of $3.5 million and $4.6 million, respectively. Also, during these periods, payments for land held for development amounted to $1.4 million and $0.3 million, respectively. Lakes plans to use its cash for continuing operations, loans to current joint ventures and tribal partners to develop existing and anticipated Indian casino operations, the pursuit of additional business opportunities, and settlement of pending litigation matters. The amount and timing of Lakes' cash outlays for casino development loans will depend on the timing of the regulatory approval process and the availability of external financing. When approvals are received, additional financing will be needed to complete the projects. It is currently planned that this third-party financing will be obtained by each individual tribe. However, there can be no assurance that if third-party financing is not available, Lakes will not be required to finance these projects directly. If Lakes must provide this financing, Lakes expects to obtain debt or equity financing which it would loan to the respective tribes as necessary. In the alternative, Lakes may be required to guarantee the tribes' debt financing or otherwise provide support for the tribes' obligations. Any guarantees by Lakes or similar off-balance sheet liabilities will increase Lakes' potential exposure in the event of a default by any of these tribes. At March 30, 2003, Lakes had approximately $72.5 million in notes receivable from Indian tribes and other parties. Most of these amounts are advances made to the tribes for the development of gaming properties managed by Lakes. See Note 5 to the Consolidated Financial Statements included in Item 1. 24
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) (UNAUDITED) The joint venture entities that hold the management contracts for the San Diego and Sacramento area casino resorts were previously jointly owned with two LLC's owned by Kevin M. Kean and Jerry A. Argovitz, (the "KAR Entities"). On January 30, 2003, subsidiaries of Lakes purchased the respective joint venture interests of the KAR Entities for nominal consideration, at which time the joint venture entities became indirect wholly owned subsidiaries of Lakes. At the time of the purchase, Lakes or its subsidiaries had notes receivable from the KAR Entities and a long-term receivable from Kevin M. Kean that, as of December 29, 2002, were in the amounts of $1.8 million and $1.9 million, respectively. In connection with the purchase transactions, Lakes and certain of its subsidiaries entered into separate agreements with Kevin M. Kean and Jerry A. Argovitz, the two individual owners of the KAR Entities. Under these agreements, Lakes and its subsidiaries have forgiven the notes receivable from the KAR Entities, subject to the agreements of Messrs. Kean and/or Argovitz to assume the obligations under the notes in certain circumstances. Under the agreements with Kevin M. Kean, Mr. Kean may elect to serve as a consultant to Lakes' subsidiaries during the term of each subsidiary's casino management contract if he is found suitable by relevant gaming regulatory authorities. In such event, Mr. Kean will be entitled to receive annual consulting fees equal to 20% of the management fees from the San Diego area casino operations and 15% of the management fees from the Sacramento area casino operations, less certain costs of these operations. If Mr. Kean is found suitable by relevant gaming regulatory authorities and elects to serve as a consultant, he will be obligated to repay 50% of the notes receivable from the KAR Entities. If Mr. Kean is not found suitable by relevant gaming regulatory authorities or otherwise elects not to serve as a consultant, he will be entitled to receive annual payments of $1 million from each of the San Diego and Sacramento area casino projects during the term of the respective casino management contracts (but not during any renewal term of such management contracts). Regardless of whether Mr. Kean serves as a consultant, a Lakes subsidiary has agreed to loan up to $1.25 million to Mr. Kean, $1 million of which must be used to fund certain obligations of Mr. Kean related to a separate joint venture formed to acquire land in the San Diego area. Mr. Kean's personal indebtedness to Lakes remained outstanding. Mr. Kean has agreed that 50% of the consulting fees or other payments payable to him under the agreements with Lakes and its subsidiaries shall be applied toward repayment of his indebtedness to Lakes. In the event of a default under the agreements, 100% of the fees and payments will be applied toward repayment of his indebtedness to Lakes. Under the agreements with Jerry A. Argovitz, if Mr. Argovitz is found suitable by relevant gaming regulatory authorities, he will be entitled to purchase for nominal consideration a 20% equity interest in the Lakes subsidiary holding a management contract with the San Diego area casino and a 15% equity interest in the Lakes subsidiary holding a management contract with the Sacramento area casino. Upon such purchase, Mr. Argovitz will become obligated to repay 50% of the notes receivable from the KAR Entities. If he is not found suitable or does not elect to purchase equity interests in the Lakes subsidiaries, Mr. Argovitz may elect to receive annual payments of $1 million from each of the San Diego and Sacramento area casino projects from the date of election through the term of the respective casino management contracts (but not during any renewal term of such management contracts). 25
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) (UNAUDITED) As part of a joint venture which will televise poker tournaments, the Company invested $0.1 million for an approximately 78% ownership position in the joint venture during 2002. The Company is also required to loan up to $3.2 million to the joint venture as needed. As of March 30, 2003, the Company had made net loans totaling $3.1 million to the joint venture. On December 28, 2001, the Company transferred title and ownership obligations of the Polo Plaza shopping center property to Metroflag Polo, LLC. In conjunction with this transaction, Lakes transferred to Metroflag BP, LLC, rights to and obligations of the adjacent Travelodge property consisting of a long-term land lease and a motel operation. This transaction was accounted for under the deposit method of accounting under the requirements of Statement of Financial Accounting Standards No. 66, Accounting for Sales of Real Estate rather than as a sale. Therefore, the fair value of the property is included as land held under contract for sale on the accompanying balance sheet as of December 29, 2002 and December 30, 2001. The total price for this combined transaction was approximately $30.9 million. Terms of the transaction include a $1.0 million down payment, which was received in January 2002, a contractual commitment to pay to Lakes $23.3 million and a second contractual commitment to pay Lakes $7.5 million. During 2002, Lakes and Metroflag restructured the terms of the Polo Plaza and Travelodge property transactions due to deteriorating economic conditions. The parties reduced the purchase price for the Polo Plaza property from $23.8 million to $21.8 million. On the payment date, which was scheduled to be no later than January 31, 2003, $16.8 million of the purchase price was to be payable to Lakes in cash and $4.0 million was to be payable through the issuance to Lakes of a preferred membership interest in Metroflag. During 2002, Lakes recorded a $3.0 million impairment charge for these properties relating to the adjustment in the purchase price and a negotiated potential discount on the return of Lakes' preferred interest. Lakes' collateral for the two contractual commitments is the property and lease rights described above which would revert back to Lakes in the event of default by Metroflag. During March of 2003, Lakes and Metroflag agreed to additional revisions to the terms of the Polo Plaza and Travelodge property transactions. The parties have increased the price of the Polo Plaza property from $21.8 million to $25.8 million. On the payment date, which the parties have agreed shall be extended to no later than May 15, 2003, $16.8 million of the purchase price is payable to Lakes in cash, $4.0 million is payable through the issuance to Lakes of a preferred membership interest in Metroflag and $4.0 million is payable through the issuance to Lakes of a subordinated membership interest in Metroflag. On or before April 30, 2004, Metroflag Polo may elect to distribute to Lakes $3.0 million plus interest in cash as full return of Lakes' preferred interest. If paid after April 30, 2004 and in no event later than December 24, 2006, the entire $4.0 million plus interest will be payable. The subordinated interest must be repurchased for $4.0 million at the time of repayment of an outstanding $3.5 million contractual commitment in connection with the Travelodge property, which is scheduled on or before December 28, 2004. If the Travelodge commitment is not repaid by December 28, 2004, ownership of the Travelodge lease rights would revert back to Lakes. If at any time the Polo Plaza property is sold and the Travelodge commitment has not been repaid, Metroflag is required to repurchase the subordinated interest for the lesser of $4.0 million or any portion of the net cash proceeds from such sale or refinancing that exceeds $60.0 million. 26
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) (UNAUDITED) In March of 2003, the parties decreased the sale price of the Travelodge property from $7.5 million to $3.5 million. The contractual commitment to pay Lakes was also decreased from $7.5 million to $3.5 million and is now payable no later than December 28, 2004. Lakes continues to own the Shark Club property, which is an approximate 3.5 acre undeveloped site adjacent to the Polo Plaza shopping center and Travelodge sites. During August 2002, Lakes formed a joint venture with Diamond Resorts, LLC, a Nevada limited liability company and time-share developer for the purpose of developing the Shark Club parcel as an upscale time-share project. The terms of this joint venture agreement require that Diamond and Lakes each make an initial working capital contribution of $250,000. Subject to Diamond obtaining a financing commitment for a construction loan sufficient to fund at least the first phase of the building improvements contemplated by the time-share project, the joint venture agreement will require Lakes to contribute the relevant portion of the Shark Club parcel, which was originally valued at $16.0 million. During December of 2002, the Shark Club parcel was adjusted to its revised estimated market value of $15.0 million resulting in an impairment charge of approximately $1.0 million, which was reflected in impairment losses in the consolidated statement of loss for the year ended December 29, 2002. Diamond has agreed to perform sales, marketing, administrative and managerial services for the project. The terms of the joint venture agreement provide for the repayment to Lakes of its contribution of property in cash based on the joint venture's cash flow and time-share unit sales. It is contemplated that Lakes will be required to make no other material contributions of cash or property to the project. On October 2, 2002, Lakes loaned $1.0 million to the joint venture. Interest accrues at a rate of 10% per annum. The loan is due and payable from first available cash flow of the joint venture (excluding any required capital contribution from a member) and no later than October 1, 2004. On April 7, 2003, Lakes announced that it has signed a Letter of Intent to sell the Shark Club property. Under the terms of the Letter of Intent, Lakes will sell the property to an entity to be managed and operated by Marriott Ownership Resorts, Inc. for a purchase price of $15.0 million in cash. Certain terms and conditions of this Letter of Intent will need to be satisfied prior to the completion of this sale, which is also subject to negotiation of a definitive purchase agreement. In addition to the $15.0 million payment, Lakes will receive $1.0 million as repayment of a loan previously made to Chateau by Lakes. Subject to the satisfaction of the necessary terms and conditions, Lakes anticipates the closing will occur in May 2003. Pursuant to the terms of the Distribution Agreement, Grand Casinos assigned to Lakes, and Lakes assumed, a lease agreement dated February 1, 1996 covering Lakes' current corporate office space of approximately 65,000 square feet with a lease term of fifteen years. The lease commenced on October 14, 1996. During 2001, also pursuant to the terms of the Distribution Agreement, Lakes entered into a capital lease arrangement for the corporate office space at which time the operating lease was cancelled. Accordingly, Lakes recorded a capital leased asset and liability in the amount of approximately $5.8 million. On January 2, 2002, as per the agreement with Grand Casinos, Lakes purchased the building for $6.4 million, including transaction expenses. This transaction resulted in the extinguishment of the Company's capital lease obligation related to the building. 27
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) (UNAUDITED) The Company had two notes payable with third parties, which were repaid during 2002. The first was collateralized by certificates of deposit, in the amount of $1.0 million. The second was collateralized by property in the amount of $0.4 million. As a part of the agreements resulting from Lakes' spin-off from Grand Casinos and related transactions, Lakes has agreed to indemnify Grand Casinos against all costs, expenses and liabilities incurred in connection with or arising out of certain pending and threatened claims and legal proceedings to which Grand Casinos and certain of its subsidiaries are likely to be parties. The Company's indemnification obligations include the obligation to provide the defense of all claims made in proceedings against Grand Casinos and to pay all related settlements and judgments. See Part II Item 1. Legal Proceedings. As security to support Lakes' indemnification obligations to Grand Casinos, Lakes deposited $7.5 million in trust for the benefit of Grand Casinos, as a wholly owned subsidiary of Park Place. In May of 2003, the Stratosphere Preference Action Settlement of approximately $2.3 million was paid out of the trust to Stratosphere. Following such payment, the remaining restricted funds of approximately $5.9 million, including interest, were released to Lakes and reclassified as unrestricted and the trust was terminated, since Lakes has satisfied all known material indemnification obligations. Subsequent indemnification obligations to Grand Casinos, if any, would be paid directly by Lakes. SEASONALITY The Company believes that the operations of all casinos to be managed by the Company will be affected by seasonal factors, including holidays, weather and travel conditions. REGULATION AND TAXES The Company is subject to extensive regulation by state gaming authorities. The Company will also be subject to regulation, which may or may not be similar to current state regulations, by the appropriate authorities in any jurisdiction where it may conduct gaming activities in the future. Changes in applicable laws or regulations could have an adverse effect on the Company. 28
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) (UNAUDITED) The gaming industry represents a significant source of tax revenues. From time to time, various federal legislators and officials have proposed changes in tax law, or in the administration of such law, affecting the gaming industry. It is not possible to determine the likelihood of possible changes in tax law or in the administration of such law. Such changes, if adopted, could have a material adverse effect on the Company's results of operations and financial results. RECENT ACCOUNTING PRONOUNCEMENTS The FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" in November 2002. This interpretation elaborates on the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of this interpretation are applicable to all guarantees and modification to guarantees made after December 31, 2002. The Company's disclosure of the indemnification and guarantee agreements of the Company is in compliance with the interpretation. The disclosure requirements in this interpretation are effective for financial statements of interim or annual periods ended after December 15, 2002. The Company does not believe the adoption of the interpretation will have a material impact on its results of operations, financial position and cash flows. The Company does have an indemnification agreement with Grand Casinos which is fully described in the Financial Condition section of this Management's Discussion and Analysis. In January 2003, the FASB issued Interpretation No. 46 (FIN46), "Consolidation of Variable Interest Entities", which addresses the consolidation of variable interest entities. The interpretation applicable immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which a Company obtains an interest after that date. For variable interests in variable interest entities acquired before February 1, 2003, the interpretation applicable applies in the first interim period beginning after June 15, 2003. The Company is in the process of evaluating all of its investments and other interests in entities that may be deemed variable interest entities under the provisions of FIN 46. If the Company's interests were deemed to constitute variable interest entities, there would be no material impact because amounts are already included as notes receivable on the accompanying condensed consolidated balance sheets. The Company cannot make any definitive conclusion until it completes its evaluation. 29
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) (UNAUDITED) In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations". SFAS No. 143 supersedes previous guidance for financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The statement applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or the normal operation of a long-lived asset. This statement was effective January 1, 2003. In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities". SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. SFAS No. 146 eliminates the definition and requirement for recognition of exit costs in Emerging Issues Task Force Issue No. 94-3 where a liability for an exit is recognized at the date of an entity's commitment to an exit plan. This statement is effective for exit or disposal activities initiated after December 31, 2002. The Company does not believe the adoption of SFAS No. 143 and 146 will have a material impact on its results of operations, financial position and cash flows. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment of FASB Statement No. 123". SFAS No. 148 provides alternative transition methods for companies that make a voluntary change to the fair-value-based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company has adopted the disclosure provisions of SFAS No. 148 and its adoption had no impact on the Company's consolidated financial position or results of operations. PRIVATE SECURITIES LITIGATION REFORM ACT The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements. Certain information included in this Form 10-K and other materials filed or to be filed by the Company with the Securities and Exchange Commission (as well as information included in oral statements or other written statements made or to be made by the Company) contain statements that are forward-looking, such as plans for future expansion and other business development activities as well as other statements regarding capital spending, financing sources and the effects of regulation (including gaming and tax regulation) and competition. 30
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) (UNAUDITED) Such forward looking information involves important risks and uncertainties that could significantly affect the anticipated results in the future and, accordingly, actual results may differ materially from those expressed in any forward-looking statements made by or on behalf of the Company. These risks and uncertainties include, but are not limited to, those relating to possible delays in completion of Lakes' casino projects, including various regulatory approvals and numerous other conditions which must be satisfied before completion of these projects; possible termination or adverse modification of management contracts; continued indemnification obligations to Grand Casinos; highly competitive industry; possible changes in regulations; reliance on continued positive relationships with Indian tribes and repayment of amounts owed to Lakes by Indian tribes; possible need for future financing to meet Lakes' expansion goals; risks of entry into new businesses; and reliance on Lakes' management. For further information regarding the risks and uncertainties, see the "Business -- Risk Factors" section of the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 2002. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's financial instruments include cash and cash equivalents, marketable securities and long-term debt. The Company's main investment objectives are the preservation of investment capital and the maximization of after-tax returns on its investment portfolio. Consequently, the Company invests with only high-credit-quality issuers and limits the amount of credit exposure to any one issuer. The Company does not use derivative instruments for speculative or investment purposes. The Company's cash and cash equivalents are not subject to significant interest rate risk due to the short maturities of these instruments. As of March 30, 2003, the carrying value of the Company's cash and cash equivalents approximates fair value. The Company has in the past and may in the future obtain marketable debt securities (principally consisting of commercial paper, corporate bonds, and government securities) having a weighted average duration of one year or less. Consequently, such securities would not be subject to significant interest rate risk. The Company's primary exposure to market risk associated with changes in interest rates involves the Company's notes receivable related to loans for the development and construction of Native American owned casinos. The loans and related note balances earn various interest rates based upon a defined reference rate. The floating rate receivables will generate more or less interest income if interest rates rise or fall. Interest income is deferred during development of the casinos because realizability of the interest is contingent upon the completion and positive cash flow from operation of the casino. As of March 30, 2003, Lakes had $72.4 million of floating rate notes receivables. Based on the applicable current reference rates and assuming all other factors remain constant, deferred interest income for a twelve month period would be $4.1 million. A reference rate increase of 100 basis points would result in an increase in deferred interest income of $0.7 million. A 100 basis point decrease in the reference rate would result in a decrease of $0.7 million in deferred interest income over the same twelve month period. 31
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) (UNAUDITED) ITEM 4. CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-14(c) promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), within 90 days of the filing date of this report. Based on their evaluation, our chief executive officer and chief financial officer concluded that Lakes Entertainment, Inc.'s disclosure controls and procedures are effective. There have been no significant changes (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation referenced above. 32
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The following summaries describe certain known legal proceedings to which Grand is a party which Lakes has assumed, or with respect to which Lakes may have agreed to indemnify Grand, in connection with the Distribution. 33
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES PART II OTHER INFORMATION (CONTINUED) STRATOSPHERE PREFERENCE ACTION In April 1998, Stratosphere served on Grand and Grand Media & Electronics Distributing, Inc., a wholly owned subsidiary of Grand ("Grand Media"), a complaint in the Stratosphere bankruptcy case seeking recovery of certain amounts paid by Stratosphere to (i) Grand Media for electronic equipment purchased by Stratosphere from Grand Media, and (ii) Grand as management fees and for costs and expenses under a management agreement between Stratosphere and Grand. Stratosphere claimed in its complaint that such amounts are recoverable by Stratosphere as preferential payments under bankruptcy law. In May 1998, Grand responded to Stratosphere's complaint denying that Stratosphere is entitled to recover the amounts described in the complaint. Discovery was completed on December 31, 2001 and the case proceeded to trial before the United States Bankruptcy Court for the District of Nevada on June 20, 2002. On December 31, 2002, the Bankruptcy Court issued its final judgment holding that: (i) payments to Grand Media for electronic equipment totaling approximately $3.3 million are not recoverable by Stratosphere as avoidable preferences, and (ii) payment to Grand for management services in the approximate amount of $2.3 million is recoverable by Stratosphere and an avoidable preference. On May 8, 2003, this judgment was satisfied out of amounts held as security to support Lakes' indemnification obligations to Grand. OTHER LITIGATION The Company has recorded a reserve assessment related to the Stratosphere Preference Action. The reserve is included in the litigation and claims accrual on the accompanying condensed consolidated balance sheets as of March 30, 2003 and December 29, 2002. Lakes is involved in various other inquiries, administrative proceedings, and litigation relating to contracts and other matters arising in the normal course of business. While any proceeding or litigation has an element of uncertainty, management currently believes that the final outcome of these matters is not likely to have a material adverse effect upon the Company's consolidated financial position or results of operations. 34
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES PART II OTHER INFORMATION (CONTINUED) ITEM 5. OTHER INFORMATION The Lakes Board of Directors previously has determined that each of the three Audit Committee members is an "independent director" under Nasdaq listing standards. The Board has been advised of an informal interpretation of the Nasdaq rules that might cause Neil I. Sell, a member of the Audit Committee, not to be considered independent. Mr. Sell is a partner in the law firm of Maslon Edelman Borman & Brand, LLP, which performs legal services for Lakes, and the fees paid by Lakes to the Maslon law firm have exceeded $60,000 per year. Under the informal interpretation, all of these fees are imputed to Mr. Sell personally, and he is not considered independent. However, under Nasdaq guidelines, he can still serve as a member of the Audit Committee if the Board of Directors determines that membership on the Audit Committee by Mr. Sell is required by the best interests of Lakes and its shareholders. The Board has made this determination considering all relevant factors, principally Mr. Sell's membership on the Audit Committee since Lakes commenced its business, resulting in his understanding of Lakes' financial statements and accounting issues; his dedication and thoroughness as a member of the Audit Committee; his previous background as a member of the Board of Directors and Audit Committee of Grand Casinos, Inc.; and his background as a certified public accountant. On May 12, 2003, Timothy J. Cope was named President of Lakes. Prior to such time, Mr. Cope, who also serves as Chief Financial Officer, served as Executive Vice-President. Lyle Berman, Lakes' previous President, continues to serve as Chairman of the Board and Chief Executive Officer. 35
LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES PART II OTHER INFORMATION (CONTINUED) ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 10.1 Acquisition Master Agreement dated January 22, 2003, by and between The Travel Channel, L.L.C. and World Poker Tour, L.L.C. (portions of this exhibit have been omitted pursuant to a request for confidential treatment and have been filed separately with the Commission pursuant to Rule 24b-2 of the Securities Exchange Act of 1934) 10.2 Amendment to Member Control Agreement of Pacific Coast Gaming - Santa Rosa, LLC 10.3 Third Amendment to Acquisition and Participation Agreement dated as of February 28, 2003, by and among MRD Gaming, LLC, Lakes Cloverdale, LLC and Lakes Corning, LLC 10.4 Assignment dated as of February 28, 2003 by and between Lakes Corning, LLC and Lakes Cloverdale, LLC 10.5 Assignment dated as of February 28, 2003 by and among Pacific Coast Gaming - Corning, LLC, MRD Gaming, LLC and Lakes Corning, LLC 99.1 Certification of Chief Executive Officer 99.2 Certification of Chief Financial Officer (b) Reports on Form 8-K (i) A Form 8-K, Item 5. Other Events, and Item 7. Financial Statements, Pro Forma Financial Information and Exhibits, was filed on March 11, 2003. (ii) A Form 8-K, Item 5. Other Events, and Item 7. Financial Statements, Pro Forma Financial Information and Exhibits, was filed on April 7, 2003. (iii) A Form 8-K, Item 5. Other Events, and Item 7. Financial Statements, Pro Forma Financial Information and Exhibits, was filed on April 14, 2003. (iv) A Form 8-K, Item 7. Financial Statements, Pro Forma Financial Information and Exhibits, and Item 12. Results of Operations and Financial Condition, was filed on April 28, 2003. 36
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: May 14, 2003 LAKES ENTERTAINMENT, INC. ------------------------- Registrant / s/ Lyle Berman ------------------------- Lyle Berman Chairman of the Board, and Chief Executive Officer /s/ Timothy J. Cope ------------------------- Timothy J. Cope President and Chief Financial Officer CERTIFICATIONS I, Lyle Berman, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Lakes Entertainment, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statement made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. I am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for Lakes Entertainment, Inc., and have: a. designed such disclosure controls and procedures to ensure that material information relating to Lakes Entertainment, Inc., including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; 37
b. evaluated the effectiveness of Lakes Entertainment, Inc.'s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. I have disclosed, based on our most recent evaluation, to Lakes Entertainment, Inc.'s auditors and the audit committee of Lakes Entertainment, Inc.'s board of directors: a. all significant deficiencies in the design or operation of internal controls which could adversely affect Lakes Entertainment, Inc.'s ability to record, process, summarize and report financial date and have identified for Lakes Entertainment, Inc.'s auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in Lakes Entertainment, Inc.'s internal controls; and 6. I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 /s/ Lyle Berman ------------------------- Lyle Berman Chief Executive Officer CERTIFICATIONS I, Timothy J. Cope, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Lakes Entertainment, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statement made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. I am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for Lakes Entertainment, Inc., and have: 38
a. designed such disclosure controls and procedures to ensure that material information relating to Lakes Entertainment, Inc., including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of Lakes Entertainment, Inc.'s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. I have disclosed, based on our most recent evaluation, to Lakes Entertainment, Inc.'s auditors and the audit committee of Lakes Entertainment, Inc.'s board of directors: a. all significant deficiencies in the design or operation of internal controls which could adversely affect Lakes Entertainment, Inc.'s ability to record, process, summarize and report financial date and have identified for Lakes Entertainment, Inc.'s auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in Lakes Entertainment, Inc.'s internal controls; and 6. I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 /s/ Timothy J. Cope ------------------------- Timothy J. Cope Chief Financial Officer 39