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 September 28, 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 November 5, 2003, there were 10,730,429 shares of Common Stock, $0.01 par value per share, outstanding. LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES INDEX <Table> <Caption> PAGE OF FORM 10-Q --------- PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS Condensed Consolidated Balance Sheets as of 3 September 28, 2003 and December 29, 2002 Condensed Consolidated Statements of Loss for the three 4 months ended September 28, 2003 and September 29, 2002 Condensed Consolidated Statements of Comprehensive 5 Loss for the three months ended September 28, 2003 and September 29, 2002 Condensed Consolidated Statement of Loss for 6 the nine months ended September 28, 2003 and September 29, 2002 Condensed Consolidated Statements of Comprehensive 7 Loss for the nine months ended September 28, 2003 and September 29, 2002 Condensed Consolidated Statements of Cash Flows for 8 the nine months ended September 28, 2003 and September 29, 2002 Notes to Condensed Consolidated Financial Statements 9 ITEM 2. MANAGEMENT'S DISCUSSION AND 19 ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ITEM 3. QUANTITATIVE AND QUALITATIVE 31 DISCLOSURES ABOUT MARKET RISK ITEM 4. CONTROLS AND PROCEDURES 31 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS 32 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 34 </Table> 2 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) (UNAUDITED) <Table> <Caption> SEPTEMBER 28, 2003 DECEMBER 29, 2002 ------------------ ----------------- ASSETS Current Assets: Cash and cash equivalents $ 31,292 $ 14,106 Accounts receivable, net 610 116 Deferred tax asset 2,640 6,771 Other current assets 961 547 -------- -------- Total Current Assets 35,503 21,540 -------- -------- Property and Equipment-Net 6,598 6,962 -------- -------- Other Assets: Land held under contract for sale 4,967 28,832 Land held for development 14,375 27,791 Notes receivable-less current installments 80,360 70,955 Cash and cash equivalents-restricted -- 8,300 Investments in and notes from unconsolidated affiliates 8,597 1,013 Deferred tax asset 6,125 3,835 Other long-term assets 8,927 6,657 -------- -------- Total Other Assets 123,351 147,383 -------- -------- TOTAL ASSETS $165,452 $175,885 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities: Accounts payable $ 178 $ 226 Income taxes payable 2,941 5,564 Litigation and claims accrual 148 5,847 Accrued payroll and related 603 252 Other accrued expenses 2,895 3,486 -------- -------- Total Current Liabilities 6,765 15,375 -------- -------- TOTAL LIABILITIES 6,765 15,375 -------- -------- COMMITMENTS AND CONTINGENCIES Shareholders' Equity: Capital stock, $.01 par value; authorized 100,000 shares; 10,640 and 10,638 common shares issued and outstanding at September 28, 2003, and December 29, 2002, respectively 106 106 Additional paid-in-capital 131,542 131,525 Retained Earnings 27,039 28,879 -------- -------- Total Shareholders' Equity 158,687 160,510 -------- -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $165,452 $175,885 ======== ======== </Table> THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 3 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF LOSS (IN THOUSANDS, EXCEPT EARNINGS PER SHARE) <Table> <Caption> (UNAUDITED) THREE MONTHS ENDED --------------------------------------- SEPTEMBER 28, 2003 SEPTEMBER 29, 2002 ------------------ ------------------ REVENUES: License fee income $ 377 $ -- -------- -------- Total Revenues 377 -- -------- -------- COSTS AND EXPENSES: Selling, general and administrative 2,504 2,700 Depreciation and amortization 135 130 -------- -------- Total Costs and Expenses 2,639 2,830 -------- -------- LOSS FROM OPERATIONS (2,262) (2,830) -------- -------- OTHER INCOME (EXPENSE): Interest income 98 134 Interest expense -- (23) Equity in loss of unconsolidated affiliates (50) (85) -------- -------- Total other income, net 48 26 -------- -------- Loss before income taxes (2,214) (2,804) Benefit for income taxes (912) (1,150) -------- -------- NET LOSS ($ 1,302) ($ 1,654) ======== ======== BASIC LOSS PER SHARE ($ 0.12) ($ 0.16) ======== ======== DILUTED LOSS PER SHARE ($ 0.12) ($ 0.16) ======== ======== WEIGHTED AVERAGE COMMON SHARES OUTSTANDING 10,639 10,638 DILUTIVE EFFECT OF STOCK COMPENSATION PROGRAMS -- -- -------- -------- WEIGHTED AVERAGE COMMON AND DILUTED SHARES OUTSTANDING 10,639 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 LOSS (IN THOUSANDS) <Table> <Caption> (UNAUDITED) THREE MONTHS ENDED ---------------------------------------- SEPTEMBER 28, 2003 SEPTEMBER 29, 2002 ------------------ ------------------ NET LOSS ($1,302) ($1,654) OTHER COMPREHENSIVE EARNINGS (LOSS), NET OF TAX: Unrealized gains (losses) on securities: Unrealized holding gains during the period -- 21 Reclassification adjustment for losses included in net loss -- 2 ------- ------- COMPREHENSIVE LOSS ($1,302) ($1,631) ======= ======= </Table> THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 5 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF LOSS (IN THOUSANDS, EXCEPT EARNINGS PER SHARE) <Table> <Caption> (UNAUDITED) NINE MONTHS ENDED ------------------------------------------ SEPTEMBER 28, 2003 SEPTEMBER 29, 2002 ------------------ ------------------ REVENUES: Management fee income $ -- $ 1,502 License fee income 3,881 -- -------- -------- Total Revenues 3,881 1,502 -------- -------- COSTS AND EXPENSES: Selling, general and administrative 7,221 14,371 Depreciation and amortization 394 349 -------- -------- Total Costs and Expenses 7,615 14,720 -------- -------- LOSS FROM OPERATIONS (3,734) (13,218) -------- -------- OTHER INCOME (EXPENSE): Interest income 649 1,306 Interest expense -- (70) Equity in loss of unconsolidated affiliates (197) (316) Other 158 -- -------- -------- Total other income, net 610 920 -------- -------- Loss before income taxes (3,124) (12,298) Benefit for income taxes (1,284) (3,401) -------- -------- NET LOSS ($ 1,840) ($ 8,897) ======== ======== BASIC LOSS PER SHARE ($ 0.17) ($ 0.84) ======== ======== DILUTED LOSS PER SHARE ($ 0.17) ($ 0.84) ======== ======== WEIGHTED AVERAGE COMMON SHARES OUTSTANDING 10,639 10,638 DILUTIVE EFFECT OF STOCK COMPENSATION PROGRAMS -- -- -------- -------- WEIGHTED AVERAGE COMMON AND DILUTED SHARES OUTSTANDING 10,639 10,638 ======== ======== </Table> THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 6 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS (IN THOUSANDS) <Table> <Caption> (UNAUDITED) NINE MONTHS ENDED SEPTEMBER 28, 2003 SEPTEMBER 29, 2002 ------------------ ------------------ NET LOSS ($1,840) ($8,897) OTHER COMPREHENSIVE LOSS, NET OF TAX: Unrealized gains (losses) on securities: Unrealized holding gains during the period -- 10 Reclassification adjustment for losses included in net loss -- 50 ------- ------- COMPREHENSIVE LOSS ($1,840) ($8,837) ======= ======= </Table> THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 7 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) <Table> <Caption> (UNAUDITED) NINE MONTHS ENDED SEPTEMBER 28, 2003 SEPTEMBER 29, 2002 ------------------ ------------------ OPERATING ACTIVITIES: Net loss ($ 1,840) ($ 8,897) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 394 349 Equity in loss of unconsolidated affiliates 197 316 Impairment of land held under contract for sale -- 3,000 Write down of related party receivables -- 4,000 Changes in operating assets and liabilities: Accounts receivable (494) 3,510 Income taxes (782) (4,719) Accounts payable (48) 185 Accrued expenses (2,818) 570 Other (414) 280 -------- -------- Net Cash Used in Operating Activities (5,805) (1,406) -------- -------- INVESTING ACTIVITIES: Short-term investments, sales/maturities -- 2,130 Payments for land held under contract for sale (629) (783) Payments received on land held under contract for sale 16,766 -- Payments received (made) for land held for development 13,416 (3,748) Advances on notes receivable (12,382) (15,257) Proceeds from repayment of notes receivable 1,000 67 Investment in and notes receivable from unconsolidated affiliates (704) (165) Decrease (increase) in restricted cash, net 5,907 (579) Increase in other long-term assets (370) (1,420) Payments for property and equipment, net (30) (1,127) -------- -------- Net Cash Provided by (Used in) Investing Activities 22,974 (20,882) -------- -------- FINANCING ACTIVITIES: Payments on capital lease obligations -- (5,714) Proceeds from issuance of common stock 17 -- Payments on long-term debt -- (350) -------- -------- Net Cash Used in Financing Activities 17 (6,064) -------- -------- Net increase (decrease) in cash and cash equivalents 17,186 (28,352) Cash and cash equivalents - beginning of period 14,106 42,638 -------- -------- CASH AND CASH EQUIVALENTS - END OF PERIOD $ 31,292 $ 14,286 ======== ======== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the period for: Interest $ -- $ 74 Income taxes 6 9 </Table> THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 8 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 which has now been completed. During July of 2003, WPT reached an agreement with TRV for a second season with TRV being granted options for five additional seasons. 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. 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. 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. 9 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 and extended the payment date to May 15, 2003. On the payment date, $16.8 million of the purchase price was paid to Lakes in cash, $4.0 million was paid through the issuance to Lakes of a preferred membership interest in Metroflag and $4.0 million was paid 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 On April 7, 2003, Lakes announced that it had signed a Letter of Intent to sell the approximate 3.5 acre undeveloped site, known as the Shark Club Parcel, for a purchase price of $15.0 million in cash. The transaction closed on July 1, 2003. In addition to the $15.0 million payment, Lakes received $1.0 million as repayment of a loan previously made by Lakes to Chateaux, LLC, a joint venture entity originally formed by Lakes and a time-share developer for the purpose of developing the Shark Club Parcel as an upscale time-share project. 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 $14.4 million and $12.8 million as of September 28, 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. 10 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 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 6 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 December 15, 2003. The Company has determined that it has no investments or other interests in entities that may be deemed variable interest entities under the provisions of FIN 46, as the development projects subject to the management agreements with the Indian Tribes are not separate entities or legal structures. 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. 11 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 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 nine months ended September 28, 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. 3. STOCK-BASED COMPENSATION At September 28, 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> NINE MONTHS ENDED THREE MONTHS ENDED ----------------------------------- ---------------------------------- SEPT. 28, 2003 SEPT. 29, 2002 SEPT. 28, 2003 SEPT. 29, 2002 -------------- -------------- -------------- -------------- Net loss: As reported $ (1,840) $ (8,897) $ (1,302) $ (1,654) Less: Total stock-based compensation expense determined under the fair value method, net of related tax effects (1,150) (1,276) (383) (426) Pro forma (2,990) (10,173) (1,685) (2,080) Net loss per share: As reported -- Basic $ (0.17) $ (0.84) $ (0.12) $ (0.16) Pro forma -- Basic (0.28) (0.96) (0.16) (0.20) As reported -- Diluted (0.17) (0.84) (0.12) (0.16) Pro forma -- Diluted (0.28) (0.96) (0.16) (0.20) </Table> 12 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 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 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 September 28, 2003, no amounts have been withheld under these provisions. 13 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) Notes receivable consist of the following (in thousands): <Table> <Caption> September 28, 2003 December 29, 2002 ------------------ ----------------- Properties under development: Notes from the Pokagon Band of Potawatomi Indians with variable interest rates (not to exceed 10%) (5.00% at September 28, 2003), receivable in 60 monthly installments subsequent to commencement date $41,450 $39,470 Notes from the Shingle Springs Band of Miwok Indians with variable interest rates (6.00% at September 28, 2003), receivable in varying monthly installments based on contract terms subsequent to commencement date 21,304 14,035 Notes from Jamul Indian Village with variable interest rates (6.00% at September 28, 2003), receivable in 12 monthly installments subsequent to commencement date 11,744 9,492 Notes from the Nipmuc Nation with variable interest rates (6.00% at September 28, 2003) receivable in varying installments based on contract terms subsequent to commencement date 4,323 3,814 Other 1,539 4,144 ------- ------- Total notes receivable $80,360 $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 September 28, 2003 and December 29, 2002, $13.7 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 September 28, 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. 14 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 6. COMMITMENTS AND CONTINGENCIES: LEASES The Company leases certain property and equipment, including an airplane, under a non-cancelable operating lease. The airplane lease expired May 1, 2003 and was renewed for a one-year period. The lease provides for one additional one-year renewal term. Approximate future minimum lease payments, due under this lease as of September 28, 2003, assuming the second one-year renewal is exercised, are as follows (in thousands): <Table> <Caption> Operating Leases ---------------- 2003 $150 2004 600 2005 200 ---- $950 ==== </Table> PURCHASE OPTIONS The Company has the right to purchase the airplane it leases during the renewal terms for approximately $8 million. 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. 15 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) As part of the indemnification agreement, Lakes has agreed that it will not declare or pay any dividends, make any distribution on account 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. 16 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) LEGAL PROCEEDINGS WILLARD EUGENE SMITH LITIGATION On October 24, 2003, Lakes announced that it had been named as one of a number of defendants in a counterclaim filed in state court in Harris County, Texas by Willard Eugene Smith involving Kean Argovitz Resorts, LLC (KAR), related persons and entities. In the counterclaim, Smith asserts that, under an alleged oral agreement with Kevin Kean, he is entitled to a percentage of fees to be received by the KAR entities or their principals relating to the Shingle Springs and Jamul casinos that Lakes' subsidiaries are developing in California. Smith also seeks recovery of damages and other relief from the KAR entities, Lakes and certain affiliates based on their conduct with respect to the alleged agreement. Lakes believes the counterclaim against it is without merit. Lakes understands that the alleged oral agreement upon which Smith bases his claim was rendered null and void in a prior judgment issued against Smith by the Harris County, Texas state court in October 2000. However, in September 2003, the court vacated the prior judgment against Smith. Lakes acquired KAR's interests in the Shingle Springs and Jamul projects on January 30, 2003. In the buyout agreements between Lakes and certain KAR entities and related principals, the KAR entities represented to Lakes that the KAR entities and their affiliates had no continuing agreements with any third party relating to the Shingle Springs and Jamul projects and agreed to indemnify Lakes and its affiliates from damages resulting from prior dealings of the KAR entities and related principals concerning the projects. Lakes will vigorously defend against the allegations made against it and will pursue its indemnification rights against the KAR entities and their principals under the buyout agreements if necessary. OTHER LITIGATION 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. 17 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) 7. RELATED PARTY TRANSACTIONS Previously, Lakes formed two joint venture partnerships with 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. A subsidiary of Lakes and Land Baron West, LLC are partners in a joint venture formed to develop or sell land purchased by the joint venture near San Diego, California. Land Baron West, LLC owed the joint venture $0.6 million, and $0.2 million, as of September 28, 2003 and December 29, 2002, respectively. These amounts are included in accounts receivable on the accompanying condensed consolidated balance sheets. 18 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 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 for the Pokagon Band of Potawatomi Indians. (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 the Nipmuc Nation, 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 ("WPT") and establish poker as the next significant televised mainstream sport. The joint venture signed an agreement with the Travel Channel ("TRV") in March 2003, for broadcast of the first season of the WPT series which has now been completed. During July of 2003, WPT reached an agreement with TRV for a second season with TRV being granted options for five additional seasons. Revenue is recognized ratably as production milestones and other conditions are met. During the first three quarters of 2003, Lakes recognized approximately $3.9 million in revenue related to the World Poker Tour. Revenues related to the second season will be recognized during 2004. 19 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) 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. Through September 28, 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. 20 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) 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 December 15, 2003. The Company has determined that it has no investments or other interests in entities that may be deemed variable interest entities under the provisions of FIN 46, as the development projects subject to the management agreements with the Indian Tribes are not separate entities or legal structures. 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. 21 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) 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. NINE MONTHS ENDED SEPTEMBER 28, 2003 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER 29, 2002 Revenues Total revenues were $3.9 million for the nine months ended September 28, 2003 compared to $1.5 million for the same period in the prior year. Revenues for the current year period were derived entirely from license fees related to the WPT series, which has completed its first full season. An agreement for a WPT second season was reached during July of 2003. Under the new agreement, WPT will receive a series of fixed license payments for the second season. These payments will commence in 2004 and are subject to satisfaction of production milestones and other conditions. WPT is also entitled to a portion of the revenues from other sources including international distribution, merchandising and certain sponsorships, and WPT is currently exploring these opportunities. Revenues for the prior year period 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 $7.6 million for the nine months ended September 28, 2003, compared to $14.7 million for the same period in the prior year. Selling, general and administrative expenses decreased from $14.4 million for the nine months ended September 29, 2002 to $7.2 million for the nine months ended September 28, 2003. This decrease is the result of impairment charges taken in the prior year period of $4.0 million relating to a note receivable from Living Benefits, LLC, and $3.0 million relating to the Polo Plaza and Travelodge properties, which was partially offset by an increase in professional fees of approximately $1.4 million related to the property sales in Las Vegas, Nevada, as well as an increase in costs incurred associated with WPT in the amount of $2.5 million during the current year period. Also during the current year period, the Company reversed a reserve assessment related to Stratosphere litigation which exceeded the final judgment amount resulting in a reversal of litigation and claims accrual in the amount of $3.2 million. 22 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Other Interest income was $0.6 million for the nine months ended September 28, 2003 compared to $1.3 million for the same period in the prior year. This decrease is primarily due to lower market rates during the period as well as a decrease in interest earned on amounts owed to Lakes by Metroflag related to the properties sold to Metroflag by Lakes in Las Vegas, Nevada. Losses Per Common Share and Net Losses For the nine months ended September 28, 2003, basic and diluted losses per common share were $0.17, compared to basic and diluted losses of $0.84 per common share, for the same period in the prior year. Losses for the period ended September 28, 2003 were $1.8 million compared to $8.9 million for the nine months ended September 29, 2002. This decrease in losses is primarily due to the impairment charges of $7.0 million taken in the prior year period discussed above. THREE MONTHS ENDED SEPTEMBER 28, 2003 COMPARED TO THE THREE MONTHS ENDED SEPTEMBER 29, 2002 Revenues Total revenues were $0.4 million for the three months ended September 28, 2003. There were no revenues in the same period in the prior year. Revenues for the current year period were derived entirely from license fees related to the WPT series, which has now completed its first full season. An agreement for a WPT second season was reached during July 2003. Revenue from the second season will be recognized in 2004 as production milestones and other conditions are met. Costs and Expenses Total costs and expenses were $2.6 million for the three months ended September 28, 2003, compared to $2.8 million for the same period in the prior year. Selling, general and administrative expenses remained nearly constant at $2.5 million for the three months ended September 28, 2003 compared to $2.7 million for the three months ended September 29, 2002. Other Interest income was $0.1 million for the three months ended September 28, 2003 and September 29, 2002. 23 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Earnings Per Common Share and Net Earnings For the three months ended September 28, 2003, basic and diluted losses per common share were $0.12, compared to basic and diluted losses of $0.16 per share, for the same period in the prior year. Losses for the three months ended September 28, 2003 were $1.3 million compared to losses of $1.7 million for the three months ended September 29, 2002. This decrease in losses relates primarily to revenue recognized during the current year period of $0.4 million related to the WPT. No revenue was recognized during the prior year period. Outlook It is currently contemplated that there will be no operating revenues for the remainder of 2003 from existing casino development projects or from the World Poker Tour. 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. The Company recently signed an agreement with TRV for a second season of the WPT series. Costs associated with WPT are expected to remain primarily consistent during the third and fourth quarters of 2003. However, revenues related to the second season will not be recognized until 2004, as production milestones and other conditions are met. Lakes anticipates that second season revenues from all sources will allow WPT to be profitable in 2004 and future years, thereby being incremental to Lakes' earnings and reducing financial risks associated with this venture. Lakes continues to closely monitor its operating expenses. FINANCIAL CONDITION At September 28, 2003, Lakes had $31.3 million in unrestricted cash and cash equivalents. Lakes considers its cash position adequate to cover expected remaining 2003 operating expenses. For the nine months ended September 28, 2003, net cash used in operating activities totaled $5.8 million. For the nine months ended September 29, 2002, net cash used in operating activities totaled $1.4 million. For the current year period, net cash provided by investing activities totaled $23.0 million. For the nine months ended September 29, 2002, net cash used in investing activities totaled $20.9 million. Included in these investing activities for the periods ended September 28, 2003 and September 29, 2002 are advances on notes receivable of $12.4 million and $15.3 million, respectively. Net receipts from land held under contract for sale were $16.1 million during the nine months ended September 28, 2003. Payments for land held under contract for sale were $0.8 million for the nine months ended September 29, 2002. Unrestricted cash increased by $5.9 million during the 2003 period as a result of the reclassification of restricted cash as unrestricted. During the nine months ended September 28, 2003, net payments received for land held for development were $13.4 million. During the prior year period, payments for land held for development amounted to $3.7 million. 24 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) 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 September 28, 2003, Lakes had approximately $80.4 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. 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. 25 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) 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). As part of the formation of WPT, the Company invested $0.1 million for an approximately 80% ownership position in the joint venture during 2002. The Company is also required to loan up to $3.2 million to WPT as needed. As of September 28, 2003, the Company had made net loans totaling $2.0 million to WPT. 26 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) On July 1, 2003, Lakes completed the sale of its Shark Club property in Las Vegas, Nevada to an entity to be managed and operated by Marriott Ownership Resorts, Inc. As consideration for this sale, Lakes received $15.0 million in cash, plus $1.0 million as repayment of a loan previously made to Chateaux by Lakes. 27 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) 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. Subsequent indemnification obligations to Grand Casinos, if any, will 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) 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. 29 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) 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. 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. 30 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK; CONTROLS AND PROCEDURES 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 September 28, 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 September 28, 2003, Lakes had $80.4 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 $4.4 million. A reference rate increase of 100 basis points would result in an increase in deferred interest income of $0.8 million. A 100 basis point decrease in the reference rate would result in a decrease of $0.8 million in deferred interest income over the same twelve month period. 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-15(e) or Rule 15d - 15(e) promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), as of the end of the period covered by this quarterly 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. 31 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDING WILLARD EUGENE SMITH LITIGATION On October 24, 2003, Lakes announced that it had been named as one of a number of defendants in a counterclaim filed in state court in Harris County, Texas by Willard Eugene Smith involving Kean Argovitz Resorts, LLC (KAR), related persons and entities. In the counterclaim, Smith asserts that, under an alleged oral agreement with Kevin Kean, he is entitled to a percentage of fees to be received by the KAR entities or their principals relating to the Shingle Springs and Jamul casinos that Lakes' subsidiaries are developing in California. Smith also seeks recovery of damages and other relief from the KAR entities, Lakes and certain affiliates based on their conduct with respect to the alleged agreement. 32 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES PART II OTHER INFORMATION (CONTINUED) Lakes believes the counterclaim against it is without merit. Lakes understands that the alleged oral agreement upon which Smith bases his claim was rendered null and void in a prior judgment issued against Smith by the Harris County, Texas state court in October 2000. However, in September 2003, the court vacated the prior judgment against Smith. Lakes acquired KAR's interests in the Shingle Springs and Jamul projects on January 30, 2003. In the buyout agreements between Lakes and certain KAR entities and related principals, the KAR entities represented to Lakes that the KAR entities and their affiliates had no continuing agreements with any third party relating to the Shingle Springs and Jamul projects and agreed to indemnify Lakes and its affiliates from damages of the KAR entities and related principals concerning the projects. Lakes will vigorously defend against the allegations made against it and will pursue its indemnification rights against the KAR entities and their principals under the buyout agreements if necessary. OTHER LITIGATION 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. 33 LAKES ENTERTAINMENT, INC. AND SUBSIDIARIES PART II OTHER INFORMATION (CONTINUED) ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 10.1 Amendment dated July 25, 2003 to Acquisition Master Agreement dated January 22, 2003, by and between The Travel Channel, LLC and World Poker Tour, LLC (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) 31.1 Certification of CEO pursuant to Securities Exchange Act Rules 13a-15(e) and 15d-15(e) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification of CFO pursuant to Securities Exchange Act Rules 13a-15(e) and 15d-15(e) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (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 July 2, 2003 (ii) A Form 8-K, Item 5. Other Events, and Item 7. Financial Statements, Pro Forma Financial Information and Exhibits, was filed on July 24, 2003 (iii) A Form 8-K, Item 5. Other Events, and Item 7. Financial Statements, Pro Forma Financial Information and Exhibits, was filed on August 7, 2003 34 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: November 12, 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 35