10-Q 1 doc1.txt 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 30, 2005 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 Number 0-22935 PEGASUS SOLUTIONS, INC. (Exact Name of Registrant as specified in its charter) DELAWARE 75-2605174 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) CAMPBELL CENTRE I, 8350 NORTH CENTRAL EXPRESSWAY, SUITE 1900, DALLAS, TEXAS 75206 (Address of principal executive office) (Zip Code) Registrant's telephone number, including area code: (214) 234-4000 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 X No Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No X The number of shares of the registrant's common stock, par value $0.01 per share, outstanding as of November 1, 2005 was 20,766,199. PEGASUS SOLUTIONS, INC. FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2005 INDEX Page ---- Part I. Financial Information Item 1. Financial Statements (Unaudited) 3 a) Condensed Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004 3 b) Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the three and nine months ended September 30, 2005 and 2004 4 c) Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and 2004 5 d) Notes to Condensed Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 12 Item 4. Controls and Procedures 20 Part II. Other Information Item 1. Legal Proceedings 20 Item 6. Exhibits 20 Signatures 21 2 Part I. Financial Information Item 1. Financial Statements (Unaudited) PEGASUS SOLUTIONS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT FOR SHARE AMOUNTS) (UNAUDITED)

See accompanying notes to condensed consolidated financial statements. 3 PEGASUS SOLUTIONS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS) (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED)

See accompanying notes to condensed consolidated financial statements. 4 PEGASUS SOLUTIONS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)

See accompanying notes to condensed consolidated financial statements. 5 PEGASUS SOLUTIONS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Overview and basis of presentation Pegasus Solutions, Inc. is a global leader in providing technology and services to hotels and travel distributors. Pegasus was formed in 1989 by 16 of the world's leading hotel and travel-related companies to be the world's premier service provider of a streamlined and automated hotel reservation process. Pegasus' services include central reservation systems, electronic distribution services, commission processing and payment services, and marketing representation services, including the consumer Web site hotelbook.com. The unaudited condensed consolidated financial statements include the accounts of Pegasus Solutions, Inc. and its wholly owned subsidiaries ("Pegasus" or the "Company"). All significant intercompany balances have been eliminated in consolidation. The Company operates under one reportable segment. Pegasus' common stock is traded on the Nasdaq National Market under the symbol PEGS. In the opinion of management, the unaudited condensed consolidated financial statements presented herein reflect all adjustments necessary to fairly state the financial position, operating results, and cash flows for the periods presented. Such adjustments are of a normal recurring nature. The results for interim periods are not necessarily indicative of results expected for the entire fiscal year. The accompanying unaudited condensed consolidated financial statements and the notes thereto should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company's Annual Report on Form 10-K for the year ended December 31, 2004. Reclassifications In 2004, the Company concluded that it was appropriate to classify certain auction rate securities that had been previously classified as cash and cash equivalents as a separately stated current asset. The Company has made adjustments to the Condensed Consolidated Statement of Cash Flows for the nine months ended September 30, 2004 to reflect the gross purchases and sales of these securities as investing activities rather than a component of cash and cash equivalents. This change in classification does not affect previously reported cash flows from operations or from financing activities in the Condensed Consolidated Statements of Cash Flows or in previously reported Condensed Consolidated Statements of Operations for any period. The Company has also made an adjustment to the Condensed Consolidated Statement of Cash Flows for the nine months ended September 30, 2004 to reflect landlord paid tenant improvements as a cash inflow in net cash provided by operating activities and a cash outflow in net cash provided by investing activities, rather than a noncash investing activity. Stock-based employee compensation The Company accounts for stock-based compensation utilizing the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees" and related Interpretations. Accordingly, no compensation expense is recognized for stock option awards because the exercise prices of employee stock options equal or exceed the market prices of the underlying stock on the dates of grant. The Company maintains stock incentive and employee stock purchase plans. Total compensation expense for these plans was $31,000 and $30,000 for the three months ended September 30, 2005 and 2004, respectively, and $93,000 and $161,000 for the nine months ended September 30, 2005 and 2004, respectively. The following table represents the effect on net income (loss) and net income (loss) per share if the Company had applied the fair value based method and recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation," to stock-based employee compensation (in thousands, except per share amounts): 6

The pro forma disclosures provided may not be representative of the effects on reported net income (loss) for future years due to future grants and the vesting requirements of the Company's stock incentive awards. For purposes of pro forma disclosures, the estimated fair value of stock-based compensation awards is amortized over the vesting period. 2. DISCONTINUED OPERATIONS AND ASSETS HELD FOR SALE In June 2005, the Board of Directors of the Company approved and committed to a formal plan to exit the property management systems (PMS) business by selling the Company's PMS operations. These operations included the PegasusCentral PMS and two other private-label property management products, Guestview and NovaPlus, that support both hotel chains and independent customers. The Company also reached an agreement with its primary PegasusCentral customer, InterContinental Hotel Group (IHG), to discontinue the use of PegasusCentral. Accordingly, the PegasusCentral PMS will no longer be used in the Holiday Inn Express properties currently using the system, and there will be no new installations. The decision to exit the PMS business was made considering the termination of the IHG agreement and the overall expected profitability of the remaining PMS operations. The PMS operations have been classified as discontinued operations for all periods presented and the PMS assets are classified as assets held for sale at September 30, 2005. In classifying the PMS assets as held for sale, the Company concluded that the carrying amount of these assets exceeded the estimated fair value less cost to sell such assets. Accordingly, in the second quarter of 2005, the Company recognized a $16.6 million pre-tax impairment charge to write down the assets to an estimated net realizable value of $1.9 million. In addition, the Company recorded an approximately $1.0 million pre-tax charge for exit and transition costs, which were paid during the third quarter of 2005. These charges are included in the Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) as discontinued operations, net of tax. Assets held for sale of $1.9 million are included in other noncurrent assets in the Condensed Consolidated Balance Sheet as of September 30, 2005. The Company will continue to analyze whether the PMS operations meet the criteria to be presented as discontinued operations for one year. 7 During October 2005, the Company completed the disposition of the Guestview and NovaPlus operations to Multi-Systems, Inc. The sale price was approximately $1.3 million, including $605,000 paid upon closing and $722,000 due under a full recourse promissory note, payable in three annual installments of $270,000, including interest at 6%. The Company expects to record a gain on the sale of approximately $370,000 in the fourth quarter of 2005, which will be included in discontinued operations. The Company expects to sell the remaining PegasusCentral PMS business by the end of the second quarter of 2006. Condensed income statement data for the discontinued operations is presented below (in thousands). The income tax benefit is calculated using a discrete statutory tax rate approach for discontinued operations.

3. STRATEGIC ALTERNATIVES On April 11, 2005, the Company announced that its board of directors is exploring various strategic alternatives to enhance shareholder value. Some possible alternatives include joint ventures, divestitures, alliances with strategic partners, taking the Company private, selling the Company to a third party, or merging with another company. The Company's board of directors has retained Bear, Stearns & Co. Inc. as its financial advisor to assist in this effort. There can be no assurance that this process will result in any specific transaction. 4. INTANGIBLE ASSETS Pegasus has acquired identifiable intangible assets that are subject to amortization. The following table presents carrying values of those intangible assets at September 30, 2005 and December 31, 2004 (in thousands):

Amortization expense for those intangible assets was $310,000 and $501,000 for the three months ended September 30, 2005 and 2004, respectively, and was $1.0 million and $1.5 million for the nine months ended September 30, 2005 and 2004, respectively. 8 5. NET INCOME (LOSS) PER SHARE The following table sets forth the computation of basic and diluted income (loss) per common share (in thousands, except per share data):

(1) Weighted average shares issuable upon exercise of stock options that were excluded from the calculation as their effect would have been anti-dilutive to income from continuing operations were 3.5 million and 1.8 million for the quarters ended September 30, 2005 and 2004, respectively, and 3.2 million and 2.4 million for the nine months ended September 30, 2005 and 2004, respectively. (2) Subject to certain conditions, the Company's convertible debt is convertible into common stock at a conversion price of approximately $20.13 per share, equal to approximately 3.7 million shares. No dilution for convertible debt was included in the calculation for the three months and nine months ended September 30, 2005 as the effect would be anti-dilutive to income from continuing operations for these periods. 9 6. STOCKHOLDERS' EQUITY On November 5, 2004, the Board of Directors approved a share buy-back plan for the repurchase of up to 1.5 million shares of Pegasus' common stock. Share buy-backs under this plan have been made under a Securities and Exchange Act of 1934 Rule 10b5-1 share repurchase plan, which allowed Pegasus to repurchase shares, subject to certain limitations, even during blackout periods. During 2005, the Company purchased approximately 518,000 shares for an aggregate cost of $6.2 million. On April 12, 2005, the Rule 10b5-1 stock repurchase plan was terminated. The Company had total repurchases under the plan of approximately 1.2 million shares for a total aggregate value of $13.9 million. Shares repurchased under Board-approved plans have all been cancelled. 7. EMPLOYEE DEFINED BENEFIT PLANS Pursuant to their employment agreements, certain Company officers are eligible for additional retirement benefits to be paid by the Company under the Supplemental Executive Retirement Plan ("SERP"). The SERP became effective on January 1, 2000 and provides supplemental retirement benefits to certain officers of the Company based on their compensation and years of service, as defined under the SERP. As a result of changes in executive management, during the first quarter 2004, Pegasus recognized a curtailment gain of $162,000 for the SERP under Statement of Financial Accounting Standards No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits" ("SFAS 88"). The Company has made cash contributions of approximately $460,000 to a trust associated with the SERP during the nine months ended September 30, 2005. In the United Kingdom, the Company operates a defined benefit plan, which is only open to employees who were part of the Reed Elsevier Pension Scheme in December 1997 (the "Utell Defined Benefit Plan"). The Utell Defined Benefit Plan provides supplemental retirement benefits to its members, based on final average compensation. The Company expects to make cash contributions of approximately $250,000 to the Utell Defined Benefit Plan during 2005. For the nine months ended September 30, 2005, cash contributions of approximately $187,000 were made. The following table provides the components of net periodic benefit costs for the three months and nine months ended September 30, 2005 and 2004 (in thousands):

In response to new tax regulations, the Company is evaluating its executive retirement program, which consists of the SERP and the Pegasus Solutions, Inc. Executive Deferred Compensation Plan (the "DCP"), a defined contribution plan that provides supplemental retirement benefits to certain management employees of the Company. The Company expects to come to a resolution of its alternatives in the fourth quarter of 2005. While the program may be unchanged with no impact to cash or the Company's results of operations, one alternative being evaluated is an amendment to the SERP and DCP which would offer participants an election to cash out their benefits that are vested at December 31, 2005 and cease future participation in the plans. This alternative would result in a cash out payment to participants of up to approximately $4.4 million, the liquidation of trust assets, associated with benefits earned under the SERP and DCP, of approximately $2.6 million, and the incurrence of a settlement charge under SFAS 88 of up to approximately $2.7 million. Assuming future participation by all the participants ceases, annual cost savings would be approximately $1.1 million. 10 8. COMMITMENTS AND CONTINGENCIES The Company is subject to certain legal proceedings, claims and disputes that arise in the ordinary course of our business. Although management cannot predict the outcomes of these legal proceedings, it does not believe these actions will have a material adverse effect on the Company's financial position, results of operations or liquidity. During the third quarter of 2005, the Company ceased the use of two office spaces, one in New York and one in Australia, prior to the lease termination dates and recorded lease termination costs of approximately $378,000 and $133,000, respectively. These costs primarily represent the future lease payments related to the vacated facilities net of estimated sublease income over the remaining lease period of 37 months for the New York facility and 30 months for the Australia facility. Concurrent, the Company leased office space in New York at reduced rates, as compared to the previous lease. 9. NEW ACCOUNTING GUIDANCE In December 2004, the Financial Accounting Standards Board ("FASB") issued SFAS No. 123R, "Share-Based Payment" ("SFAS 123R"), which replaces SFAS No. 123, "Accounting for Stock-Based Compensation" and supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." In March 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 107, "Share-Based Payment," which provides interpretive guidance related to SFAS 123R. SFAS 123R requires compensation costs related to share-based payment transactions to be recognized in financial statements. With limited exceptions, the amount of compensation cost is measured based on the fair value of the equity or liability instrument issued on the grant date. SFAS 123R requires liability awards to be remeasured each reporting period and compensation costs to be recognized over the period that an employee provides service in exchange for the award. In April 2005, the SEC delayed the effective date of SFAS 123R to the beginning of the annual reporting period that begins after June 15, 2005. The Company continues to evaluate SFAS 123R to determine the impact on its consolidated financial statements and currently intends to adopt the modified prospective transition method. SFAS 123R is expected to have a negative effect on consolidated net income. In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154, "Accounting Changes and Error Corrections-A Replacement of APB Opinion No. 20 and FASB Statement No. 3" ("SFAS 154"). SFAS 154 requires retrospective application to prior periods' financial statements of changes in accounting principle. It also requires that the new accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings for that period rather than being reported in an income statement. The statement will be effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company does not expect the adoption of SFAS 154 to have a material effect on the Company's consolidated financial position or results of operations. On October 22, 2004, the President of the United States signed the American Jobs Creation Act of 2004 (the "Act"). The Act creates a temporary incentive for United States corporations to receive repatriations of accumulated earnings of foreign subsidiaries by providing an 85 percent dividends received deduction for certain qualifying dividends from certain qualifying foreign corporations. The Company does not presently intend to repatriate accumulated earnings of foreign subsidiaries. 11 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with the Management's Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2004. This discussion and analysis contains forward-looking statements within the meaning of the federal securities laws, including statements using terminology such as "may," "will," "expects," "plans," "intends," "anticipates," "believes," "estimates," "potential," or "continue," or a similar negative phrase or other comparable terminology regarding beliefs, hopes, plans, expectations or intentions for the future. Forward-looking statements involve various risks and uncertainties. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain and the actual results and timing of certain events could differ materially from our current expectations. Factors that could cause or contribute to such a difference include, but are not limited to, changes in general economic conditions, variation in demand for our products and services and in the timing of our sales, changes in product and price competition for existing and new competitors, changes in our level of operating expenditures, delays in developing, marketing and deploying new products and services, terrorist activities, action by U.S. or other military forces, global health epidemics, changes in hotel room rates, capacity adjustments by airlines, negative trends in the overall demand for travel, other adverse changes in general market conditions for business and leisure travel, any strategic alternative undertaken by the Company, the inability of the Company to sell the property management systems (PMS) operations, risks associated with a PMS sale transaction and the inability of the Company to terminate the PMS service as expected, as well as other risks and uncertainties, including those appearing in under the caption "Risk Factors" in the Company's Annual Report on Form 10-K for the year ended December 31, 2004. OVERVIEW Pegasus is a global leader in providing technology and services to hotels and travel distributors. Founded in 1989, Pegasus' customers include a majority of the world's travel agencies and more than 60,000 hotel properties around the globe. Pegasus' services include central reservation systems, electronic distribution services, commission processing and payment services, and marketing representation services, including the consumer Web site, www.hotelbook.com(TM). The Company's representation services, including Utell by Pegasus(TM) and Unirez by Pegasus(TM), are used by nearly 7,000 member hotels in approximately 140 countries, making Pegasus the hotel industry's largest third-party marketing and reservations provider. Pegasus has 18 offices in 13 countries, with corporate headquarters in Dallas and regional hubs in London, Scottsdale and Singapore. STRATEGIC ALTERNATIVES On April 11, 2005, we announced that our board of directors is exploring various strategic alternatives to enhance shareholder value. Some possible alternatives include joint ventures, divestitures, alliances with strategic partners, taking the company private, selling the company to a third party, or merging with another company. Our board of directors has retained Bear, Stearns & Co. Inc. as its financial advisor to assist in this effort. There can be no assurance that this process will result in any specific transaction. DISCONTINUED OPERATIONS In June 2005, our Board of Directors approved and committed to a formal plan to exit the property management systems (PMS) business by selling the PMS operations. These operations include the PegasusCentral PMS and two other private-label property management products, Guestview and NovaPlus, that support both hotel chains and independent customers. We also reached an agreement with our primary PegasusCentral customer, InterContinental Hotel Group (IHG), to discontinue the use of PegasusCentral. Accordingly, the PegasusCentral PMS will no longer be used in the Holiday Inn Express properties currently using the system, and there will be no new installations. The decision to exit the PMS business was made considering the termination of the IHG agreement and the overall expected profitability of the remaining PMS operations. 12 The PMS operations have been classified as discontinued operations for all periods presented and the PMS assets are classified as assets held for sale at September 30, 2005. In classifying the PMS assets as held for sale, we concluded that the carrying amount of these assets exceeded the estimated fair value less cost to sell such assets. Accordingly, in the second quarter of 2005, we recognized a $16.6 million pre-tax impairment charge to write down the assets to an estimated net realizable value of $1.9 million. In addition, the Company recorded an approximately $1.0 million pre-tax charge for exit and transition costs, which were paid during the third quarter of 2005. We will continue to analyze whether the PMS operations meet the criteria to be presented as discontinued operations for one year. During October 2005, we completed the disposition of the Guestview and NovaPlus operations to Multi-Systems, Inc. The sale price was approximately $1.3 million, including $605,000 paid upon closing and $722,000 due under a full recourse promissory note, payable in three annual installments of $270,000, including interest at 6 percent. We expect to record a gain on the sale of approximately $370,000 in the fourth quarter of 2005, which will be included in discontinued operations. We expect to sell the remaining PegasusCentral PMS business by the end of the second quarter of 2006. For further information, please see Note 2 to the Condensed Consolidated Financial Statements. OPERATING TRENDS The following are trends that we have experienced or anticipate. Certain of these trends have or may have a negative impact on our revenues and profitability. - We have experienced a lengthening in the implementation cycle for our services, and once implemented, contracts in some instances are taking longer than anticipated to ramp up to expected transaction volumes. - Revenues from new product offerings are lower than previously anticipated. For instance, PegsTour , a new service which automates hotel reservations by tour operators and wholesale travel distributors, has experienced delays due to the implementation effort required by travel distributors and hotels (including development of an interface and business process changes). - In many instances, our service offerings continue to experience lower pricing on new contracts and contract renewals, arising from increased competition from lower-cost competitors and hotel and travel agency consolidations. However, this trend has begun to stabilize and is not expected to erode future revenues. - We continue to see an increase in the percentage of Internet reservations made at hotel chain Internet sites versus third-party Internet sites that utilize our services. - We continue to experience losses in our portfolio of customers, as some larger customers cease to outsource some of the services we offer or outsource to our competitors. For our commission processing service line, this trend has resulted in the loss of hotel participants, which could affect whether our travel agent customers continue to use our service. Further, we expect to cease providing commission processing services to one of our largest hotel participants early in the first quarter of 2006. For the trailing twelve months ended September 30, 2005, this hotel participant represented approximately 18 percent of our financial services revenues, and we paid them approximately $1.2 million in incentive payments, which are recorded in cost of services. - We are experiencing a year-over-year decline in our revenues. Positive operating trends include: - Average daily room rates (ADR) are improving. - We are experiencing stability of foreign currency exchange rates. - Pricing for Internet distribution is increasing. - We have established business partners in key regions around the world expanding our market reach in Latin America, Asia and Eastern Europe. - We have been able to reduce the Internet distribution revenue share that we pay out. 13 NEW PRODUCT DEVELOPMENT AND GROWTH INITIATIVES Our future success depends on our ability to successfully develop leading technologies, enhance our existing services and develop and introduce new services to meet the changing needs of our current and prospective customers. We rely on third party arrangements for much of the development and enhancement of our services, including outsourcing outside of the U.S. During the first quarter, we launched weekly commission processing. With this enhancement to our commission processing service, both hotels and travel agencies benefit from more efficient cash flow. During the second quarter, we launched hotelbook.com, which creates another way for independent hoteliers to compete online with the major hotel brand Web sites. We also expanded our presence in China by opening an office in Beijing, which is a key part of our strategy to expand our business in the Asia-Pacific region. Additionally, we have delivered a new release of our internet booking engine, Netbooker, and a new rate tracking service, as well as established a strategic relationship with Open Hospitality for Web services. We are in the development phase of an automated system that will enable us to expand the use of our financial services into other travel markets, such as car rental and cruises, enhance the functionality of our weekly commission processing, and increase our financial services operating efficiency. We have evaluated funding and development alternatives related to this technology, including collaboration with outside parties. Such collaboration may result in changes in the development, integration and deployment of this software and may result in alternate financing arrangements such as future revenue sharing. We are presently reevaluating this project and a decision on its future is not likely until the strategic alternative initiative is completed. The carrying value of this technology is $8.3 million as of September 30, 2005. Changes in strategy, market condition, the outcome of our strategic alternative initiative, or other assumptions may significantly impact our determinations regarding whether an impairment exists and could significantly reduce the carrying value associated with this project. FLUCTUATION OF FOREIGN CURRENCIES Pegasus derives a significant portion of its revenue from customers located outside the United States. Particularly in Europe, fluctuations of foreign currencies such as the euro and the British pound relative to the U.S. dollar result in our earning more or less revenue and expending higher or lower expenses than we otherwise might have earned or spent if currency exchange rates had remained stable. RESULTS OF OPERATIONS THREE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004 Revenues. The table and discussion below address revenues by service line for the three months ended September 30, 2005 and 2004 (dollars in thousands).

Representation services revenues decreased primarily due to continued impact of reduced pricing and the transition of a significant Unirez by Pegasus customer to our central reservation service. A slight increase in ADR for our Utell by Pegasus offering was offset by a 5 percent decrease in reservation volumes and the average commission earned percentage. On a sequential quarter basis, the average commission earned has stabilized. 14 Reservation services revenues decreased primarily due to the loss of a customer and continued pricing pressure on contract renewals. Partially offsetting these decreases was the transition of one customer from Unirez by Pegasus to our reservations services late in 2004. Net transactions decreased compared to the same quarter last year; however, excluding these two customers, net transactions processed increased 6 percent. Financial services revenues were affected by reduced transactions and pricing, resulting from travel agency consolidations, partially offset by the continued benefit from improved ADR. Distribution services revenues increased compared to the prior year quarter. Total transactions increased 5 percent, with Global Distribution Services (GDS) transactions increasing 10 percent and Internet transactions decreasing 8 percent. The decrease in Internet transactions reflects an increase in the percentage of Internet bookings made at hotel companies' proprietary Web sites that do not utilize Pegasus' Internet distribution service, as well as the impact of a customer loss. Excluding this customer loss, Internet transactions increased 9 percent. Customer reimbursements increased due to an overall increase in our customers' GDS costs because of an increase in GDS transactions and GDS pricing. Operating Expenses. The table and discussion below address operating expenses for the three months ended September 30, 2005 and 2004 (dollars in thousands).

Operating expenses for the quarter ended September 30, 2005, were two percent higher that the prior year. The following factors contributed most significantly to the year over year impact: - $1.0 million of severance and lease termination costs incurred during the third quarter of 2005; - An increase in depreciation and amortization related to new capital projects going into production; offset by - Lower headcount and employee-related expenses; and - Tight management of all variable operating costs. Cost of services expenses, excluding customer reimbursements, decreased in the third quarter 2005 primarily due to lower customer incentives, communications expenses, and processing costs, commensurate with the decrease in revenues, partially offset by severance of $256,000 and lease termination costs of $133,000. Cost of services, excluding customer reimbursements, as a percentage of service revenues was 50 percent and 48 percent for the three months ended September 30, 2005 and 2004, respectively. Customer reimbursements increased primarily due to an overall increase in our customers' GDS costs because of an increase in GDS transactions and GDS pricing. Research and development expenses were higher year over year, primarily due to a decrease in capitalized payroll costs, as development efforts were focused on projects that were not capitalizable. Research and development expenses as a percentage of service revenues were 2 percent for the third quarter in both 2005 and 2004. 15 General and administrative expenses were flat with the prior year, with increases related to lease termination costs of $378,000 being offset by lower third-party service costs incurred, primarily related to tax and audit professional services. General and administrative expenses as a percentage of service revenues were 14 percent and 13 percent for the three months ended September 30, 2005 and 2004, respectively. Marketing and promotion expenses increased slightly primarily due to additional personnel and consultant costs arising from a greater focus on sales, marketing and promotion activities, including costs related to the launch of our own travel Web site, hotelbook.com. Marketing and promotion expenses as a percentage of service revenues were 12 percent and 11 percent for the three months ended September 30, 2005 and 2004, respectively. Depreciation and amortization expenses increased due to depreciation and amortization related to capital expenditures being put into production. Interest expense, net. Net interest expense decreased from $498,000 to $323,000 for the third quarter 2005 compared to the third quarter 2004 due to higher capitalization of interest related to our software development efforts and higher interest rates. Income tax expense. Pegasus recorded income tax expense on continuing operations of $1.4 million and $2.4 million for the third quarter 2005 and 2004, respectively, reflecting year-to-date effective rates of 36 percent for both years. The effective rate for 2005 differed from the statutory rate of 35 percent, primarily due to the geographic apportionment of profits and losses and the impact of state income taxes, nondeductible expenses, and foreign taxes. Tax expense (benefit) is calculated using the estimated annual effective tax rate approach on continuing operations and a discrete statutory tax rate approach on discontinued operations. Discontinued operations. For information regarding discontinued operations, please see Note 2 to the Condensed Consolidated Financial Statements. NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004 Revenues. The table and discussion below address revenues by service line for the nine months ended September 30, 2005 and 2004 (dollars in thousands).

Representation services revenues decreased primarily due to the continued impact of reduced pricing and the transition of a significant Unirez by Pegasus customer to our central reservation service. A 4 percent increase in ADR for our Utell by Pegasus offering was offset by a decrease in reservation volumes and the average commission earned percentage. On a sequential quarter basis, the average commission earned has stabilized. Reservation services revenues decreased primarily due to continued pricing pressure on contract renewals and the loss of a customer. Partially offsetting these decreases was the transition of one customer from Unirez by Pegasus to our reservations services late in 2004. Net transactions decreased compared to the same period last year; however, excluding these two customers, net transactions processed increased 3 percent. Financial services revenues decreased primarily due to an impact of approximately $1.5 million associated with the initial implementation of weekly commission processing in March 2005. While this enhancement to our commission processing service will benefit both hotels and travel agencies, its initial implementation impacted the timing of services we normally would have performed 16 in March. Under the new process and technology, once commission data is input into the system, it is automatically included in the next weekly cycle. Because of the timing of data submission and when we provided our services, revenues for only approximately three weeks of data were recognized in March related to hotels that elected to utilize our weekly commission processing. Further, revenues decreased related to hotels that elected to stay on a monthly commission processing schedule because we were unable to provide services to or process any of the data submitted by these hotels until April. Offsetting the first quarter negative impact to revenues of approximately $2.1 million was the $600,000 positive impact in the second quarter of 2005, representing incremental revenues earned in the month of conversion, as hotel companies switched from monthly to weekly commission processing. The financial impact of implementing weekly commission processing was substantially complete by the end of the second quarter of 2005, as the majority of expected customer conversions to weekly commission processing were completed. Aside from this impact, financial services revenues were affected by reduced transactions and pricing, resulting from travel agency consolidations, partially offset by the continued benefit from improved ADR. Distribution services revenues decreased primarily due to a 6% decrease in the number of Internet transactions. The decrease in Internet transactions reflects an increase in the percentage of Internet bookings made at hotel companies' proprietary Web sites that do not utilize Pegasus' Internet distribution service, as well as the impact of a customer loss. In addition, reduced pricing from the second quarter 2004 sale of Travelweb LLC to Priceline.com negatively affected year-over-year comparisons through May 2005. Improved pricing on premium channel Internet transactions and an 8 percent increase in GDS transactions partially offset these decreases. Customer reimbursements increased due to an overall increase in our customers' GDS costs because of an increase in GDS transactions and GDS pricing. Operating Expenses. The table and discussion below address operating expenses for the nine months ended September 30, 2005 and 2004 (dollars in thousands).

Operating expenses for the nine months ended September 30, 2005 decreased 1 percent from the prior year. The following factors contributed most significantly to the year over year impact: - Prior year expenses included severance and related costs of $2.4 million related to a first quarter 2004 strategic change in our information technology organization compared to $1.0 million of severance and lease termination costs incurred during the third quarter of 2005; - Headcount and employee-related expenses were lower year-over-year; - Tight management of all variable operating costs; and - Marketing and promotion expenses increased as we remain committed to sales and marketing efforts. Cost of services expenses, excluding customer reimbursements, for the prior year included severance and related costs of $1.9 million related to a first quarter 2004 strategic change in our information technology organization. Cost of services also decreased as a result of the implementation of weekly commission processing in our financial services offering. Consistent with the change in timing of revenue recognition, customer incentives were reduced by approximately $150,000 during the nine months ended September 30, 2005. The remainder of the decrease is due to lower customer incentives, communications expenses, and processing costs, commensurate with the decrease in revenues. Cost of services, excluding customer reimbursements, as a percentage of service revenues were 52 percent and 51 percent for the nine months ended September 30, 2005 and 2004, respectively. 17 Customer reimbursements increased primarily due to an overall increase in our customers' GDS costs because of an increase in GDS transactions and GDS pricing. Research and development expenses were down year over year, primarily due to lower headcount and employee-related expenses. Research and development expenses as a percentage of service revenues was 2 percent for the nine months ended September 30, 2005 and 2004. General and administrative expenses for the prior year included severance and related costs of $465,000 related to a first quarter 2004 strategic change in our information technology organization offset by a first quarter curtailment gain of $162,000 for the Supplemental Executive Retirement Plan due to changes in executive management. Expenses also decreased due to lower third-party costs incurred, primarily related to tax and audit professional services. General and administrative expenses as a percentage of service revenues were 15 percent and 14 percent for the nine months ended September 30, 2005 and 2004, respectively. Marketing and promotion expenses increased primarily due to additional personnel and consultant costs arising from a greater focus on sales, marketing and promotion activities, including costs related to the launch of our own travel Web site, hotelbook.com. Marketing and promotion expenses as a percentage of service revenues were 13 percent and 11 percent for the nine months ended September 30, 2005 and 2004, respectively. Depreciation and amortization increased primarily due to depreciation and amortization related to capital expenditures being put into production. This increase was partially offset by completing the amortization of a software asset in the second quarter of 2004, which accounted for $460,000 in amortization in 2004. Gain on Sale. On May 3, 2004, Pegasus sold its interest in Travelweb, LLC to an affiliate of Priceline.com, Inc. and received $4.2 million in cash, recognizing a gain of approximately $2.0 million. Interest expense, net. Net interest expense decreased from $1.5 million to $1.1 million for the nine months ended September 30, 2005 compared to the nine months ended September 30, 2004 due to higher capitalization of interest related to our software development efforts and higher interest rates. Income tax expense. Pegasus recorded income tax expense on continuing operations of $2.6 million and $5.1 million for the nine months ended September 30, 2005 and 2004, respectively, reflecting year-to-date effective rates of 36 percent for both years. The effective rate for 2005 differed from the statutory rate of 35 percent, primarily due to the geographic apportionment of profits and losses and the impact of state income taxes, nondeductible expenses, and foreign taxes. Tax expense (benefit) is calculated using the estimated annual effective tax rate approach on continuing operations and a discrete statutory tax rate approach on discontinued operations. Discontinued operations. For information regarding discontinued operations, please see Note 2 to the Condensed Consolidated Financial Statements. LIQUIDITY AND CAPITAL RESOURCES Historically, Pegasus has primarily relied on cash flows from operations to provide working capital for current and future operations and for capital investments. From time to time, we have also utilized bank lines of credit, proceeds from equity and debt offerings and private debt to supplement our ability to fund operating cash requirements, capital investments and acquisitions. We assess our liquidity in terms of our ability to generate cash to fund our operating and investing activities. Key indicators we use to make this assessment are current assets, current liabilities and net cash flow from operating activities. Our principal source of capital during the first nine months of 2005 included cash and cash equivalents of $27.2 million and auction rate securities of $3.0 million. Our cash flows from operations of $21.2 million included $5.8 million related to our commission processing service. Excluding this factor, cash flows from operations of $15.4 million were sufficient to provide for working capital requirements. Other sources of cash during the first nine months of 2005 were $9.8 million net proceeds from the sale or maturity of marketable securities and $1.5 million of proceeds from stock option exercises. 18 Cash outlays in the first nine months of 2005 included the repurchase of approximately 518,000 shares of common stock for $6.2 million. The common stock repurchases were made under a Rule 10b5-1 stock repurchase plan that was approved on November 5, 2004 and terminated effective April 12, 2005. Another component of our cash outlays included capital expenditures of $17.3 million consistent with our capital strategy of investing in software development projects meeting our return on investment criteria. Our capital expenditures primarily consist of personnel costs, interest expense and outside consultant costs for software development, computer hardware, furniture, fixtures and other office equipment. We expect to continue incurring capital expenditures related to software development and the addition of capacity to existing systems. We estimate full year 2005 capital expenditures will total approximately $19 to $20 million. We may also collaborate with outside parties for software development or other business needs. The potential capital and financing arrangements required for such arrangements is uncertain. On April 11, 2005, we announced that our board of directors is exploring various strategic alternatives to enhance shareholder value. Some possible alternatives include joint ventures, divestitures, alliances with strategic partners, taking the Company private, selling the Company to a third party, or merging with another company. There can be no assurance that this process will result in any specific transaction. Our future liquidity and capital requirements will depend on numerous factors, including: - Our profitability; - Seasonality of our operations; - Operational cash requirements; - Competitive pressures; - Development of new services and applications; - Timing of capital expenditures; - Response to unanticipated cash requirements; and - Potential impact of strategic alternatives. Further, in response to new tax regulations, we are evaluating our executive retirement program, which consists of the Supplemental Executive Retirement Plan ("SERP"), a defined benefit plan which provides supplemental retirement benefits to certain officers of the Company based on their compensation and years of service, as defined under the SERP, and the Pegasus Solutions, Inc. Executive Deferred Compensation Plan (the "DCP"), a defined contribution plan that provides supplemental retirement benefits to certain management employees of the company. We expect to come to a resolution of our alternatives in the fourth quarter of 2005. While the program may be unchanged with no impact to cash or our results of operations, one alternative being evaluated is an amendment to the SERP and DCP which would offer participants an election to cash out their benefits that are vested at December 31, 2005 and cease future participation in the plans. This alternative would result in a cash out payment to participants of up to approximately $4.4 million, the liquidation of trust assets, associated with benefits earned under the SERP and DCP, of approximately $2.6 million, and the incurrence of a settlement charge under SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits," of up to approximately $2.7 million. Assuming future participation by all the participants ceases, annual cost savings would be approximately $1.1 million. We believe that we will be able to generate cash flows from operations sufficient to meet our operating and capital requirements through at least the next twelve months. In addition to exploring strategic alternatives as discussed above, we may in the future also consider financing alternatives to fund our requirements, including possible public or private debt or equity offerings. However, there can be no assurance that any financing alternatives sought by us will be available or will be on terms that are attractive to us. Further, any debt financing may involve restrictive covenants, and any equity financing may be dilutive to stockholders. 19 Pegasus had two irrevocable standby letter of credit agreements with JPMorgan Chase Bank totaling $1.7 million at December 31, 2004, collateralizing the leases for the Dallas and Scottsdale offices. During the first quarter of 2005, we released one of these letters of credit, replacing the $450,000 letter of credit for the Dallas facility with a deposit of $181,000. ITEM 4. CONTROLS AND PROCEDURES Disclosure Controls and Procedures. The Company maintains disclosure controls and procedures designed to ensure that it is able to record the information it is required to disclose in the reports it files with the SEC, and to process, summarize and report this information within the time periods specified in the rules and forms of the SEC. The Company's Chief Executive and Chief Financial Officers are responsible for establishing and maintaining these procedures, and, as required by the rules of the SEC, evaluating their effectiveness. Based on their evaluation of the Company's disclosure controls and procedures which took place as of the end of the period covered by this report, the Chief Executive and Chief Financial Officers concluded that the Company's disclosure controls and procedures are effective to ensure that the Company is able to record, process, summarize and report the information it is required to disclose in the reports it files with the SEC within the required time periods and to ensure that information required to be disclosed in the Company's Exchange Act reports is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Changes in Internal Control over Financial Reporting. During the quarter ended September 30, 2005, there have been no changes in the Company's internal control over financial reporting identified in connection with the evaluation described above that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS Pegasus is subject to certain legal proceedings, claims and disputes that arise in the ordinary course of business. Although management cannot predict the outcomes of these legal proceedings, we do not believe these actions will have a material adverse effect on our financial position, results of operations or liquidity. ITEM 6. EXHIBITS a) Exhibits *Exhibit 31.1 - Certification of Chief Executive Officer, Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. *Exhibit 31.2 - Certification of Chief Financial Officer, Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. **Exhibit 32.1 - Certification of Chief Executive Officer and Chief Financial Officer, Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * Filed herewith. ** Furnished herewith. 20 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PEGASUS SOLUTIONS, INC. November 9, 2005 /s/ JOHN F. DAVIS, III ----------------------- John F. Davis, III, President, Chief Executive Officer and Chairman (Principal Executive Officer) November 9, 2005 /s/ SUSAN K. CONNER ---------------------- Susan K. Conner, Executive Vice President and Chief Financial Officer (Principal Accounting Officer) 21 EXHIBIT INDEX Exhibit Number Description ---------------- -------------------------------------------------------------- *31.1 Certification of Chief Executive Officer, Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. *31.2 Certification of Chief Financial Officer, Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. **32.1 Certification of Chief Executive Officer and Chief Financial Officer, Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant Section 906 of the Sarbanes-Oxley Act of 2002. * Filed herewith. ** Furnished herewith. Exhibit 31.1 CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, John F. Davis, III, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Pegasus Solutions, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; and c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 9, 2005 /s/ JOHN F. DAVIS, III ---------------------- John F. Davis, III President, Chief Executive Officer and Chairman Exhibit 31.2 CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, John F. Davis, III, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Pegasus Solutions, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; and c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 9, 2005 /s/ SUSAN K. CONNER ---------------------- Susan K. Conner Executive Vice President and Chief Financial Officer Exhibit 32.1 CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Pegasus Solutions, Inc. (the "Company") on Form 10-Q for the period ended September 30, 2005 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), we, the undersigned, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002, that: 1. The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)); and 2. The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. November 9, 2005 /s/ JOHN F. DAVIS, III ---------------------- John F. Davis, III, President, Chief Executive Officer and Chairman November 9, 2005 /s/ SUSAN K. CONNER ---------------------- Susan K. Conner, Executive Vice President and Chief Financial Officer

PEGASUS SOLUTIONS INC 10-Q