As an analyst for Lakes Entertainment, Inc. (LACO), you need to be aware of the risks associated with one of the projects currently underway.  Lakes Entertainment has been touting the Jamul Casino as a relatively risk-free project that will generate large returns in the near future.  There are three key terms in the previous sentence that all investors are interested in: specifically risk, return and timing. 

Each of these areas has issues which have not been fully documented by Lakes Entertainment.  Our purpose of contacting you is to present the facts that have either been omitted or minimized by Lakes Entertainment as part of their communication with the investment community.  Since you have a significant amount of capital involved with this organization you may want to have information to ensure that your investment is properly evaluated.

Risk:  The project in Jamul has significantly more risk than has been documented.

• Land Ownership:  A lawsuit addressing the ownership of the land the casino is planned to be built upon could leave Lakes Entertainment with nowhere to build.
• Competition:  There are 3 casinos within 20 minutes of Jamul, all with Class III machines and resort amenities.
• Investment Decisions:  Lakes Entertainment has invested a great deal of capital that has generated no stakeholder value.
• Community Involvement:  The community of Jamul is united against the proposed casino and has enlisted the help of local and state government.

Large Returns:  The returns on the Jamul project are not enticing.

• Reduced Revenue:  Lakes Entertainment has dropped the annual revenue projections from $266M/year to $67M/year over the past year.
• Class II Machines:  The current plan only calls for Class II machines, these are much less profitable and the recent expansions of nearby casinos will hurt customer traffic.
• Cost of Operations:  Lakes Entertainment is late to the table with this project, all other casinos in the area have large advertising budgets, player retention programs in place and Jamul will have to draw patrons away from those facilities despite having inferior gaming equipment – thus these costs will be higher.

Near Future:  There will be no returns for the foreseeable future

• The California Transportation Department (Caltrans) review will take 1 to 3 years once the Encroachment Permit Application has been received.  It has not yet been submitted and due to the complexity the expectation is that it will be closer to 3 years than 1 year.

This letter has been sent only to inform you of some of the issues you may not have been aware of regarding the Jamul project.  All we ask is that you evaluate the information and determine if this project is really in the best interests of your organization.  For more detail on these items please see the following pages.  Thank you for your time.

Risk

Lakes Entertainment would like you to believe that the Jamul Casino is going to be a hugely successful casino in San Diego County.  This is far from the truth.  There are a number of factors that have been conveniently neglected:  land ownership, Class II facility, competition, investment decisions and community involvement.

Land Ownership
Lakes Entertainment projects the Jamul project as a six acre project with 101 acres still under review by the Department of the Interior for annexation.  The Jamul Indian Village (JIV) is actually composed of three separate parcels, each deeded separately, and has never given reservation status, it is merely land held in trust by the Federal Government for Jamul Indians of ½ degree or greater blood.  The truth of the matter is that the Jamul Indian Tribe (the Tribe) has jurisdiction over a little more than an acre of land.  The remaining 4.66 acres are currently the focus of a lawsuit brought by Jamul Indians who are not part of the Tribe but rightful inheritors of the land.  Due to the manner in which the land deeded, the fact that the grant pre-dates the tribe’s existence and the lack of reservation status the case has merit and is currently in front of the U.S. Federal Claims Court in Washington D.C.  Due to this legal entanglement it is very unlikely any company will finance construction until such time that the ownership of the land is properly adjudicated. 

Class II Facility
For investors unfamiliar with Indian Casinos there are Class II and Class III facilities.  Class II facilities are Indian-style card games (where the patrons play against one another and pay the house a fixed sum for the purpose of doing so) and bingo-like games.  Class III facilities are those similar to Las Vegas style casinos with patrons betting against the house.  It is well known in the industry that Class II devices have lower player demand and hence lower profitability.  The National Indian Gaming Council (NIGC) is set to release a new, more restrictive interpretation of what constitutes a Class II machine in the very near future.  As such these machines will soon be even less favored by the gambling patron. 

Why then would Lakes Entertainment attempt to build a Class II facility that would put it at a competitive disadvantage?  Despite whatever other reasons Lakes Entertainment may claim the reason for building a Class II facility is because the project cannot meet the environmental stipulations required in a Class III compact.  The tribe has submitted two woefully inadequate Environmental Impact Reports in previous attempts to gain Class III status and in both cases they were abandoned.  The State of California has maintained that they will need to meet these objectives before a Class III machine is to be placed into their casino. 

Competition
Another item Lakes Entertainment uses as a differentiator when discussing the Jamul project is its proximity to downtown San Diego.  Although the casino may literally be closer to downtown there is less than a 1 mile difference from downtown San Diego to Jamul versus downtown San Diego to Sycuan.  Lakes Entertainment proposes putting in a Class II facility which is roughly equidistant from downtown San Diego as the Sycuan casino, which just received ratification of an alteration in its compact for an additional 3,000 class III machines.  Due to the expansion of the Sycuan casino they will be adequately positioned to meet the market needs without having overflow customers that will go to Jamul.

In addition to Class III gaming at Sycuan there are other facilities which will never be available at Jamul: a golf course, hotel, restaurants and more.  The other nearby casinos, Viejas and Barona, have similar facilities.  Viejas has already expanded its capacity with a compact modification a few years back allowing it more Class III machines and Barona will likely be petitioning the governor for additional Class III machines in the very near future.  All of which leads one to ask – how many gamblers can East San Diego County reasonably service?  Given that there are three large scale casinos that have full features why would a customer select a Class II facility with no features?

Investment Decisions
There has been quite a bit of ballyhoo from Lakes Entertainment regarding the Jamul facility.  First it was a 101 acre facility, then a thirty story facility, now a Class II facility.  Each of these reincarnations cost quite a bit of money to design – all decreasing the return on the project. 

Currently Lakes Entertainment is publicizing the construction of a driveway.  Let’s examine this from a couple of different angles:

1. They’re building a driveway yet they’ve not finalized plans on the casino.  How can they be sure that the driveway is correct?
2. Caltrans has already stated that the driveway that has been built will not be approved for casino patron traffic, thus the driveway is a financial sinkhole.
3. The driveway that they’ve built is roughly 40 feet wide narrowing to a 20 foot wide access to Highway 94.  The reason?  If they widen the access and touch the Caltrans right away, Caltrans will step in and require an Encroachment Permit immediately.
4. These decisions would all seem related to gaining favor within the investment community yet have a net negative payback.

As you can see significant funds have been invested in the Jamul project with nothing to show for it.  The casino is no closer to realization today than it was when it was first proposed, yet Lakes Entertainment continues to emphasize that this project is building value. 

Community Activism
Lakes Entertainment has put in a small blurb regarding community activism in the 10-K in previous years.  The local community along with surrounding communities stands united to stop this project and has been successful thus far.  The local County Supervisor is opposed to the casino, SANDAG is opposed to the casino and Governor Scharzenegger has written letters in opposition to the casino.  All of which contribute to the inability of Lakes Entertainment to move forward with this project.  Rest assured that the community activism will continue to be a risk for the Jamul project.

Large Returns

The generation of large returns based on opening a casino in Jamul is unimaginable.  Some of the major risks to obtaining any returns:

Reduced Gaming Revenue
As noted previously Class II devices earn significantly less than Class III devices.  Reviewing Lakes Entertainment’s most recent 10-Q the proposed casino has been significantly downscaled.  The net impact of this downscaling is that annual revenue is now projected to be in the $67M range.  If we look back into the 10-Q one year ago the projected revenue was in the $266M range.  So in the space of a year the projected revenue has dropped nearly $200M, nearly 75%!

Add to that the competition in the surrounding area, the fact that the competition have established brands, the competition have already enrolled the frequent gambler in their loyalty programs, the competition have already spent millions of dollars in public outreach programs and you can see why making a dent in the market is going to be difficult, at best.

Lack of Class III machine licenses
Also of concern is that when the original compacts were signed there was a statewide cap on the number of Class III machines.  Each tribe also negotiated its own compact with a set number of Class III machines.  However the sum of the machines negotiated on behalf of each tribe, when totaled up, was greater than the statewide cap.  This resulted in a first-come, first-serve allocation of licenses to operate Class III machines.  Since the statewide cap has been met there is no capability for the Tribe to obtain Class III licenses without renegotiating their compact with the State of California. 

Cost of Operations
The proposed casino will have to be erected, staffed and managed.  Costs for utilities will have to be paid.  Note that due to the small size of the project Lakes Entertainment is proposing a fleet of sewage trucks to remove effluent from the facility, every day, in perpetuity.  No small effort and no small cost – also note that any spillage will have negative impact upon the clientele.  In fact the proposed casino will have to at least maintain – if not exceed – the level of service offered by other casinos in the nearby area.  All of this leads to a cost of operations in excess of the industry average. 

In addition the Tribe is already over $42M in debt to Lakes Entertainment.  The latest 10-Q also states that the results for the Jamul project are unaudited, so it is possible that these numbers are much worse than stated.  The number provided results in nearly $7M in annual interest that the Tribe must pay – not to mention Lakes Entertainment’s management fees.  If the Tribe cannot maintain operations then Lakes Entertainment will have to close the facility and take a loss on the entire venture immediately.  More likely, Lakes Entertainment will allow the casino to pay its operating debt while not paying down the original note nor paying any of the management fees.  Thus Lakes Entertainment becomes the last debt holder paid.

Near Future

Lakes Entertainment is attempting to sway the market that the return on the Jamul project is coming soon – they are making progress building a driveway and the casino should be open by 2010.  If you review the history of Lakes Entertainment’s SEC filings you will find that the casino has always been somewhere in the 29-36 month window of completion – even years ago.  Now they want you to trust them when they say this time it’s just around the corner.  There are a number of factors that will force the proposed casino out much further than that time frame.

Land Ownership Lawsuit
As was mentioned earlier the existence of a lawsuit will stall all activities related to financing any construction (excepting usurious rates).  Given that this has been in the Federal Court system for over a decade another two to three years for a judgment is quite likely. 

Caltrans Encroachment Permit
Lakes Entertainment has only started recently started to reference Caltrans with regards to the Jamul project.  The Tribe attempted to submit an Encroachment Permit Application with Caltrans a few months ago.  It was so inadequate that Caltrans did not even accept the application. 

Local opposition has started working with Caltrans to ensure that any Encroachment Permit requested by the Tribe be held to the same standard as any other Encroachment Permit.  Caltrans has agreed that this is the case and thus a full Environmental Impact Report will be required prior to any Encroachment Permit review.  In addition Caltrans will require a significant fee from the Tribe in order to begin processing the review as applicants in California are required to pay for the Caltrans services they use – including reviewing documents, performing studies, etc.  Expect the effort for Caltrans to review the Encroachment Permit Application, which has not yet been received, to take one to three years after receipt – with it more likely being on the longer end than the shorter end. 

Conversion from Class II to Class III
Lakes Entertainment and the Tribe have been guilty in the past of pushing the concept that the ability to convert the casino from a Class II facility to a Class III facility is merely a paperwork exercise and should be accomplished rather quickly.  The State of California has made no indication that the ability to build a Class II casino (which does not require an Environmental Impact Report) and allow the operator to immediately petition the state for the ability to invoke their Class III compact against the same facility will be permitted.  This would be a flaw in the process and the State of California cannot allow precedent to be set in this manner.  Expect the State to take an interest in any conversion and ensure that the proper environmental safeguards have been adopted.

One more item you should be aware of -- Lakes Entertainment recently presented to Roth Capital Partners.  Here is an excerpt from that presentation regarding the Jamul project:

Tim Cope: Also in some phase of development is the Jamul Casino with Jamul Indian Village near San Diego. This is a situation where they own 6, own, a, they have 6 acre reservation (1) so it doesn’t require any trust in land process or NIGC approval.  We expect to open with approximately a thousand gaming devices, this is currently plan to all Class II when it opens, and 25 table games.
Lyle Berman: The next project is the Jamul Casino in Jamul California. And will be financed and developed for the Jamul Indian Village tribe. It is part of the greater San Diego market. San Diego currently has three major casinos in the market so this would be the fourth.(2)  It is the closest to downtown San Diego. And if you go, when you look at the San Diego market, we’re on highway 83 but it’s the major highway going out to the other casinos is highway …Is it 10?, is… There’s highway 8, we’re on off highway 94.(3)  We’re on 94, it’s highway 8, right.  We’re on 94, but on highway 8, you get to, if you are coming anywhere from the north, in order to get to the casinos you pretty much have to get on highway 8. And then there is a spot that’s kind of equidistant from all four casinos. You can go straight out highway 8 to Viejas, you go up in the hills to one of the casinos, you can go to Sycuan, which is in the south and ourselves which in the south. But if you are coming from the south or the due west we are the closest casino. So it’s a very, very good location. It’s going to start out with at this point a thousand gaming devices which are Class II. The tribe has a compact with the state but the state has claims that the access to their reservation, they won’t approve it, so the tribe has told the state we’ll just operate class II at this point, and right now the current status of this project is the tribe is right now building, improving the road from the reservation on to the highway. The tribe has a legal opinion that there is nothing that the state or anybody else can do to stop it.(4) There are some people, some anti-casino people there who are questioning that ruling. We don’t know if there will be a lawsuit yet or not, but we’re hoping there won’t be and we then we will start construction in late 2008.

(1) Mr. Cope’s statement does not take into account the pending litigation for 4.66 acres of the total 6.  There is no documentation that states the property is a reservation.
(2) There are 11 Indian gaming casinos in San Diego County, the most in the country. 5 are in the East County area, all with Class III gaming machines.
(3) Mr. Berman is not even sure as to where the tribe is located. Highway 94 is a two-lane, mountainous rural road that has been given a Grade F from the California Department of Transportation.
(4) The tribe is bound by state law to get an encroachment permit and no “legal opinion” can change that.

Summary

There are a multitude of other ancillary issues – however these are a few of the most glaring examples of why the Jamul project is bad business for Lakes Entertainment and a bad investment for you.