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  As Of               Filer                 Filing     As/For/On Docs:Pgs              Issuer               Agent

 3/16/06  Pegasus Solutions Inc             10-K       12/31/05   12:198                                    Bowne of Dallas I..01/FA

Document/Exhibit                   Description                      Pages   Size 

 1: 10-K        Annual Report                                       HTML  1,095K 
 2: EX-10.8     Employment Agreement - Michael Kistner              HTML     33K 
 3: EX-10.25    First Amendment to Office Lease                     HTML     34K 
 4: EX-10.27    First Amendment to Office Lease                     HTML     11K 
 5: EX-10.28    Second Amendment to Office Lease                    HTML    152K 
 6: EX-10.29    Third Amendment to Office Lease                     HTML     18K 
 7: EX-10.30    Fourth Amendment to Office Lease                    HTML     16K 
 8: EX-21.1     Subsidiaries of the Company                         HTML      6K 
 9: EX-23.1     Consent of Independent Registered Public            HTML      6K 
                          Accounting Firm                                        
10: EX-31.1     Certification of Ceo Pursuant to Section 302        HTML     11K 
11: EX-31.2     Certification of Cfo Pursuant to Section 302        HTML     11K 
12: EX-32.1     Certification of Ceo and Cfo, Pursuant to Section   HTML      8K 
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Table of Contents

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission file number 0-22935

Pegasus Solutions, Inc.

Campbell Centre I, 8350 North Central Expressway, Suite 1900 Dallas, Texas 75206

Registrant’s telephone number, including area code:

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

      Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.     YES o          NO þ

      Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.     YES o          NO þ

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

      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     o

      Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

      Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.).          YES o          NO þ

      The aggregate market value of the registrant’s voting stock held by non-affiliates on June 30, 2005, based on the closing price of the registrant’s common stock on such date as reported on the NASDAQ national market, was $132,105,211.

      The number of shares of the registrant’s common stock, par value $0.01 per share, outstanding as of March 9, 2006 was 20,804,229.

TABLE OF CONTENTS

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PART I

      Except where expressly indicated or the context otherwise requires, the “Company,” “Pegasus,” “we,” “our” or “us” when used in this Annual Report refers to Pegasus Solutions, Inc., a Delaware corporation, and its predecessors and consolidated subsidiaries. This report contains forward looking statements within the meaning of the federal securities laws, including statements using terminology such as “may,” “will,” “expects,” “plans,” “initiatives,” “intends,” “anticipates,” “believes,” “estimates,” or “potential,” 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 future effect of plans, initiatives 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, the failure of the Company to complete the transaction as contemplated by the Agreement and Plan of Merger dated December 19, 2005 among Perseus Holding Corp., 406 Acquisition Corp., and the Company (the “Merger Agreement”) (See Item 7 of the Annual Report on Form 10-K under the caption “The Merger Agreement” for more information) or delays with respect to the Merger Agreement, 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, regional or 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, the inability of the Company to sell the balance of its property management systems, or PMS business, as well as other risks and uncertainties, including those appearing in Item 1A of the Annual Report on Form 10-K under the caption “Risk Factors.”

      Pegasus is a global leader in providing technology and services to hotels and travel distributors. Founded in 1989, our customers include a majority of the world’s travel agencies and more than 60,000 hotel properties around the globe. Our services include central reservation systems, electronic distribution services, commission processing and payment services, and marketing representation services, including the consumer Web site hotelbook.com™. Our representation services, including Utell by Pegasus™ and Unirez by Pegasus™, are used by more than 7,000 hotels in more than 130 countries, making Pegasus the hotel industry’s largest third-party marketing and reservations provider. We have 17 offices in 12 countries, including regional hubs in London, Scottsdale and Singapore.

Strategy

      Our vision is to be the world leader in providing comprehensive and innovative solutions designed to transform critical business processes for hotels and travel distributors. Key elements of our strategy include the following:

	•	Pursue Complete, Integrated Technology Solutions. We strive to bring together all of the reservation, distribution and commission processing technology needs of our customers instead of just a specific application. This includes providing services ranging from Web site integration to complete information technology outsourcing.
	•	Develop Leading Technologies and Expedite the Time to Market for New Products. We strive to develop new technologies, services and solutions to meet the changing needs of our current and prospective customers. During 2005, we defined service line strategies and related technology needs. We have also continued to implement new software development processes with a focus on expediting the time to market of new products and reducing development costs.
	•	Capitalize on Our Extensive and Diverse Portfolio of Independent Hotels and Small Hotel Groups. We believe consumers’ demand for a unique hotel experience, combined with lower cost distribution channels such as the Internet, will increase the presence of independent hotels and small hotel groups

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		internationally and in the United States. With more than 7,000 hotels using our representation services, we have an opportunity to grow revenues by cross-selling our other services and by launching consumer channels to market our member hotels directly to consumers.
	•	Pursue Emerging Hospitality Markets. We believe emerging markets such as Asia — in particular, China — Eastern Europe, and Latin America present a significant opportunity for revenue growth. We plan to utilize business partners, including sales agent partners, to expedite penetration in emerging markets in a cost effective manner.
	•	Build Strategic Alliances and Partnerships. We seek to build strategic alliances and partnerships, particularly related to sales distribution and product packaging. We believe that these relationships will broaden the brand recognition and market presence of our services and help to expand our customer base. We may also seek to partner or acquire assets, technology and businesses that provide complementary services to our existing customers or access to other new travel-related markets and customers.
	•	Provide Outstanding Customer Service. In 2005, we continued our company-wide campaign to embrace customer satisfaction as part of our corporate culture. To emphasize the importance of customer satisfaction, a portion of our employees’ compensation is tied to customer satisfaction benchmarks.

Services

      Through our comprehensive and integrated service offerings we can provide one or more of the following services to hotels and travel distributors worldwide:

      Reservation Services. Our award winning Central Reservation Services (“CRS”) utilize our RezView^® application at its core. Hotel chains and hotel representation companies use a CRS to store information about all of their properties in a central database and then use that information to make and modify reservations and to generate various operational, management and marketing reports.

      Offered under the application service provider (“ASP”) model, our CRS service is a cost effective option for those hotel chains and hotel representation companies that neither have, nor want, the overhead associated with developing, implementing and maintaining the systems infrastructure inherent to CRS ownership.

      We provide CRS services on an ASP basis to approximately 7,000 hotel properties, representing approximately 850,000 hotel rooms worldwide (including properties in our Utell by Pegasus representation portfolio). We also offer call center services to these clients. During 2005, we began offering our call center services on a stand-alone basis to clients requiring an outsourced solution for the entire operation or to support expansion into select, strategic geographic regions.

      Distribution Services. Distribution services provides the connections and interfaces that enable hotels to distribute their rates and inventory to — and receive reservations from — the four global distribution systems (“GDSs”) used by travel agencies worldwide, a growing number of tour operators, wholesalers, and a wide variety of Powered by Pegasus^® Internet sites. During 2005, distribution services processed approximately 29 million transactions. Distribution services include:

	•	GDS distribution — GDS distribution is offered to hotel customers. Our GDS distribution service offering automates hotel reservations through traditional GDS channels. The offering consists of connectivity to the four major GDSs (Sabre, Galileo, Amadeus and Worldspan) for reservation-related transactions, support of GDS maintenance activities, such as availability status and rate update functions, and standard reporting on transactional activity.
	•	Third-party Internet sites — We provide travel-related Internet sites access to our hotel information database containing content and images on more than 60,000 properties and on-line hotel reservation capability. We provide this service to several of the leading travel Internet sites such as Expedia.com, Orbitz.com, and our own hotelbook.com and Utell.com.

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	•	Hotel Internet sites — A component of the online distribution environment, NetBooker® is a Pegasus developed and hosted online Internet booking engine available to hoteliers and travel portal companies who want a private label Internet site with integrated, seamless availability and booking engine but without the responsibilities and overhead of internal design, development and hosting. Hotel Internet sites that are “Powered by Pegasus” offer brand-loyal Internet shoppers real-time rates, availability and booking capabilities.
	•	PegsTour™ — This new product provides a direct link between tour operators and travel suppliers that is a new alternative to the traditional facsimile method tour operators have used to book reservations.

      Representation Services. We offer a variety of hotel representation services to independent hotels and small hotel groups. Pegasus represents more than 7,000 independent and small hotel group properties around the world.

      To market and sell their rooms, many independent hotels and small hotel groups associate themselves with our representation services and use our systems and infrastructure to offer and accept reservations for their rooms. Hotels typically utilize our representation services to obtain a presence in the primary electronic distribution channels (GDSs and the Internet) through our CRSs and global voice reservation capability.

      Our Unirez by Pegasus service provides a connection to all GDSs and thousands of linked third-party Internet sites through a leading Web-based CRS. Our advanced technology offers a user-friendly interface that allows hotel customers to upload or modify hotel data, including room rates, availability and descriptions, at any time.

      In addition to the distribution connectivity and CRS service, our Utell by Pegasus offering includes marketing programs, sales representation, a voice reservation call center network covering over 40 countries, and enhanced revenue management support. Hotels using our Utell^® offering benefit from the enhanced market image created by affiliation with Utell by Pegasus, a well-known name in hotel distribution, as well as worldwide sales and marketing support.

      Utell representation customers also have the option to utilize our financial services capabilities under the names Paytell™ and TravelCom^®. In some international markets, it is customary for travelers to prepay for hotel rooms and other travel arrangements. Paytell is a service that allows travelers to prepay for reservations, with Pegasus remitting amounts to hotels when the guest stay occurs. TravelCom is an Internet-based proprietary system that allows member hotels to expedite commission payments to travel agents.

      During 2005, we launched hotelbook.com™, which creates another way for independent hoteliers to compete online with the major hotel brand Web sites. Hotelbook.com is our website for independent hotels that participate in our representation service. Hotelbook.com presents travelers with a unique lodging option in today’s increasingly complex online travel arena. Hotelbook.com strives to provide travelers with a place to find something different in a hotel. With approximately 5,000 independent hotels in approximately 1,900 cities around the globe, hotelbook.com enables a user to research independent hotels worldwide, make commissionable bookings, get instant confirmations, check commissions and check out the latest promotions.

      Also during 2005, we opened an office in Beijing to expand our presence in the emerging China market.

      Financial Services. Financial services provides comprehensive commission processing and payment solutions to hotels, other travel suppliers and travel agencies in more than 200 countries. Key services include: commission processing; commission reconciliation and tracking for member agencies; and global commission solutions for participating hotels.

      Each week, or on a monthly basis depending on the participating hotel’s preference, Pegasus consolidates, distributes, reconciles, tracks and reports millions of dollars in commission payments to travel agency locations worldwide on behalf of more than 35,000 participating hotel properties. Traditionally, the process of reconciling and paying hotel commissions to travel agencies was based on transaction-specific hotel data and consisted of a number of relatively small payments to travel agencies, often including payments in multiple currencies. Our value-added commission consolidation and reporting service benefits both hotel and travel agency participants by providing a single, monthly commission payment to member travel agencies from

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      Other Services. Pegasus regularly seeks to develop other new or enhanced technologies, services and solutions to meet the changing needs of our current and prospective customers. Pegasus has not received a material amount of revenue from these services, and there can be no assurance that any of these services will produce a material amount of revenue in the future.

Competition

      Our service offerings face competition from within their respective markets. Principal factors affecting our customers’ purchasing decisions for our services include pricing, product functionality, product performance and the breadth of service offerings. To compete successfully, we must meet our customers’ expectations and develop new technological solutions to meet the changing needs of the hospitality industry. We cannot assure you that any of our services will compete successfully. Please see the Risk Factors section below which further discusses competitive pressures.

      Reservation Services. Our reservation services compete with hotel companies that develop and host their own CRSs and third parties that provide CRS and related services under a license agreement or as an ASP. Our reservation service competitors include TRUST International (subsidiary of Cendant Corporation), SynXis Corporation (subsidiary of Sabre Holdings Corporation), TravelCLICK Inc. and MICROS Systems, Inc.

      Distribution Services. Pegasus’ distribution services support a variety of distribution channels, each with its own competition. For example:

	•	GDS connectivity — Our GDS connectivity service competes primarily with WizCom International, Ltd. (subsidiary of Cendant Corporation). Customers may change their electronic reservation interface to WizCom or to another similar service. Also, some hotels have established a direct connection to one or more GDSs rather than through an intermediary, such as Pegasus or WizCom. Other hotels may choose to take the same action. If hotels establish this direct connection, they would bypass our intermediary position and eliminate the need to pay our fees. However, the cost to maintain a separate connection to each GDS is typically more costly than maintaining a single connection to Pegasus.
	•	Third-party and hotel Internet sites — Our online distribution services face competition in the online hotel room reservation business from GDSs, middleware providers and Internet sites establishing direct connections to a hotel chain’s CRS. Middleware provider competitors are Internet site development companies that could develop an interface directly between a hotel’s property system and a travel Internet site or an interface between a hotel company’s CRS and a travel Internet site. Hotels have been increasingly promoting the use of their own Internet sites. The cost of entry into the Internet hotel room reservation business is relatively low. However, the cost to maintain a separate connection to each Internet site is typically more costly than maintaining a single connection to Pegasus.
	•	PegsTour™ — Our PegsTour service faces competition primarily from tour operators who continue to maintain their current manual processes to manage this business versus the automated approach we offer with PegsTour. Cendant Corporation also offers a similar service.

      Representation Services. Our hotel representation services compete with other providers of distribution, sales and marketing services, including hotel groups, franchisors, reservation companies and other travel or hotel representation companies. Our primary competitors offering hotel representation services are Vantis/ TravelCLICK Inc., SHS-WorldHotels, Supranational Hotels, SynXis Corporation, Sceptre Hospitality Resources, and TransHotel. Hotelbook.com competes primarily with proprietary websites for independent hotel groups.

      Financial Services. Our commission processing service faces competition principally from Perot Systems, Inc. In addition, current or prospective hotel customers can decide to process commission payments on their own.

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Seasonality

      Our business, particularly our representation services, is sensitive to seasonal changes in the demand for hotel rooms. The demand for business and leisure travel is typically lower in the first and fourth quarters of the year; therefore, these quarters have historically generated lower revenue than the second and third quarters. Because the majority of our operating expenses are fixed, fluctuations in revenue from quarter to quarter may have a material effect on operating income for the respective quarters.

International Operations

      We derive approximately 44 percent of our revenue from customers located outside the United States, primarily in the United Kingdom. Fluctuations in the value of foreign currencies relative to the U.S. dollar directly impact our revenues and expenses. More information regarding specific risks associated with our foreign operations and our exposure to movements in foreign currency exchange rates is available under the heading “Risk Factors” and “Item 7A. Quantitative and Qualitative Disclosures about Market Risk.” See enterprise-wide disclosures in Note 17 to the consolidated financial statements included in Item 8 of this Annual Report on Form 10-K.

Intellectual Property

      We are continually developing new technology and enhancing existing proprietary technology. Currently, one United States patent has been issued to us, and a second United States patent has been allowed and we expect that it will issue in the second half of 2006. In addition, we have filed a total of six patent applications in Australia, Canada and the European Union. One patent application in China has been allowed but has not yet issued, and the remainder are in various stages of the application process. We primarily rely on a combination of trademark, copyright, trade secrets, confidentiality procedures and contractual provisions to protect our technology and other intellectual property rights. Despite these protections, it may be possible for unauthorized parties to copy, obtain or use certain portions of our proprietary technology. Any misappropriation of our intellectual property could have a material adverse effect on our competitive position.

Research and Development

      Our research and development activities primarily consist of software development, development of enhanced communication protocols and custom user interfaces, and database design and enhancement. Our total research and development expense related to continuing operations was $3.4 million, $3.7 million and $4.5 million for 2005, 2004, and 2003, respectively.

Employees

      At February 28, 2006, we had 1,049 employees, 671 of whom are located in the United States. We had 150 people performing information technology functions, 759 people performing sales and marketing, customer relations and business development functions, and the remainder performing corporate functions, such as finance, legal, human resources and administrative. We have no unionized employees. We believe that our employee relations are satisfactory.

Available Information

      The public may read and copy any materials filed with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-732-0330. As an electronic filer, Pegasus’ reports, proxy and information statements, and other information is available at the SEC’s Internet site, http://www.sec.gov.

      Our Internet address is www.pegs.com. Select company SEC reports, including reports on Form 10-K, Form 10-Q and Form 8-K (and amendments to those reports), are available free of charge on our Web site as soon as reasonably practicable after electronic filing or furnishing with the SEC. Our Code of Ethics for Senior Financial Officers, amendments thereto and waivers thereof are published and maintained on our Web site.

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      The following risk factors should be carefully considered in conjunction with the other information included or incorporated by reference in this report. If any of these risks occur, our business, financial condition, operating results, cash flows and securities’ market prices could be materially adversely affected. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business, financial condition or trading price of our securities.

Risks related to our industry

      Nearly all of our revenues are directly or indirectly dependent on the hotel industry, which is highly sensitive to any change in the general economic climate as well as economic conditions affecting business and leisure travel in particular. The hotel industry is susceptible to rapid and unexpected downturns, as experienced after the events of September 11, 2001, the war in Iraq, and the SARS health crisis. In the event of any future downturn in the hotel industry, we would likely experience significantly reduced revenues, as the use of our services and the demand for our future services and solutions would decline. A continued downturn in the hotel industry or any reduction in hotel reservation volume, average daily room rates, or the demand for travel generally, would negatively impact our business, operating results and financial condition.

      Many factors affect the hotel industry, most of which are beyond our control. The hotel industry and demand for hotel rooms or travel may be affected by, among other things:

	•	General economic conditions including recession, inflation and currency fluctuations
	•	The existence or threat of military conflict, terrorism or political instability
	•	Increased government regulation and enforcement
	•	Natural disasters, such as hurricanes, earthquakes, and tsunamis, and any other unfavorable weather events or patterns
	•	Global or regional health issues
	•	Gasoline and aviation fuel price escalation
	•	Labor strikes
	•	Instability in the airline industry

      We may experience substantial period-to-period fluctuations in our results of operations as a consequence of these factors and others and the general economic conditions affecting the demand for hotel rooms and travel.

      Pegasus financial services, which includes our commission processing service, derives revenues based on the dollar value of travel agency commissions paid by hotels. The dollar value of these commissions is based on the number of reservations, the length of stay and the room rate. Hotels typically are under no contractual obligation to pay room reservation commissions to travel agencies. Hotels could elect to reduce the current industry customary commission rate of 10 percent, limit the maximum commission generally paid for a hotel room reservation or eliminate commissions entirely. Hotels increasingly utilize other direct distribution channels, like the Internet, or offer negotiated rates to major corporate customers that are non-commissionable to travel agencies. If there is any decline in average daily room rates, change in the commission payment

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      We offer volume-based discounted fees for some of our services. Recent consolidation in the hotel industry has resulted in a higher percentage of discounted fees and this trend could continue. In addition, the GDS industry has consolidated into four major GDSs. If further consolidation occurs, the value of our services and the benefits to hotel operators of utilizing our GDS distribution service would be reduced. Any potential decrease in our customer base or any potential increase in the percentage of discounted fees may adversely affect the profitability of our business.

Risks Related to the Company

      Our announcement in April 2005 of our intent to explore strategic alternatives for the Company resulted in some level of uncertainty amongst our employees and some of our customers during the ensuing months the initiative was underway. Our announcement of an agreement to sell the Company helped to alleviate some of this uncertainty. If we fail to close the sale of the Company as contemplated or the closing is delayed, it likely would increase the level of uncertainty amongst our employees and some of our customers. This development may result in the following adverse effects upon our business, operating results and financial condition:

	•	a less productive work force
	•	loss of employees
	•	delays in entering into or refusals to enter into contracts with some of our customers and third party service providers
	•	continued management focus on the strategic alternative initiative rather than ongoing business initiatives
	•	the incurrence of significant expenses relating to the failed transaction
	•	possible litigation arising out of a failed transaction.

      If we fail to close the sale of the Company as contemplated or the closing is delayed, it likely would result in a drop and/or significant fluctuation in our stock price.

      Our future success depends on our ability to successfully develop leading technologies, enhance our existing services and develop and introduce new services. In particular, our technologies and services must meet the demands of our current and prospective customers on a timely and cost-effective basis, staying abreast of technological advances and evolving industry standards and practices.

      Although we strive to be a technological leader, future technology advances may not complement or be compatible with our services. In addition, we may be unable to economically and timely incorporate technology changes and advances into our business. We may be unsuccessful in effectively developing and implementing new technologies, adapting our services to emerging industry standards or developing, introducing and marketing service enhancements or new services in a timely manner and with acceptable performance levels. For example, during 2005, we discontinued our PMS services, a decision made in part because of the

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      We also may experience difficulties that could delay or prevent the successful development or introduction of these services. It is also possible that a new service, while achieving a technological success, may fail to be accepted and utilized by prospective customers.

      If we are unable to successfully develop, introduce and implement new services or enhance existing services on a timely and cost-effective basis or if new services do not achieve market acceptance, it could adversely affect our ability to compete in the marketplace and negatively affect our business. Any such failures could have a material negative impact on our operating results and financial condition, including write-downs or write-offs related to impaired assets.

      Service failures, delays in the implementation of our service offerings or our failure to deliver services in a timely manner with acceptable service levels could result in reduced revenues, particularly since our transaction-based revenues are dependent upon services being available, reduced pricing for our services, a loss of customers, an inability to effectively compete and breach of contract claims. Certain service failures could also require us to credit customers pursuant to service level agreements, which we intend to use more frequently in the future.

      We compete in markets that are rapidly evolving, intensely competitive and involve continually changing technology and industry standards. We may experience increased competition from current and potential competitors, many of which have significantly greater financial, technical, marketing and other resources than we possess. Consolidation among our competitors may result in economies of scale, or broader or more comprehensive service offerings with which we may have difficulty competing. Competitive pressures have contributed to less profitable arrangements with some of our customers and could reduce our market share or require us to reduce the prices of our services. Consolidation among travel distribution companies, such as Cendant and Expedia, may increase competitive pressure with respect to our service offerings to travel distribution companies and the hotels that may utilize our distribution capabilities. Our inability to compete effectively with alternative service providers could adversely affect our business, operating results and financial condition.

      Our business is dependent upon our customer arrangements with hotel chains, independent hotels, hotel representation firms, travel management companies, travel agencies, travel agency consortia, global distribution systems, travel-related Internet sites and Internet-based information and reservation systems. In the future, our customers may elect to perform certain functions themselves, may circumvent our services, may select the services of competing companies, or we may otherwise be unable to continue or renew these arrangements on favorable terms or initiate new arrangements. In addition, customers may elect to utilize our lower cost service offerings over our higher-priced offerings that provide us with greater revenue. For example, our representation customers may switch from our Utell by Pegasus offering to our Unirez by Pegasus offering, resulting in less revenue to us. If we are unable to renew, continue or initiate customer arrangements on a favorable basis, it could result in a significant reduction in our customer base and revenue sources.

      We rely on certain third party arrangements for the provision of our services and increasingly for the development and enhancement of our services. Such “outsourcing” presents a number of risks primarily

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      We rely on third parties for many services, including remittance and worldwide currency exchange services for our commission processing service and for facility maintenance and enterprise resource planning system hosting. If we are unable to renew or extend our contracts with existing third-party service providers or enter into contracts with alternate service providers on favorable terms, it could adversely affect our business, operating results and financial condition.

      Our operations depend on our ability to protect our computer systems and databases against damage or system interruptions from fire, earthquake, power loss, telecommunications failure, unauthorized entry, malfunctions, human error or other events beyond our control. A significant amount of our computer equipment is located in Scottsdale, Arizona. Any unanticipated problems may cause a significant system outage or data loss. Despite the implementation of security measures, our infrastructure may also be vulnerable to break-ins, computer viruses or other disruptions caused by our customers or others. Our infrastructure may also fail to provide consistent dependable service as a result of circumstances both in and out of our control. Any damage to our databases, failure of communication links, security breach or other factors that cause interruptions in our operations could adversely affect our business, operating results and financial condition.

      Our potential future growth may place significant demands on management as well as on our administrative, operational and financial resources. Expanding our business to take advantage of new market opportunities will require significant management attention and Company resources, possibly adversely impacting our existing operations. In order to obtain certain distribution, supply or operations capabilities, our attempts to expand may involve an increased use of revenue sharing arrangements, which may affect our profitability or result in additional liabilities.

      We plan to expand our presence in international markets, particularly including the Asia-Pacific region in general and specifically China. In addition to being subject to the risks of international operations described below, it is costly to establish new international operations and our net sales from international market segments may not offset the expense of establishing and maintaining the operations. We have relatively little experience in marketing and distributing our services in many of these international markets, and we may not succeed in these efforts.

      We also regularly evaluate acquisition and strategic alliance opportunities and in the future may make additional acquisitions of other companies or technologies or enter into strategic alliances. Acquisitions and strategic alliances involve many risks including:

	•	Difficulty in integrating or otherwise assimilating technologies, products, personnel and operations
	•	Diversion of management’s attention from other business concerns
	•	Issuance of dilutive equity securities and the incurrence of debt or contingent liabilities
	•	Write-offs and amortization expense related to identifiable intangible assets
	•	Loss of key employees of acquired organizations
	•	Risks of entering markets in which we have no or limited prior experience
	•	Payments of cash and the assumption of liabilities of other businesses

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	•	An inability to adequately protect our intellectual property
	•	The failure of strategic alliances to perform as expected

      Our inability to manage growth or to integrate any acquisitions or strategic alliances could adversely affect our business, operating results and financial condition.

      Our expense levels are based primarily on our estimate of future revenues and are largely fixed in the short-term. In the future, we may not accurately predict the transaction volumes and room rates that directly impact our revenues, the introduction of new or enhanced services by us or our competitors or the degree of customer acceptance of new services. In the short-term, we may also be unable to adjust spending rapidly enough to compensate for any unexpected revenue shortfall. This could adversely impact our business, operating results and financial condition. Accordingly, we believe that period to period comparisons of our operating results should not be relied upon as an indication of future performance.

      Many of our customers are independent hotels, travel agencies and other travel industry participants that are particularly exposed to any downturn in the economy and other factors that adversely impact the hotel industry. Some of these customers may have inadequate financial strength to make current payments to us or remain as going concerns. In some instances we may be unable to collect payments from these customers or we may extend credit to them in the form of unsecured promissory notes or otherwise. Our inability to collect payments from these customers in the future could result in a material adverse effect on our business, operating results and financial condition.

      We derive a substantial portion of our revenue from customers located outside the United States, primarily in Europe. If the value of foreign currencies relative to the U.S. dollar decreases, our revenues translate into a lower U.S. dollar amount.

      Our international operations are also subject to other risks, including:

	•	Impact of possible adverse political and economic conditions, including difficulties in the repatriation of investments or profits
	•	Potentially adverse tax consequences
	•	Impact of the policies and regulations of the United States and foreign governments on foreign trade and commerce, such as the USA PATRIOT Act and other laws enforced by the U.S. Office of Foreign Assets Control
	•	Compliance with information privacy laws and related enforcement actions
	•	Reduced protection for intellectual property rights in some countries
	•	Changes in regulatory requirements
	•	Cost of adapting our services to foreign markets
	•	High costs associated with office closures and personnel reductions

      Our success depends upon our proprietary technology and other intellectual property rights. We currently rely upon a combination of trademark, patents, copyright, trade secrets, confidentiality procedures and

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      Our success depends on our ability to retain the services of our current executive officers and other key personnel, and to manage effectively any transition in the event of a change in such key personnel. We cannot guarantee that we will be able to successfully identify, attract, motivate and retain other highly skilled personnel in a timely and effective manner. Our failure to retain our officers and key personnel or to recruit new personnel could adversely affect our business, operating results and financial condition.

      Our operations are subject to the laws and regulations of the United States and numerous states and international jurisdictions. Changes regarding any of these laws and regulations, their enforcement or our understanding of the applicable requirements could force us to change our operations or result in other uncertain adverse consequences. Our efforts to comply with the requirements of the Sarbanes-Oxley Act of 2002, particularly the provisions of Section 404 regarding the certification and audit of our internal control over financial reporting, have resulted in material expenditures of financial and employee resources and may continue to do so in the future. Also, as a result of our customer relationships and our status as an intermediary with respect to certain services, federal, state or foreign governmental authorities, competitors or consumers could raise antitrust or anti-competitive concerns.

      In addition, we are subject to the same federal, state, local and foreign jurisdiction laws as other companies conducting business on the Internet and in e-commerce, including with respect to taxation, user privacy, data protection, consumer protection, payment processing, electronic contracts and other issues. Many of these laws and regulations are new, have not yet been thoroughly interpreted by the courts, and are subject to change by many jurisdictions, which could have a material adverse effect on our business, operating results and financial condition. Any change in tax laws, their interpretation or our legal conclusions regarding the collection of sales or similar taxes in connection with our services could result in substantial tax liabilities for past sales and decrease our profitability and revenues going forward.

      We have provisions in our certificate of incorporation and bylaws that are intended to make it more difficult for a third party to acquire us. These provisions include the staggered terms of our Board of Directors, the exclusive right of the Board of Directors to fill vacancies on the board, and restrictions on the right of stockholders to remove members of the Board of Directors. We are also subject to the provisions of Delaware law that restrict certain business combinations with interested stockholders even if such a combination would be beneficial to stockholders. In addition, we have a stockholder rights plan. The rights are exercisable only if a person or group of affiliated persons acquires, or has announced the intent to acquire, 20 percent or more of our common stock. We also have certain payment and other obligations that are triggered by a change of control in connection with agreements with certain third parties and employees.

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      In connection with the Merger Agreement, our board of directors approved and adopted the Merger Agreement in a manner such that the restrictions imposed on business combinations under Delaware law would not apply to the applicable merger transaction. Additionally, on December 19, 2005 Pegasus entered into an amendment to its rights agreement that provides that none of the execution, delivery or performance of the Merger Agreement or the closing of the merger or any of the other transactions contemplated by the merger agreement will trigger the separation or exercise of the rights under the rights agreement or any adverse event under the rights agreement.

      Except for agreements or amendments described in the preceding paragraph, these provisions will remain effective and could discourage potential acquisition proposals or delay or prevent a change in control transaction. They could also discourage others from making tender offers for our shares. As a result, these provisions may prevent the market price of our common stock from reflecting the effects of actual or rumored takeover attempts. These provisions may also prevent significant changes in our Board of Directors and our management.

      From time to time, we are involved in legal and other regulatory proceedings. We intend to defend our rights vigorously during any of these proceedings. Regardless of the merits of any issues raised in any of these proceedings, our involvement could result in substantial costs and other liabilities not covered by insurance as well as divert management’s time and attention from our business, which could adversely affect our business, financial condition and results of operations.

      In connection with the sale of the convertible notes in July 2003, we incurred $75 million of indebtedness which increased our interest payment obligations. The degree to which we are leveraged could adversely affect our ability to obtain further financing for working capital or other purposes and could make us more vulnerable to industry downturns and competitive pressures. Our ability to meet our debt service obligations will be dependent upon our future performance, which will be subject to the financial, business and other factors affecting our operations, many of which are beyond our control.

      Our ability to generate cash flow from operations to make interest payments on the convertible notes will depend on our future performance, which will be affected by a range of economic, competitive and business factors, many of which are beyond our control. If our operations do not generate sufficient cash flow from operations to satisfy our debt service obligations, we may need to borrow additional funds to make these payments or undertake alternative financing plans, such as refinancing or restructuring our debt, or reducing or delaying capital investments and acquisitions. We may secure a credit facility as additional protection against short-term liquidity concerns. However, such credit facility, other additional funds or alternative financing may not be available to us on favorable terms, or at all. Our inability to generate sufficient cash flow from operations or obtain additional funds or alternative financing on acceptable terms could have a material adverse effect on our business, financial condition and results of operations.

      At maturity, the entire outstanding principal amount of the convertible notes will become due and payable by us. In addition, on July 16, 2008, July 16, 2013 and July 16, 2018 or if a fundamental change occurs, as defined in the indenture relating to the convertible notes, each holder of the convertible notes may require that we purchase all or a portion of that holder’s notes. The merger contemplated by the Merger Agreement constitutes such a fundamental change. While the debt financing anticipated in connection with this Merger Agreement contemplates the repayment of the amounts owing under the convertible notes, we

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      Several factors have caused, and may in the future cause, our stock price to be significantly volatile, which may be unrelated to our operating performance in certain cases. Our stock price could be subject to wide fluctuations in response to a variety of factors including the following:

	•	Uncertainty relating to the closing of the sale of the Company as provided in the Merger Agreement
	•	General economic conditions
	•	Acts of terrorism, retaliation for such acts, political instability, health epidemics, natural disasters, war and the prospect of war
	•	Actual or anticipated variations in our quarterly operating results
	•	Our ability to successfully develop, introduce and gain acceptance of new or enhanced products and services to the hotel industry on a timely basis
	•	Unexpected changes in demand for our services and solutions
	•	Adverse findings, conclusions or changes in requirements with respect to our internal controls assessment and audit pursuant to Section 404 of the Sarbanes-Oxley Act of 2002
	•	Unpredictable volume and timing of customer revenues due to the terms of customer contracts, changes in the hotel industry and other factors
	•	Purchasing and payment patterns, as well as pricing policies, of our competitors
	•	Announcements of technological innovations or new services by us or our competitors
	•	Changes in financial estimates, expectations and methodologies by securities analysts
	•	Conditions, trends or perceived prospects in the Internet and online commerce industries
	•	Changes in the market valuations of other similarly situated companies and hospitality and technology stocks in general
	•	Announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments
	•	Unscheduled system downtime
	•	Lack of confidence in the Company’s ability to execute on certain products or services
	•	Sales of substantial amounts of shares of our common stock in the public market, or the perception that those sales may occur

      We have in the past and may in the future make investments in other companies and ventures. There can be no assurance of the success of any such investment. Additionally, Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities,” may require us to consolidate entities with which we have an affiliation but no voting or operational control. In doing so, we may have little or no control over the success of the company or venture and we may be required to record the losses of these consolidated entities in our financial statements.

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      None.

      Our corporate headquarters is located in a leased facility with approximately 100,000 square feet of space in Dallas, Texas. We also have regional hubs in Scottsdale, London and Singapore with approximately 145,000, 40,000 and 8,000 square feet of leased office space, respectively. In total, we have 17 offices in 12 countries, all of which are leased facilities. We believe that our existing facilities are well maintained and in good operating condition. We believe that our planned and existing facilities are adequate for our anticipated levels of operations.

      Pegasus is subject to certain legal proceedings, claims and disputes that arise in the ordinary course of business. Although management cannot predict the outcome 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.

      No matter was submitted to a vote of our stockholders during the fourth quarter of the fiscal year ended December 31, 2005.

PART II

      Our common stock has been traded on the NASDAQ National Market under the symbol “PEGS” since August 7, 1997. At March 9, 2006, there were approximately 320 record holders of our common stock although we believe that the number of beneficial owners of our common stock is substantially greater.

      The following table shows the range of quarterly high and low sales prices for Pegasus’ common stock.

      We intend to retain any future earnings for use in our business and do not intend to pay cash dividends in the foreseeable future. The payment of future dividends, if any, will be at the discretion of our Board of Directors and will depend, among other things, upon future earnings, operations, capital requirements, restrictions in financing agreements, requirements related to our convertible debt offering, our general financial condition and general business conditions.

      On September 28, 1998, our Board of Directors declared a dividend distribution of one right for each outstanding share of our common stock to stockholders of record at the close of business on October 13, 1998.

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      On December 19, 2005, concurrently with the execution of the Merger Agreement, the Company and American Stock Transfer & Trust Company, as Rights Agent, entered into an amendment (the “Rights Agreement Amendment”) to the Company’s Rights Agreement dated as of September 28, 1998 (the “Rights Agreement”). The Rights Agreement Amendment provides that none of the execution, delivery or performance of the Merger Agreement, the consummation of the related merger or any of the other transactions contemplated by and pursuant to the Merger Agreement will trigger the separation or exercise of the stockholder rights or any adverse event under the Rights Agreement. In particular, none of Perseus Holding Corp., 406 Acquisition Corp. or any of their affiliates shall be deemed to be an Acquiring Person (as defined in the Rights Agreement) solely by virtue of the execution, delivery or performance of the Merger Agreement or the consummation of the merger or any of the other transactions contemplated by and pursuant to the Merger Agreement. The Rights Agreement Amendment also provides that the Rights Agreement will terminate immediately prior to the effective time of the merger contemplated by the Merger Agreement.

      The following selected consolidated financial data as of and for the years ended December 31, 2005 and 2004, and for the year ended December 31, 2003 are derived from the consolidated financial statements of Pegasus that have been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, and are included as Item 8 of this Annual Report on Form 10-K. Selected consolidated financial data as of December 31, 2003, and as of and for the years ended December 31, 2002 and 2001 are derived from Pegasus’ audited financial statements that are not included herein.

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      The following data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and with Pegasus’ consolidated financial statements and notes thereto.

(1)	Pegasus’ selected consolidated financial data includes the operating results of REZ, Inc. following the acquisition in April 2000.
(2)	Pegasus’ selected consolidated financial data includes the operating results of GETS following the acquisition in September 2001.
(3)	Pegasus’ selected consolidated financial data includes the operating results of Unirez following the acquisition in December 2003.
(4)	Effective January 1, 2002, in accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangibles,” Pegasus ceased to record goodwill amortization.
(5)	Revenues have been reclassified to give effect to the 2002 adoption of the Emerging Issues Task Force, or EITF, Issue 01-14, “Income Statement Characterization of Reimbursements Received for “Out-of-Pocket” Expenses Incurred.”
(6)	In 2004 the Company reclassified bad debt expense to General and Administrative Expenses from Cost of Services. The reclassified amounts totaled $1.3 million and $3.4 million in 2002 and 2001, respectively.
(7)	The Company has reclassified its property management systems operations as discontinued operations for all periods presented.

      The Company has not paid any cash dividends during the past five years.

      The following discussion and analysis should be read in conjunction with the selected consolidated financial data included as Item 6 of this Annual Report on Form 10-K and the consolidated financial statements and notes thereto included as Item 8 of this Annual Report on Form 10-K. This discussion and

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      Pegasus is a global leader in providing technology and services to hotels and travel distributors. Founded in 1989, our customers include a majority of the world’s travel agencies and more than 60,000 hotel properties around the globe. Our services include central reservation systems, electronic distribution services, commission processing and payment services, and marketing representation services, including the consumer Web site hotelbook.com^TM. Our representation services, including Utell by Pegasus^TM and Unirez by Pegasus^TM, are used by more than 7,000 hotels in more than 130 countries, making Pegasus the hotel industry’s largest third-party marketing and reservations provider. We have 17 offices in 12 countries, including regional hubs in London, Scottsdale and Singapore.

The Merger Agreement

      As a result of our strategic alternative process, which was announced in April 2005, Pegasus Solutions, Inc. has entered into an Agreement and Plan of Merger, dated December 19, 2005 (the “Merger Agreement”), with Perseus Holding Corp. (“Parent”) and 406 Acquisition Corp., a direct wholly owned subsidiary of Parent (“Merger Sub”). Parent and Merger Sub are entities controlled by an investment group consisting of entities affiliated with Prides Capital Partners, L.L.C. and Tudor Investment Corporation.

      The Merger Agreement contemplates that Merger Sub will be merged with and into the Company, with the Company continuing as the surviving corporation (the “Surviving Corporation”) in such merger as a direct wholly owned subsidiary of Parent (the “Merger”), and each outstanding share of common stock of the Company owned by stockholders other than those affiliated with the investment group will be converted in the Merger into the right to receive $9.50 per share in cash.

      The Company has made various representations, warranties and covenants in the Merger Agreement, including, among others, not to (a) solicit proposals relating to alternative business combination transactions or (b) subject to certain exceptions which permit the board of directors to comply with its fiduciary duties, enter into discussions concerning, or provide confidential information in connection with, alternative business combination transactions. Subject to certain exceptions that permit the board of directors to comply with its fiduciary duties, the Company’s board of directors has agreed to recommend that the Company’s stockholders vote in favor of and adopt and approve the Merger and the Merger Agreement. The Merger Agreement also includes covenants pertaining to the operation of the Company’s business between execution of the Merger Agreement and the closing of the Merger.

      Consummation of the Merger is subject to various conditions, including, among others, the approval and adoption of the Merger Agreement by the Company’s stockholders, the absence of certain legal impediments to consummation of the Merger, the receipt of certain regulatory approvals and the funding of debt to complete the Merger.

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      The Merger Agreement contains certain termination rights, including in the event the Company receives a superior proposal, and provides that, upon the termination of the Merger Agreement under specified circumstances, as defined therein, the Company may be required to pay Parent a termination fee equal to $8.25 million. In addition, in certain circumstances where the Merger Agreement is terminated, including in the event the Merger Agreement is terminated and the Company is required to pay the termination fee to Parent, the Company is required to reimburse Parent for its fees and expenses incurred in connection with the Merger Agreement, up to a maximum of $1 million.

      In connection with the execution of the Merger Agreement, an affiliate of Prides Capital Partners, L.L.C. agreed to provide a limited guarantee of the liabilities of Parent and Merger Sub under the Merger Agreement. In addition, John F. Davis, III, Susan K. Conner and Robert J. Boles, Jr. have agreed with Prides Capital Partners, L.L.C. to waive, for a period of six months following the Merger, their rights to severance pay in the event that they terminate employment during that period. These individuals also have agreed to invest in the Company following completion of the Merger.

      Additionally, on December 19, 2005, the Company and American Stock Transfer & Trust Company, as Rights Agent, entered into an amendment (the “Rights Agreement Amendment”) to the Rights Agreement, dated as of September 28, 1998 (the “Rights Agreement”). The Rights Agreement Amendment provides that none of the execution, delivery or performance of the Merger Agreement, the consummation of the Merger or any of the other transactions contemplated by and pursuant to the Merger Agreement will trigger the separation or exercise of the stockholder rights or any adverse event under the Rights Agreement. In particular, none of Parent, Merger Sub or any of their affiliates shall be deemed to be an Acquiring Person (as defined in the Rights Agreement) solely by virtue of the execution, delivery or performance of the Merger Agreement or the consummation of the Merger or any of the other transactions contemplated by and pursuant to the Merger Agreement. The Rights Agreement Amendment also provides that the Rights Agreement will terminate immediately prior to the effective time of the Merger.

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 our 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.

      We also reached an agreement with its primary PegasusCentral customer, InterContinental Hotel Group (“IHG”), to discontinue the use of PegasusCentral. The transition of IHG properties off of Pegasus Central is substantially complete, and there will be no new installations. The decision to exit the PMS business was made considering the termination of the IHG agreement, the overall expected profitability of the remaining PMS operations, and the strategic alternative process announced in April 2005.

      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 December 31, 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, we 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 Consolidated Statements of Operations and Comprehensive Income (Loss) as discontinued operations, net of tax. Assets held for sale of approximately $1.0 million are included in other noncurrent assets in the Consolidated Balance Sheet as of December 31, 2005. The Company 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%. We recorded a gain on the sale of approximately $371,000 in the fourth quarter of

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Revenues

      Our business and particularly our revenues are sensitive to changes in the demand for, and average daily rates associated with, hotel rooms. Our distribution and reservation services revenues are primarily attributable to transaction-based activities, while our representation and financial services revenues are based in large part on a combination of reservation volume and average daily rates. Our revenues are dependent on new contracts, and we have experienced a lengthening in the sales and implementation cycle for some of our services.

      Representation Services. We offer a variety of hotel representation services to independent hotels and small hotel groups through our Utell by Pegasus and Unirez by Pegasus services. Representation services revenues primarily consist of reservation processing fees, membership fees and fees for various marketing services. Representation services revenues represented approximately 42 percent of service revenues for 2005.

      Reservation Services. We provide CRS services on an ASP basis. Reservation services revenues consist of transaction fees as well as maintenance, voice services, and support fees related to our RezView CRS software. Reservation services revenues represented approximately 21 percent of service revenues for 2005.

      Financial Services. Our financial services provide comprehensive commission processing and payment solutions to hotels, other travel suppliers and travel agencies. Financial services revenues consist of both travel agency and hotel fees. Travel agency fees are based on a percentage of the value of hotel commissions processed by us on behalf of participating travel agencies. Revenues from travel agency fees can vary substantially from period to period based on the demand for hotel rooms, the types of hotels (such as upscale or economy) at which reservations are made and fluctuations in overall room rates and foreign currency exchange rates. In addition, some participating hotels generally pay fees based on the number of commissionable transactions that Pegasus processes for the hotel. Financial services revenues represented approximately 20 percent of service revenues for 2005.

      Distribution Services. Our distribution services provide the connections and interfaces that enable hotels to distribute their rates and inventory to — and receive reservations from — the four GDSs used by travel agencies worldwide, a growing number of tour operators, wholesalers, and a variety of Internet sites Powered by Pegasus. Distribution services revenues primarily consist of transaction fees, commissions and monthly subscription or maintenance fees. In addition, new hotel customers typically pay a one-time fee for establishing the connection between the hotel’s central reservation system and the electronic distribution technology. New third-party Internet site customers typically pay a one-time fee for establishing the connection between the third-party Internet site and our electronic distribution technology, which is amortized over the related contract period. Distribution services revenues represented approximately 17 percent of service revenues for 2005.

      Other Services. Pegasus regularly seeks to develop new services to capitalize on its existing technology and customer base and to provide additional electronic hotel reservation capabilities and information services to its existing customers and to other participants in the travel distribution process. Pegasus has not received a material amount of revenue from these services, and we cannot assure you that any of these services will produce a material amount of revenue in the future.

      Customer Reimbursements. Revenues applicable to customer reimbursements are primarily related to GDS fees that we pay on behalf of and subsequently bill our customers. In the future, if our customers decide to pay these vendors directly, our customer reimbursements revenue and customer reimbursements cost of services will decrease accordingly. Pegasus’ billings for out-of-pocket expenses, such as third-party vendor GDS and telecommunication charges, are classified as customer reimbursements, which is a component of total revenues, and the related costs are classified as customer reimbursements, which is a component of total costs of services.

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Costs

      Our costs of services, which exclude depreciation and amortization, consist principally of personnel costs relating to information technology; customer service and telemarketing; facilities; and equipment maintenance costs. Costs of services also include the cost of customer reimbursements and certain incentive-based payments. We make incentive-based payments to some demand generators, including third-party Internet sites, because they provide us with access to higher transaction volumes for our services than we could reach otherwise. We also make incentive-based payments to some hotels because they generate high commission volumes for our financial services. These incentive-based payments are generally either based on transaction volumes that are expensed as incurred or consist of lump sum payments that are accounted for as an asset and expensed over the contract term.

      Research and development costs consist principally of personnel costs, related overhead costs and fees paid to outside consultants. General and administrative expenses are primarily personnel, legal and accounting-related, bad debt and certain facilities costs. Marketing and promotion expenses consist primarily of personnel costs, advertising, public relations and participation in trade shows and other industry events. Depreciation and amortization expense includes depreciation of computer equipment, office furniture, office equipment and leasehold improvements, as well as amortization of software and intangible assets.

      Interest income primarily includes income earned on the Company’s investments. Interest expense primarily includes interest and amortization of capitalized issuance costs related to the $75 million convertible debt offering.

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 in expenses than we otherwise might have earned or spent if currency exchange rates had remained stable.

Years Ended December 31, 2005 and 2004

      Overview. During 2005, we experienced a decline in revenues, primarily due to lower pricing on new and renewal contracts. This primarily stemmed from delays in developing new technology and enhancements to our existing technology, increased competition from lower-cost competitors, and hotel and travel agency consolidations. We believe this trend has stabilized. Our operating costs remained consistent year over year, with the benefits of tight control over discretionary spending being offset by investments in marketing and sales and expenditures related to our strategic alternative initiative.

      We made a decision during 2005 to exit the PMS business by selling these operations, which included the PegasusCentral PMS and two other private-label property management products, Guestview and NovaPlus, that support both hotel chains and independent customers. The decision to exit the PMS business was made considering the termination of the agreement with our primary PegasusCentral customer, IHG, and the overall expected profitability of the remaining PMS operations.

      Other significant developments include the following:

	•	We launched weekly commission processing during the first quarter. 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 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.

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	•	We have delivered a new release of our internet booking engine, Netbooker, and a new rate tracking service, and have established a strategic relationship with Open Hospitality for Web services.
	•	We initiated transactions using our new PegsTour service.

      Operating Trends. The following 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, PegsTourTM, 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.
	•	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 late in the first quarter of 2006. For the year ended December 31, 2005, this hotel participant represented approximately 19 percent of our financial services revenues, and we paid them approximately $1.1 million in incentive payments, which are recorded in cost of services.
	•	We experienced a year-over-year decline in our revenues.

      Positive operating trends include:

	•	We have increased our speed in providing new technologies and enhancements to our products.
	•	Average daily room rates (“ADR”) are improving.
	•	We believe the trend of lower pricing on new contracts and contract renewals has begun to stabilize and is not expected to erode future revenues.
	•	Pricing for Internet distribution is increasing.

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	•	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.

      Revenues. The table and discussion below address revenue by service line for the years ended December 31, 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 2 percent increase in ADR for our Utell by Pegasus offering was offset by a decrease in reservation volumes and the average commission earned percentage. The average commission earned stabilized in the latter months of 2005.

      Reservation services revenues decreased primarily due to the effects of pricing pressure on contract renewals from late 2004 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.

      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 in March 2005. 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 2005 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 2005. Offsetting the first quarter 2005 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 in 2005 were consistent with 2004. Improved pricing on premium channel Internet transactions and a 9 percent increase in GDS transactions was offset by a slight decrease in the number of Internet transactions. The decrease in Internet transactions reflects the trend of large customers operating their own 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.

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      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 year ended December 31, 2005 compared to the year ended December 31, 2004 (dollars in thousands).

      Overall, operating expenses for the year ended December 31, 2005 were flat compared to the prior year. The following factors contributed most significantly to the year over year fluctuations in the operating expense line items:

	•	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 $1.3 million of severance and lease termination costs incurred during 2005;
	•	Headcount and employee-related expenses were lower year-over-year;
	•	All variable operating costs were carefully managed in 2005;
	•	We incurred costs of $1.6 million in 2005 related to the strategic alternatives initiative, $1.3 million of which is included in general and administrative expenses; and
	•	Marketing and promotion expenses increased as we remain committed to sales and marketing efforts, including the launch of hotelbook.com and promotional activities related to our representation services.

      Cost of services expenses, excluding customer reimbursements, in 2004 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 2005. The remainder of the decrease is due to lower customer incentives, communications expenses, and processing costs, commensurate with the decrease in revenues and cost-saving initiatives. Cost of services, excluding customer reimbursements, as a percentage of service revenues were 51 percent in 2005 and 2004.

      Customer reimbursements in 2005 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 in both 2005 and 2004.

      General and administrative expenses in 2005 decreased primarily due to lower third-party costs incurred, primarily related to tax and audit professional services, and prior year severance and related costs of $465,000 for the first quarter 2004 strategic change in our information technology organization. These decreases were partially offset by costs of $1.3 million in 2005 related to the strategic alternatives initiative, $378,000 of costs related to the closing of an office, and a prior year curtailment gain of $162,000 for the Supplemental

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      Marketing and promotion expenses in 2005 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 12 percent in 2005 and 2004, respectively.

      Depreciation and amortization in 2005 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 $921,000 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 income. Interest income in 2005 increased from $1.1 million to $1.6 million compared to 2004, due to higher interest rates and higher cash balances.

      Interest expense. Interest expense in 2005 decreased from $3.0 million to $2.9 million compared to 2004 due to higher capitalization of interest related to our software development efforts.

      Income tax expense. Pegasus recorded income tax expense on continuing operations of $3.2 million and $8.0 million in 2005 and 2004, respectively, reflecting effective rates of 38 percent for 2005 and 39 percent for 2004. 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.

      Discontinued operations. In June 2005, the Board of Directors of the Company approved and committed to a formal plan to exit the 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, IHG, to discontinue the use of PegasusCentral. For further information regarding discontinued operations, please see Note 3 to the Consolidated Financial Statements.

Years Ended December 31, 2004 and 2003

      Overview. After several difficult years for the hotel industry, the year ended December 31, 2004 showed gradual but steady recovery in both reservation volumes and ADR. Pegasus benefited from both the improved economic and industry environments as well as the December 2003 strategic acquisition of Unirez, Inc. Strength in foreign currencies, particularly the euro and the British pound, also favorably impacted Pegasus. Offsetting these benefits, increased competition resulted in reduced pricing on contract renewals and new business. In addition, an increase in the percentage of Internet reservations made at hotel chain Internet sites versus third-party Internet sites negatively impacted our distribution services revenues.

      Due to the improved operating environment, we increased discretionary spending in 2004 with a focus on customer satisfaction, sales, marketing, product development and employee retention activities intended to promote long-term growth. We also incurred additional expenses related to compliance with the Sarbanes-Oxley Act of 2002.

      Organizationally, we made leadership changes in key functions during 2004, particularly our information technology and product management groups. We also established or enhanced processes throughout the company with the goal of expediting the time to market on new products and improving customer satisfaction. During this transition period, we still met our earnings goals and made significant progress on product development priorities established at the beginning of the year.

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      Revenues. The table and discussion below address revenue by service line for the years ended December 31, 2004 and 2003 (dollars in thousands).

      Representation services revenues increased primarily due to the results of operations of Unirez by Pegasus, which was acquired December 1, 2003 and contributed $14.7 million to revenues in 2004, compared to $874,000 in 2003. Utell by Pegasus revenues increased $586,000, or 1 percent, over 2003 due to a 4 percent increase in reservations and a 9 percent increase in ADR. The improved ADR reflects a strong euro and British pound, which contributed $3.9 million to the increase in representation service revenues. Partially offsetting this increase was a decrease in Utell by Pegasus membership fees due to fewer hotels in the portfolio, and a 6 percent decrease in the average commission percentage earned, resulting from lower pricing on new contracts and contract renewals, as expected, arising out of increased competition from lower-cost competitors.

      Reservation services revenues decreased primarily due to lower per unit pricing on contract renewals, despite a 6 percent increase in net transactions processed. Excluding carryover revenue in early 2003 from three previously terminated contracts, reservation service revenues increased 2 percent over prior year.

      Financial services revenues increased primarily as a result of a 7 percent increase in gross commissions processed and due to improved ADR and the trend of processing more foreign currency payments, which earn additional fees.

      Distribution services revenues decreased despite a 10 percent increase in GDS transactions and a flat number of Internet transactions. Internet transaction volumes reflect an increase in the percentage of Internet bookings made at hotel companies’ proprietary Internet sites; these transactions do not utilize Pegasus’ Internet distribution services. In addition, the decrease in revenue was primarily due to the loss of Unirez as a distribution services customer, which provided $1.5 million in revenue in 2003, reduced pricing on Travelweb transactions, and a decrease in revenue per transaction. In conjunction with Priceline’s acquisition of Travelweb, we extended terms of the services contract, but with lower pricing.

      Customer reimbursements increased primarily due to operations of our new Unirez by Pegasus representation service and an overall increase in our customers’ GDS costs because of an increase in GDS transactions.

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      Operating Expenses. The table and discussion below address operating expenses for the year ended December 31, 2004 compared to the year ended December 31, 2003 (dollars in thousands).

      Operating expenses increased slightly in 2004 compared to 2003, as expected. The increase primarily related to the following:

	•	The addition of Unirez by Pegasus operations;
	•	An increase in the number of and rates for incentive-based payments to third parties, as well as an increase in transaction volume;
	•	An increase in employee related expenses due to merit increases and bonuses in 2004;
	•	An increase in sales and marketing efforts with a focus on increasing revenues and improving customer satisfaction; and
	•	An increase in audit fees and other internal and external costs associated with the internal control requirements of the Sarbanes-Oxley Act of 2002.

      These expense increases were partially offset by the absence of restructure costs in 2004.

      Cost of services, excluding customer reimbursements, increased primarily due to $3.6 million in added expenses for our Unirez by Pegasus representation service; $1.9 million of severance and related costs incurred in the first quarter of 2004 related to a strategic change in the Company’s information technology organization; a $1.4 million increase in incentive based payments to third parties because of new contracts and increases in transaction volumes and rates; and $1.2 million in increased consulting costs for IT initiatives. Cost of services, excluding customer reimbursements, as a percentage of service revenues were 51 percent and 52 percent in 2004 and 2003, respectively.

      Customer reimbursements increased primarily due to operations of our new Unirez by Pegasus representation service and an overall increase in our customers’ GDS costs because of an increase in GDS transactions.

      Research and development expenses decreased in 2004 compared to 2003 primarily due to cost savings realized from the 2003 restructuring, slightly offset by $593,000 in additional expenses related to the Unirez acquisition. Research and development expenses as a percentage of service revenues were 2 percent and 3 percent in 2004 and 2003, respectively.

      General and administrative expenses increased slightly primarily due to $715,000 of bad debt expense in 2004, as compared to zero in 2003, $465,000 in severance and related costs incurred in the first quarter of 2004 related to a strategic change in the Company’s IT organization, $217,000 in added expenses of Unirez by Pegasus, and an increase of approximately $900,000 for audit and other fees related to the internal control requirements of the Sarbanes-Oxley Act. These increases were partially offset by a decrease in payroll related expenses and benefit plan costs because of decreased headcount in 2004. General and administrative expenses as a percentage of service revenues were 14 percent and 15 percent in 2004 and 2003, respectively.

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      Marketing and promotion expenses increased due primarily to increased personnel costs arising from Unirez by Pegasus, a greater focus on marketing and promotion activities, and the cost of a new sales incentive compensation program launched in January 2004. Marketing and promotion expenses as a percentage of service revenues were 12 percent and 11 percent in 2004 and 2003, respectively.

      Depreciation and amortization expenses decreased primarily because certain intangible assets related to the REZ acquisition were fully amortized in March 2003. This was partially offset by a $2.1 million increase in amortization expense related to intangible assets from the December 2003 Unirez acquisition.

      During 2003, the company incurred restructuring charges of $5.9 million, related to the reorganization of its operations from a business unit structure into distinct functional areas.

      Interest income. Interest income earned on the company’s investments decreased by $310,000 in 2004 compared to 2003 as the Company’s funds available for investment decreased in conjunction with the stock repurchase plan cash outlays of $55.7 million in 2004.

      Interest expense. Interest expense increased by $1.4 million compared to 2003 primarily related to interest and amortization of capitalized debt issuance costs for the July 2003 convertible debt offering.

      Gain on sale. On May 3, 2004, Pegasus sold its interest in Travelweb, LLC to an affiliate of Priceline.com, Inc. (“Priceline”) and received $4.2 million in cash, recognizing a gain of approximately $2.0 million. The sale agreement contained a contingent earn-out valued at approximately $4.7 million; however, the required conditions to receive the shares of Priceline common stock on the one-year anniversary of the Closing Date were not met.

      Income tax expense. Pegasus recorded income tax expense on continuing operations of $8.0 million and $622,000 in 2004 and 2003, respectively, representing effective tax rates of 39 percent for 2004 and 54 percent for 2003. The effective tax rate for 2004 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.

      Discontinued operations. In June 2005, the Board of Directors of the Company approved and committed to a formal plan to exit the 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, IHG, to discontinue the use of PegasusCentral. For further information regarding discontinued operations, please see Note 3 to the 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 proceeds from equity and debt offerings 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 sources of capital during 2005 included cash and cash equivalents, which totaled $32.3 million at year end, and auction rate securities, which totaled $5.7 million at year end. Our cash flows from operations of $30.6 million included $5.8 million related to our commission processing service and were sufficient to provide for working capital requirements. Other sources of cash during 2005 were $7.1 million net proceeds from the sale or maturity of marketable securities and $1.5 million of proceeds from stock option exercises. Additionally, 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

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      Cash outlays in 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. During 2004, we repurchased approximately 4.7 million shares of common stock for $55.7 million.

      Another component of our cash outlays included capital expenditures of $19.9 million consistent with our capital strategy of investing in software development projects meeting our return on investment criteria. In 2005, $17.4 million of the capital expenditures related to continuing operations and $2.5 million related to discontinued operations. 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 2006 capital expenditures will total approximately $15 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.

      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
	•	Completion of the merger under the Merger Agreement and related financing

      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. If the merger transaction is not completed, we may in the future 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.

      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.

     Convertible debt

      On July 21, 2003, Pegasus issued $75 million aggregate principal amount of convertible senior notes through a private placement. Pegasus utilized a portion of the proceeds of the offering to effect the December 1, 2003 acquisition of Unirez. Pegasus expects to use the remaining net proceeds from the offering for working capital and other general corporate purposes, including stock repurchases.

      The notes bear interest at an annual rate of 3.875 percent, payable semi-annually through the maturity date of July 15, 2023. Each note is convertible into Pegasus’ common stock at a conversion price of approximately $20.13 per share (equal to an initial conversion rate of approximately 49.6808 shares per $1,000 principal amount of notes), subject to adjustment in certain circumstances. Holders of the notes may convert

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      Pegasus may redeem all or some of the notes for cash at any time on or after July 15, 2008, at a redemption price equal to the principal amount of the notes plus any accrued and unpaid interest to the redemption date. As noted above, holders may require us to purchase the notes on July 16 of 2008, 2013 and 2018, or in other specified circumstances, at a purchase price equal to the principal amount due plus any accrued and unpaid interest to the purchase date and additional amounts, if any.

      If a fundamental change occurs, as defined in the indenture relating to the convertible notes, each holder of the convertible notes may require that we purchase that holder’s notes. The merger contemplated by the Merger Agreement constitutes such a fundamental change, and the debt financing anticipated in connection with the Merger Agreement contemplates the repayment of the amounts owing under the convertible notes.

     Off-balance sheet arrangements and contractual obligations

      Pegasus currently has no off-balance sheet financing arrangements.

      The following table identifies material future contractual cash obligations of the Company as of December 31, 2005. Operating leases represent our cash obligations associated with agreements to use equipment or facilities that are enforceable and legally binding for fixed terms. Purchase obligations include cash obligations associated with agreements to purchase services or equipment that are enforceable and legally binding for fixed terms, or estimated cash obligations for agreements with variable pricing provisions. Convertible debt represents scheduled principal and interest payments for the Company’s July 2003 convertible debt offering, described above. Other long-term liabilities include commission checks to be refunded to hotels, as well as Pegasus’ estimated cash obligations associated with funding its employee retirement plans.

      In addition to the contractual obligations included in the table above, we also have funding requirements related to our Executive Retirement Program and a United Kingdom defined benefit plan, which is open to certain employees who were part of the Reed Elsevier Pension Scheme in December 1997. Pursuant to their employment agreements, certain company officers are eligible to participate in the Executive Retirement Program, consisting of (1) the Supplemental Executive Retirement Plan (the “SERP”), as amended, 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 (2) the Pegasus Solutions, Inc. Executive Deferred Compensation Plan (the “DCP”), as amended, a defined contribution plan that provides supplemental retirement benefits to certain management employees of the Company. Commencing in 2003, we are obligated to make annual cash payments to a trust associated with benefits earned under the Executive Retirement Program. The amounts funded to the trust may be available to creditors of the Company, but are generally not available for use in our ongoing operations. Subsequent to year end 2005, the Company made payments to the trust of $310,000 related to the SERP and $256,000 related to the DCP in connection with benefits earned in 2005. Also subsequent to year end 2005, the Company made SERP benefit payments of $340,000 to an executive who terminated participation in the SERP in 2004 using funds outside of the trust.

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      We expect that contributions to the United Kingdom defined benefit plan in 2006 will total approximately $167,000.

Inflation

      Pegasus does not believe that inflation has materially impacted results of operations during the past three years. Substantial increases in costs and expenses could have a significant impact on its results of operations to the extent such increases are not passed along to customers.

Critical Accounting Policies and Estimates

      Preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and judgments that affect the reported financial position and results of operations during the reporting period. Our estimates and judgments are continually evaluated based on available information and experience. Because the use of estimates is inherent in the financial reporting process, actual results could differ from estimates. If there is a significant unfavorable change to current conditions, it will likely result in a material adverse impact to our business, operating results and financial condition.

      Certain accounting policies require higher degrees of judgment than others in their application. Pegasus considers the following to be critical accounting policies due to the estimation processes involved in each. For a detailed discussion of Pegasus’ significant accounting policies, including recently issued accounting standards, see Note 1 to the Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K.

      Our senior management has discussed the development and selection of these critical accounting policies and estimates, and this related disclosure in this report, with our Audit Committee.

     Accounts and notes receivables

      As of December 31, 2005, Pegasus had accounts receivable as a result of its ongoing operations of approximately $26.7 million. Additionally, we have notes receivable totaling $6.3 million at December 31, 2005, related to the sale of business units. These receivables are monitored by management for collectibility. Pegasus maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. These estimates of losses require judgments that are based on available information and experience, such as the payment histories and known financial conditions of the parties. These estimates are significant because Pegasus may incur additional expense to increase its allowance for doubtful accounts and may receive less cash than expected if the financial condition of the parties was to deteriorate, resulting in an impairment of their ability to make payments. Pegasus’ allowances for doubtful accounts and notes receivable totaled approximately $3.9 million as of December 31, 2005.

     Impairment of long-lived assets, including goodwill

      As of December 31, 2005, Pegasus has goodwill totaling approximately $163.2 million related to its acquisitions of REZ, Inc. (“REZ”) in 2000, Global Enterprise Technology Solutions, LLC (“GETS”) in 2001 and Unirez, Inc. (“Unirez”) in 2003. Under the guidance of SFAS 142, goodwill is analyzed for impairment at least annually. This analysis requires significant estimates and judgments by management, involving the carrying value and the estimated fair value of the Company. Because Pegasus operates as a single reportable unit, the company performs its analysis using market capitalization as fair value. While the most recent periodic impairment analysis performed as of September 30, 2005 indicated that no impairment of

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      As of December 31, 2005, Pegasus has unamortized capitalized software costs totaling $40.9 million, which we review periodically for impairment as triggering events occur. This impairment analysis requires the comparison of unamortized carrying values to estimated net realizable values. The estimated net realizable value is based on significant judgments such as estimated future cash flows from the related services, or expected benefits of the software and is based on available information and experience. See Note 3 for information regarding impairment charges related to discontinued operations in 2005.

      We are in the development phase of an automated system that represents the next generation of our financial services offering that will provide hoteliers the ability to customize their commission payment process options across multiple travel agency segments and access real-time and specialized reporting through a customer service portal. The enhancements to this product are designed to add significant functionality to hoteliers. 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 the outcome of the development alternatives and methodologies are not expected to be concluded until after the close of the merger transaction. The carrying value of this technology is $8.4 million as of December 31, 2005. Because this system represents the next generation of our current financial services operations, which generates revenues of over $30 million per year, we believe no impairment exists as of December 31, 2005. However, 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.

     Employee benefit plans

      Pegasus sponsors defined benefit plans for certain employees, including the SERP in the United States and a United Kingdom plan open only to employees who were part of the Reed Elsevier Pension Scheme in December 1997 (the “Utell Defined Benefit Plan”). Our employee pension costs and obligations are dependent upon our assumptions used by actuaries in calculating such amounts. These assumptions include salary growth, long-term return on plan assets, discount rates and other factors. The salary growth assumptions are either stated in the plan or reflect our long-term actual experience and future and near-term outlook. The long-term return on plan assets for the Utell Defined Benefit Plan, which is a funded plan, is determined based on expected returns as of the accounting date, primarily based on equities which comprise the majority of assets in the plan. Expected returns on equity plan assets were determined to range between 6% and 9%. Specific to the Utell Defined Benefit Plan, which is a funded plan, a one percent change in expected returns on plan assets would result in a $125,000 change to Pegasus’ annual expense associated with this plan. The assumed discount rate for determining obligations for the SERP is determined in reference to high quality corporate bonds available in the market as of December 31, 2005 (by reference to the Citigroup Corporate High Quality Yield curve) and by determining the net effective rate equivalent to discounting each future benefit payment by the spot rate for that year. The assumed discount rate for the Utell Defined Benefit Plan is determined in reference to the annualized yield on a 15-year AA rated corporate bond (by reference to the iBoxx). Actual results that differ from our assumptions are accumulated and amortized over the future working life of the plan participants. While we believe that the assumptions used are appropriate, significant differences in actual experience or significant changes in assumptions would affect our pension costs and obligations.

      Although realization is not assured, we have concluded that it is more likely than not that the deferred tax assets at December 31, 2005, for which a valuation allowance was determined to be unnecessary, will be realized in the ordinary course of operations based on the available positive and negative evidence, primarily our projected earnings. The amount of the net deferred tax assets are considered realizable, however, they

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      We will continue to assess the assumptions used to determine the need for a valuation allowance. Should we determine that we would not be able to realize all or part of our components of the deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to earnings in the period such determination were made.

     Stock–Based Compensation

      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. The requirements of SFAS 123R are effective for the Company’s first quarter beginning January 1, 2006. The Company intends to use the modified prospective transition method of adoption. Although the Company continues to evaluate SFAS 123R to determine the impact on its consolidated financial statements, SFAS 123R is expected to have a negative effect on consolidated net income. In 2005, the Company did not issue stock options to a large number of employees through a broad-based stock option grant. Since the 2005 stock option grants were significantly lower than preceding years and no determination has been made in regards to future year grants, the Company is unable to fully project future SFAS 123R stock-based compensation expense. However, stock-based compensation expense for 2006, without taking into account the completion of the merger under the Merger Agreement, will at a minimum approximate $1.9 million, net of tax. The accounting treatment for the Company’s restricted stock awards will not change upon adoption of SFAS 123R and has not been significant. No determination has been made regarding future stock-based compensation awards.

      At the effective time of the merger under the Merger Agreement, if any, each outstanding stock option, whether or not vested or exercisable, will terminate and thereafter represent the right to receive an amount in cash, without interest and less applicable tax withholding, equal to the number of shares of our common stock subject to each option as of the effective time of the merger, multiplied by the excess, if any, of $9.50 over the exercise price per share of common stock subject to such option. As of December 31, 2005, there were 420,475 stock options outstanding with an exercise price of less than $9.50 outstanding and a weighted-average exercise price of $7.62. Also at the effective time of the merger under the Merger Agreement, if any, each restricted stock award (38,875 shares of restricted stock were outstanding on December 31, 2005) granted under the Plans will be converted into the right to receive $9.50 in cash per share, without interest and less applicable tax withholding. From the date of the Merger Agreement date until completion of the merger under the Merger Agreement, if any, the Company has agreed, subject to certain exceptions and unless Prides gives its prior written consent, not to grant any equity or equity based awards.

Recently Issued Accounting Standards

      Additional information regarding recently issued accounting standards is included in Note 1 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.

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      Pegasus is exposed to certain market risks, including the effects of foreign currency exchange rate fluctuations, and uses derivative financial instrument contracts to manage foreign exchange risks. Pegasus has established a control environment that includes policies and procedures for risk assessment and the approval, reporting and monitoring of derivative financial instrument activities. Company policy prohibits holding or issuing derivative financial instruments for trading purposes. We do not currently utilize hedge accounting with regard to these derivatives.

      To reduce the impact of foreign exchange rate fluctuations on consolidated results of operations and future foreign currency denominated cash flows, Pegasus was a party to various forward exchange contracts at December 31, 2005. These contracts reduce exposure to currency movements affecting existing foreign currency denominated assets and liabilities, primarily trade receivables and payables.

      A summary of forward exchange contracts to sell or purchase foreign currencies in place as of December 31, 2005 is as follows (in thousands):

      All contracts included above matured no later than February 2006. Because of the short-term nature of these contracts, the fair value approximates the contract value. The difference between the fair value and contract value is included in the consolidated balance sheet as accounts receivable and was not material at December 31, 2005. Pegasus used similar forward exchange contracts and had either sell or purchase forward exchange contracts of a similarly short-term nature in place on December 31, 2004. As of December 31, 2004, Pegasus had approximately $22.6 million in sell forward exchange contracts and $4.6 million in purchase forward exchange contracts. Pegasus’ positions with respect to these forward exchange contracts differed as of December 31, 2005 compared to December 31, 2004 because of changes in Pegasus’ non-U.S. denominated trade payables and receivables. For more information on derivative financial instruments see Notes 1 and 8 to the consolidated financial statements included in Item 8 to this Annual Report on Form 10-K.

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Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders

      We have completed integrated audits of Pegasus Solutions, Inc.’s 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005, and an audit of its 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

Consolidated financial statements and financial statement schedule

      In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Pegasus Solutions, Inc. and its subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

      As discussed in Note 2 to the consolidated financial statements, the Company has entered into an Agreement and Plan of Merger, dated December 19, 2005, with an investment group affiliated with Prides Capital Partners, L.L.C. and Tudor Investment Corporation.

Internal control over financial reporting

      Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control — Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating

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      A company’s internal control over financial reporting is a process designed 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. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

      Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

PRICEWATERHOUSECOOPERS LLP

Dallas, Texas

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PEGASUS SOLUTIONS, INC.

CONSOLIDATED BALANCE SHEETS