**UNITED STATES SECURITIES ANDEXCHANGE COMMISSION**

 

**Washington, D.C. 20549**

 

**Form 10-Q**

 
| **(Mark One)**                                                                                                                                                                                                                                                              |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **ý**                                                                                                                                                                                                                                                                  | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                        |   |   |
| **For the quarterly period ended  September 30, 2005**                                                                                                                                                                                                                 |
|                                                                                                                                                                                                                                                                        |   |   |
| **or**                                                                                                                                                                                                                                                                      |
|                                                                                                                                                                                                                                                                        |   |   |
| **o**                                                                                                                                                                                                                                                                       | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                        |   |   |
| **For the transition period from                    to                    .** |

** **

**Commission File Number: 000-30700**

 

**Crown Media Holdings, Inc.**

(Exact Name of Registrant as Specified in ItsCharter)

 
| **Delaware**                                                     | ** ** | **84-1524410**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or Other Jurisdiction  of  Incorporation or Organization) |       | (I.R.S. Employer  Identification No.) |

 

**12700 Ventura Boulevard,**

**Suite 200**

**Studio City, California  91604**

(Address of Principal Executive Offices and ZipCode)

 

**(818) 755-2400**

(Registrant’s Telephone Number, Including AreaCode)

 

 

(Former Name, Former Address, and Former FiscalYear,

if Changed Since Last Report.)

 

Indicate by check markwhether the registrant:  (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.  Yes  ý     No o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inExchange Act Rule 12b-2).  Yes  ý     No o

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12 b-2 of theExchange Act). Yes ýNo o

 

As of November 2, 2005,the number of shares of Class A Common Stock, $.01 par value outstandingwas 74,054,524, and the number of shares of Class B Common Stock, $.01 parvalue, outstanding was 30,670,422.

 

 

----

 

**TABLE OF CONTENTS**

 
| **PART I**  | **Financial Information**                                                                                                    |   |
|------------------|------------------------------------------------------------------------------------------------------------------------------|--------|
|             |                                                                                                                         |   |
| Item 1           | Financial  Statements (Unaudited)                                                                                            |   |
|             | CROWN MEDIA  HOLDINGS, INC. AND SUBSIDIARIES                                                                                 |   |
|             | Condensed  Consolidated Balance Sheets – December 31, 2004 and September 30, 2005 (Unaudited)            |   |
|             | Condensed  Consolidated Statements of Operations and Comprehensive Loss (Unaudited)                                          |   |
|             | - Three and Nine  Months Ended September 30, 2004 and 2005  Condensed Consolidated Statements of Cash Flows (Unaudited) |   |
|             | - Nine Months Ended  September 30, 2004 and 2005  Notes to Unaudited Condensed Consolidated Financial Statements        |   |
|             |                                                                                                                         |   |
| Item  2          | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                  |   |
|             |                                                                                                                         |   |
| Item  3          | Quantitative  and Qualitative Disclosures About Market Risk                                                                  |   |
|             |                                                                                                                         |   |
| Item 4           | Controls  and Procedures                                                                                                     |   |
|             |                                                                                                                         |   |
| **PART II** | **Other  Information**                                                                                                       |   |
|             |                                                                                                                         |   |
| Item  2          | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                 |   |
|             |                                                                                                                         |   |
| Item  4          | Submission  of Matters to a Vote of Security Holders                                                                         |   |
|             |                                                                                                                         |   |
| Item 6           | Exhibits                                                                                                                     |   |
|             |                                                                                                                         |   |
| Signatures       |                                                                                                                         |   |

 

2

----

 

*In this Form 10-Q the terms “CrownMedia Holdings” or the “Company,” refer to Crown Media Holdings, Inc.  and, unless the context requires otherwise,subsidiaries of Crown Media Holdings that operate or have operated ourbusinesses, Crown Media United States, LLC (“Crown Media United States”), CrownMedia Distribution, LLC (“Crown Media Distribution”), and, until completion ofthe sale of our international business in April 2005, Crown MediaInternational, LLC (“Crown Media International”) and Crown EntertainmentLimited (“Crown Entertainment”). The term “common stock” refers to our Class Acommon stock and Class B common stock, unless the context requiresotherwise.*

 

*Thenames Hallmark, Hallmark Entertainment and other product or service names aretrademarks or registered trademarks of their owners.*

* *

**PART I. FINANCIAL INFORMATION**

 

**Item 1.  *Financial Statements (Unaudited)***

 

**CROWN MEDIA HOLDINGS, INC. ANDSUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED BALANCE SHEETS**

**(In thousands, except par valueand number of shares)**

 
| ** **                                                                                    | ** ** | **As of  December 31,  2004** | ** ** | **As of  September 30,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                    | ** ** | ** **                         | ** ** | ** **                          | ** ** |
| ASSETS                                                                                        |       |                               |       |                                |       |
|                                                                                          |       |                               |       |                                |       |
| Cash and cash equivalents                                                                     |       | $                                  | 12,102     |                                | $          | 9,365 |   |
| Accounts receivable, less allowance for doubtful accounts of $6,695 and  $3,235, respectively |       | 75,459                             |       | 54,726                              |       |
| Program license fees — affiliates                                                        |       | 40,048                             |       | 29,853                              |       |
| Program license fees — non-affiliates                                                    |       | 78,823                             |       | 60,387                              |       |
| Subtitling and dubbing, net                                                                   |       | 1,143                              |       | —                              |       |
| Receivable from affiliate                                                                     |       | 16,644                             |       | 23,190                              |       |
| Receivable from buyer of international business                                               |       | —                             |       | 1,928                               |       |
| Prepaid and other assets                                                                      |       | 13,887                             |       | 11,321                              |       |
| Total current assets                                                                          |       | 238,106                            |       | 190,770                             |       |
|                                                                                          |       |                               |       |                                |       |
| Accounts receivable                                                                           |       | 6,798                              |       | 14,746                              |       |
| Program license fees — affiliates                                                        |       | 59,987                             |       | 65,136                              |       |
| Program license fees — non-affiliates                                                    |       | 135,372                            |       | 141,971                             |       |
| Subtitling and dubbing                                                                        |       | 1,583                              |       | —                              |       |
| Film assets, net                                                                              |       | 599,013                            |       | 400,421                             |       |
| Subscriber acquisition fees, net                                                              |       | 120,013                            |       | 90,265                              |       |
| Property and equipment, net                                                                   |       | 32,829                             |       | 19,736                              |       |
| Goodwill                                                                                      |       | 314,033                            |       | 314,033                             |       |
| Prepaid and other assets                                                                      |       | 5,034                              |       | 12,893                              |       |
| Total assets                                                                                  |       | $                                  | 1,512,768  |                                | $          | 1,249,971 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

3

----

 
| ** **                                                                                                                                                                                                         | ** ** | **As of  December 31,  2004** | ** ** | **As of  September 30,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                                                                                                         | ** ** | ** **                         | ** ** | ** **                          | ** ** |
| LIABILITIES AND STOCKHOLDERS’  EQUITY (DEFICIT)                                                                                                                                                               |       |                               |       |                                |       |
|                                                                                                                                                                                                               |       |                               |       |                                |       |
| LIABILITIES:                                                                                                                                                                                                       |       |                               |       |                                |       |
| Accounts payable and accrued  expenses                                                                                                                                                                             |       | $                                  | 40,228     |                                | $          | 20,534 |   |
| Liability for restricted stock  units                                                                                                                                                                              |       | 13,649                             |       | 9,312                               |       |
| Subscriber acquisition fees  payable                                                                                                                                                                               |       | 35,223                             |       | 12,028                              |       |
| License fees payable to  affiliates                                                                                                                                                                                |       | —                             |       | 1,453                               |       |
| License fees payable to  non-affiliates                                                                                                                                                                            |       | 79,815                             |       | 65,907                              |       |
| Payables to affiliates                                                                                                                                                                                             |       | 13,512                             |       | 15,892                              |       |
| Payables to buyer of  international business                                                                                                                                                                       |       | —                             |       | 7,956                               |       |
| Credit facility and interest  payable                                                                                                                                                                              |       | 479                                |       | 180,172                             |       |
| Capital lease obligations                                                                                                                                                                                          |       | 2,276                              |       | 598                                 |       |
| Deferred revenue                                                                                                                                                                                                   |       | 612                                |       | 1,076                               |       |
| Deferred credit from technical  services agreement                                                                                                                                                                 |       | —                             |       | 1,323                               |       |
| Total current liabilities                                                                                                                                                                                          |       | 185,794                            |       | 316,251                             |       |
|                                                                                                                                                                                                               |       |                               |       |                                |       |
| Accrued expenses                                                                                                                                                                                                   |       | 21,617                             |       | 23,766                              |       |
| Subscriber acquisition fees  payable                                                                                                                                                                               |       | 678                                |       | —                              |       |
| License fees payable to  affiliates                                                                                                                                                                                |       | 151,980                            |       | 146,414                             |       |
| License fees payable to  non-affiliates                                                                                                                                                                            |       | 111,761                            |       | 129,920                             |       |
| Line of credit and interest  payable to HC Crown                                                                                                                                                                   |       | 81,067                             |       | 85,976                              |       |
| Payable to Hallmark  Entertainment affiliates                                                                                                                                                                      |       | 100,000                            |       | 70,000                              |       |
| Payable to buyer of  international business                                                                                                                                                                        |       | —                             |       | 9,254                               |       |
| Senior unsecured note to HC  Crown, including accrued interest                                                                                                                                                     |       | 460,930                            |       | 496,868                             |       |
| Credit facility                                                                                                                                                                                                    |       | 310,000                            |       | —                              |       |
| Capital lease obligations                                                                                                                                                                                          |       | 22,817                             |       | 16,329                              |       |
| Company obligated mandatorily  redeemable preferred interest                                                                                                                                                       |       | 11,488                             |       | 13,668                              |       |
| Deferred credit from technical  services agreement                                                                                                                                                                 |       | —                             |       | 5,500                               |       |
| Total liabilities                                                                                                                                                                                                  |       | 1,458,132                          |       | 1,313,946                           |       |
| Commitments and contingencies                                                                                                                                                                                      |       |                               |       |                                |       |
| STOCKHOLDERS’ EQUITY  (DEFICIT):                                                                                                                                                                              |       |                               |       |                                |       |
| Class A common stock, $.01 par value; 200,000,000 shares  authorized; 73,863,037 shares and 74,053,621 shares issued and outstanding as  of December 31, 2004, and September 30, 2005, respectively |       | 739                                |       | 741                                 |       |
| Class B common stock, $.01 par value; 120,000,000 shares authorized;  30,670,422 shares issued and outstanding as of December 31, 2004, and  September 30, 2005                                     |       | 307                                |       | 307                                 |       |
| Additional paid-in capital                                                                                                                                                                                         |       | 1,365,450                          |       | 1,423,255                           |       |
| Accumulated other  comprehensive income                                                                                                                                                                            |       | 3,434                              |       | —                              |       |
| Accumulated deficit                                                                                                                                                                                                |       | (1,315,294                         | )          | (1,488,278                          | )          |
| Total stockholders’ equity (deficit)                                                                                                                                                                          |       | 54,636                             |       | (63,975                             | )          |
| Total liabilities and stockholders’ equity (deficit)                                                                                                                                                          |       | $                                  | 1,512,768  |                                | $          | 1,249,971 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

4

----

 

**CROWN MEDIA HOLDINGS, INC. ANDSUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS ANDCOMPREHENSIVE LOSS**

**(In thousands, except per sharedata)**

 
| ** **                                                                                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2004**                                   | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                                                                      | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                                                                                        |       |                                       |       |                                      |       |   |   |   |   |
| Subscriber fees                                                                                 |       | $                                          | 2,398      |                                      | $          | 4,554 |   | $ | 7,285 |   | $ | 13,357 |   |
| Advertising                                                                                     |       | 24,305                                     |       | 33,275                                    |       | 73,706 |   | 104,243 |   |
| Advertising by Hallmark Cards                                                                   |       | 256                                        |       | 285                                       |       | 1,050 |   | 1,310 |   |
| Film asset license fees                                                                         |       | 4,336                                      |       | 2,102                                     |       | 12,589 |   | 7,354 |   |
| Sublicense fees and other revenue                                                               |       | —                                     |       | 10,454                                    |       | — |   | 10,667 |   |
| Total revenue, net                                                                              |       | 31,295                                     |       | 50,670                                    |       | 94,630 |   | 136,931 |   |
| Cost of Services:                                                                               |       |                                       |       |                                      |       |   |   |   |   |
| Programming costs:                                                                              |       |                                       |       |                                      |       |   |   |   |   |
| Affiliates                                                                                      |       | 7,947                                      |       | 10,574                                    |       | 23,182 |   | 30,667 |   |
| Non-affiliates                                                                                  |       | 13,689                                     |       | 18,622                                    |       | 37,530 |   | 54,964 |   |
| Amortization of film assets                                                                     |       | 3,865                                      |       | 13,830                                    |       | 12,542 |   | 33,175 |   |
| Impairment of film assets                                                                       |       | 19,321                                     |       | 22,939                                    |       | 19,321 |   | 22,939 |   |
| Subscriber acquisition fee amortization expense                                                 |       | 6,780                                      |       | 8,688                                     |       | 18,355 |   | 26,891 |   |
| Other cost of services                                                                          |       | 2,953                                      |       | 3,212                                     |       | 7,126 |   | 9,738 |   |
| Total cost of services                                                                          |       | 54,555                                     |       | 77,865                                    |       | 118,056 |   | 178,374 |   |
| Selling, general and  administrative expense                                                    |       | 13,096                                     |       | 15,837                                    |       | 36,203 |   | 42,608 |   |
| Marketing expense                                                                               |       | 912                                        |       | 1,832                                     |       | 11,248 |   | 19,082 |   |
| Depreciation and amortization  expense                                                          |       | 1,531                                      |       | 993                                       |       | 4,842 |   | 3,525 |   |
| Loss from continuing operations before interest  expense and income tax provision          |       | (38,799                                    | )          | (45,857                                   | )          | (75,719 | ) | (106,658 | ) |
| Interest expense                                                                                |       | (15,140                                    | )          | (19,346                                   | )          | (43,751 | ) | (53,686 | ) |
| Loss from continuing operations before income tax provision                                     |       | (53,939                                    | )          | (65,203                                   | )          | (119,470 | ) | (160,344 | ) |
| Income tax provision                                                                            |       | —                                     |       | (4                                        | )          | — |   | (10 | ) |
| Loss from continuing operations                                                                 |       | (53,939                                    | )          | (65,207                                   | )          | (119,470 | ) | (160,354 | ) |
| Loss from discontinued  operations, net of tax                                                  |       | (51,823                                    | )          | —                                    |       | (68,355 | ) | (10,666 | ) |
| Loss from sale of discontinued  operations, net of tax                                          |       | —                                     |       | (615                                      | )          | — |   | (1,964 | ) |
| Net loss                                                                                        |       | $                                          | (105,762   | )                                         | $          | (65,822 | ) | $ | (187,825 | ) | $ | (172,984 | ) |
| Other comprehensive income  (loss):                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Foreign currency translation adjustment                                                         |       | (175                                       | )          | —                                    |       | 306 |   | (3,434 | ) |
| Comprehensive loss                                                                              |       | $                                          | (105,937   | )                                         | $          | (65,822 | ) | $ | (187,519 | ) | $ | (176,418 | ) |
| Weighted average number of Class A and Class B shares outstanding,  basic and diluted |       | 104,533                                    |       | 104,656                                   |       | 104,533 |   | 104,580 |   |
| Loss from continuing  operations, basic and diluted                                             |       | (0.52                                      | )          | (0.62                                     | )          | (1.14 | ) | (1.53 | ) |
| Loss from discontinued  operations, basic and diluted                                           |       | (0.49                                      | )          | (0.01                                     | )          | (0.66 | ) | (0.12 | ) |
| Net loss per share, basic and  diluted                                                          |       | $                                          | (1.01      | )                                         | $          | (0.63 | ) | $ | (1.80 | ) | $ | (1.65 | ) |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

5

----

 

**CROWN MEDIA HOLDINGS, INC. ANDSUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

 
| ** **                                                                       | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                       | ** ** | **2004**                                  | ** ** | **2005** | ** ** |
| ** **                                                                       | ** ** | ** **                                | ** ** | ** ** | ** ** |
| CASH FLOWS FROM OPERATING  ACTIVITIES:                                           | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Net loss                                                                         |       | $                                         | (187,825   | ) | $ | (172,984 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities:     |       |                                      |       |   |   |
| Loss from discontinued operations                                                |       | 68,355                                    |       | 10,666 |   |
| Loss from sale of discontinued operations                                        |       | —                                    |       | 1,964 |   |
| Impairment of film assets                                                        |       | 19,321                                    |       | 22,939 |   |
| Depreciation and amortization                                                    |       | 106,679                                   |       | 160,127 |   |
| Accretion on company obligated mandatorily redeemable preferred  interest        |       | 1,723                                     |       | 2,180 |   |
| Provision for allowance for doubtful accounts (recoveries)                       |       | (831                                      | )          | 1,002 |   |
| Gain on sale of property and equipment                                           |       | —                                    |       | (24 | ) |
| Stock-based compensation                                                         |       | 8,319                                     |       | 8,279 |   |
| Changes in operating assets and liabilities:                                     |       |                                      |       |   |   |
| (Increase) decrease in accounts receivable                                       |       | (2,556                                    | )          | (5,194 | ) |
| Increase in receivable from buyer of international business                      |       | —                                    |       | (428 | ) |
| Additions to program license fees                                                |       | (58,894                                   | )          | (113,981 | ) |
| Additions to subscriber acquisition fees                                         |       | (23,100                                   | )          | (7,187 | ) |
| Increase in prepaid and other assets                                             |       | (3,582                                    | )          | (14,282 | ) |
| Increase (decrease) in accounts payable and accrued liabilities                  |       | (12,420                                   | )          | (1,033 | ) |
| Increase in interest payable                                                     |       | 35,018                                    |       | 40,839 |   |
| Increase (decrease) in subscriber acquisition fees payable                       |       | 8,911                                     |       | (23,873 | ) |
| Increase (decrease) in license fees payable to affiliates                        |       | 18,736                                    |       | (4,113 | ) |
| Increase (decrease) in payables to affiliates                                    |       | (141                                      | )          | (34,165 | ) |
| Increase in deferred revenue                                                     |       | 675                                       |       | 470 |   |
| Net cash used in continuing operating activities                                 |       | (21,612                                   | )          | (128,798 | ) |
| CASH FLOWS FROM INVESTING  ACTIVITIES:                                           |       |                                      |       |   |   |
| Purchases of property and equipment                                              |       | (590                                      | )          | (848 | ) |
| Payments to buyer of international business                                      |       | —                                    |       | (7,405 | ) |
| Proceeds from the disposition of property and equipment                          |       | —                                    |       | 25 |   |
| Proceeds from disposition of international business, net of funds  transfer fees |       | —                                    |       | 221,979 |   |
| Net cash provided by (used in) investing activities                              |       | (590                                      | )          | 213,751 |   |
| CASH FLOWS FROM FINANCING  ACTIVITIES:                                           |       |                                      |       |   |   |
| Proceeds from issuance of common stock upon exercise of stock options            |       | —                                    |       | 1,693 |   |
| Proceeds from tax sharing agreement with Hallmark Cards                          |       | 39,465                                    |       | 56,100 |   |
| Borrowings under the credit facility                                             |       | 15,000                                    |       | 65,000 |   |
| Principal payments on the credit facility                                        |       | (5,000                                    | )          | (195,000 | ) |
| Principal payments on capital lease obligations                                  |       | —                                    |       | (436 | ) |
| Net cash provided by (used in) financing activities                              |       | 49,465                                    |       | (72,643 | ) |
| NET CASH USED IN DISCONTINUED  OPERATIONS                                        |       | (24,357                                   | )          | (14,758 | ) |
| Effect of exchange rate changes on cash                                          |       | 357                                       |       | (289 | ) |
| Net increase (decrease) in cash and cash equivalents                             |       | 3,263                                     |       | (2,737 | ) |
| Cash and cash equivalents,  beginning of period                                  |       | 4,306                                     |       | 12,102 |   |
| Cash and cash equivalents, end  of period                                        |       | $                                         | 7,569      |   | $ | 9,365 |   |
| Supplemental disclosure of  certain cash and non-cash activities:                |       |                                      |       |   |   |
| Interest paid                                                                    |       | $                                         | 10,453     |   | $ | 11,668 |   |
| Income taxes paid                                                                |       | $                                         | 1,848      |   | $ | 850 |   |
| Payable to buyer of international business                                       |       | $                                         | —     |   | $ | 24,616 |   |
| Prepayment on technical services agreement                                       |       | $                                         | —     |   | $ | 12,643 |   |
| Deferred credit from technical services agreement                                |       | $                                         | —     |   | $ | 7,644 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

6

----

 

**CROWN MEDIA HOLDINGS, INC. ANDSUBSIDIARIES**

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**For the Three and Nine MonthsEnded September 30, 2004 and 2005**

 

**1. Business and Organization**

 

***Organization***

 

Crown Media Holdings, Inc. (“Crown Media Holdings,”“Crown Media” or the “Company”), through its subsidiaries, owns and operatespay television channels (collectively the “Hallmark Channel” or the “channel”)dedicated to high quality, entertainment programming for adults and families,in the United States and, prior to the sale of its international business, invarious countries throughout the world. Domestically, the Hallmark Channel isoperated and distributed by Crown Media United States, LLC (“Crown Media UnitedStates”). Significant investors in Crown Media Holdings include HallmarkEntertainment Investments Co. (“Hallmark Entertainment Investments”), asubsidiary of Hallmark Cards, Incorporated (“Hallmark Cards”), the NationalInterfaith Cable Coalition, Inc. (“NICC”), and, indirectly through theirinvestments in Hallmark Entertainment Investments, Liberty Media Corporation (“LibertyMedia”) and J.P. Morgan Partners (BHCA), L. P. (“J.P. Morgan”). Theinternational operations of the Hallmark Channel were operated in the UnitedKingdom, by Crown Entertainment Limited (“Crown Entertainment”) and elsewhereby Crown Media International, LLC (“Crown Media International”). Crown MediaInternational commenced its operations outside the United States in 1995.

 

***Saleof the International Business***

 

In April 2005, the Company completed the saleof  its international business to a groupof investors comprised of Equity Partners, 3i and U.K. executive David Elstein(collectively, “Sparrowhawk,” the “buyer” or the “buyer of  international business”). The sale includedthe international versions of the Hallmark Channel distributed outside theUnited States, the international rights to over 580 titles in the Crown Mediafilm library, and the Network Operations Center based in Denver, Colorado.  The Company received cash proceeds of $209.3million, net of the prepayment described below, and recognized an accounting lossof $1.3 million from the sale. Approximately $4.7 million of transaction costswere incurred by the Company in connection with the sale.

 

In accordance with the conditions of the sale, theCompany has accrued $24.6 million which represents the estimated present valueof the cash that is expected to be paid to or on behalf of the buyer at varioustimes through December 31, 2015. Included in this amount is $16.7 million of estimated payments, whichwas determined using the contractual payments due on certain lease arrangementsthat were assumed by the buyer. Payments to the buyer are due at or about thesame time the buyer is obligated to pay the lessor.  In addition, the Company agreed to pay thebuyer approximately $3.2 million in cash, which was determined as thedifference between $4.0 million and the estimated net realizable value ofreceivables of $0.8 million.  Also, theCompany has estimated a liability of approximately $4.5 million to pay the estimatedresidual and participation costs that the buyer would otherwise be obligated topay to third parties through April 2015. The amount of this liability could fluctuate based upon the actualinternal usage or sales of these films by the buyer. Any revisions to theseestimated liabilities will be reflected as gain (loss) from the sale ofdiscontinued operations in future periods.

 

TheCompany will continue to use the Network Operations Center sold to Sparrowhawk forthe distribution of the domesticchannel pursuant to a $25.3 million, seven year technical services agreementwith the buyer. The Company made a prepayment under the technical servicesagreement to the buyer in the amount of $12.7 million upon closing of the saletransaction and the balance is payable monthly in equal installments throughthe expiration of the agreement. The unused portion of the prepayment isclassified as Prepaid and Other Assets in the accompanying condensed consolidatedbalance sheet and will be amortized to operating expense over the life of thecontract. A deferred credit of $7.6 million ($6.8 million as of September 30,2005) was recorded to reflect the amount by which the $25.3 million contractexceeded the estimated fair value of the related services. The deferred creditwill be amortized over the life of the contract, resulting in a reduction ofoperating expenses in future periods.

 

7

----

 

Subsequentto the sale, the Company has no continuing economic involvement with theoperations of the international business.

 

***Strategic Alternatives for the Company***

 

TheCompany announced on August 18, 2005, that its Board of Directors hasauthorized the Company to explore strategic alternatives for the Company,including a potential sale of the Company to a third party.  In support ofthis initiative, a Special Committee of independent directors of the Board ofDirectors is overseeing the process. There can be no assurance that the Companywill enter into or consummate any transaction, or as to terms or timingthereof.

 

***Liquidity***

 

As of September 30,2005, the Company had $9.4 million in cash and cash equivalents on hand and$40.0 million available under its bank credit facility. The $40.0 million ofthe availability under the bank credit facility is subject to the approval ofHallmark Cards prior to the Company being able to draw such funds. As of September 30,2005, the Company had borrowed $180.0 million under its bank credit facility,which matures May 31, 2006.

 

The Company’s principal sources of funds are currentlyavailable cash on hand, cash generated by operations, amounts available forborrowing under its bank credit facility and potentially, tax sharing payments.As noted above, the Company’s ability to access the remaining $40.0 million underthe bank credit facility is subject to Hallmark’s approval.  There can be no assurance that Hallmark Cardswill approve such additional drawings and, if such drawings are not approved,the Company will need alternative sources of funding or will need tosignificantly curtail expenses. The Company expects that additional paymentsunder the tax sharing agreement, if any, will be less in the future than theyhave been in the past assuming that the Company’s financial performanceimproves as indicated by internal projections. Furthermore, the tax sharingpayments can be affected by Hallmark Cards’ tax position and its ability toutilize the Company’s tax losses.

 

The Company’s liquidity is also impacted by theresults of its operations.   The abilityof the existing sources of liquidity to be sufficient to fund the Company’soperations, depend upon the Company’s future operating results meetingexpectations.  In particular, continuedgrowth in subscriber revenue, advertising revenue, and library sales arerequired.  As a result, any decline inthe popularity of the Hallmark Channel, any significant future modifications tothe Company’s distribution agreements, an economic decline in the advertisingmarket, an increase in program acquisition costs, an increase in competition orother adverse operating conditions would impact the Company’s liquidity and itsability to fund the current level of operations.  To the extent that the Company requiresadditional capital and additional drawings on the bank credit facility areeither not available or insufficient, the Company would seek additionalfinancing from the issuance of debt or equity securities or from strategictransactions which provide capital.

 

TheCompany expects to continue making investments in programming, marketing anddistribution during the next twelve months ending September 30, 2006.However, the Company’s liquidity position has demanded that all areas ofexpenses, including programming, marketing and distribution be closely reviewedand monitored.  The Company reducedexpenses in certain areas during the third quarter of 2005 and expects thatsimilar expense reductions will occur in the fourth quarter of 2005. TheCompany’s principal uses of funds for the remainder of 2005 are expected toinclude the payment of operating expenses, licensing of programming, subscriberacquisition fees and interest under its bank credit facility.

 

TheCompany currently believes that cash on hand, cash generated by operations andthe remaining availability under its bank credit facility (assuming thatHallmark Cards approves additional borrowings and assuming that the banks drawdown on an irrevocable letter of credit provided by Hallmark Cards which supportsthe bank credit facility, or the banks extend such facility beyond May 31,2006), which are currently its principal sources of funds, will be sufficientto fund the current level of operations and meet its liquidity needs through September 30,2006.

 

TheCompany’s bank credit facility will expire on May 31, 2006.   If the Company is not able to arrange forthe extension, refinancing or replacement of the bank credit facility prior toits maturity and the bank draws down on the irrevocable letter of credit,Hallmark Cards would acquire all obligations and the rights of the lendingbanks under the bank credit facility.  Inthat event, Hallmark Cards could demand payment of outstanding amounts at anytime.

 

8

----

 

However, Hallmark Cards has also confirmed to the Company that it willnot request any reimbursement of amounts drawn on such letter of credit priorto October 31, 2006.  Hallmark Cardsalso confirmed that it and its wholly-owned subsidiaries will not requestpayment of the license fees and other amounts payable to affiliates of HallmarkCards prior to October 31, 2006 (see note 9).

 

Asconsideration for extending the demand period for the possible reimbursement ofamounts drawn on the letter of credit supporting the credit facility, theCompany agreed to convert its license fees payable to Hallmark affiliates,which were approximately $133.0 million, to a promissory note bearing interestat LIBOR plus 3% per annum.  The term ofthe promissory note began on October 1, 2005 and is payable in full on October 31,2006.

 

Due tothe Company’s liquidity needs, the Company anticipates that prior to October 31,2006, it will be necessary to either extend or refinance (i) the bankcredit facility and (ii) the license fees ($133.0 million) and (iii) otheramounts ($70.0 million) payable to affiliates of Hallmark Cards. In thealternative or as part of a combination of actions, the Company would considervarious alternatives as indicated above, including refinancing the bank credit facility,raising additional capital through the issuance of equity or debt securities orentering into strategic alternatives.

 

Upon maturity of the creditfacility on May 31, 2006, the lending group led by JP Morgan Chase has theright to elect to forego the receipt of cash to pay the principal amount of thecredit facility in full, which is provided for under the terms of anirrevocable letter of credit provided by Hallmark Cards described innote 9, butinstead can elect to initiate a process to foreclose on the Company’s assets.Such foreclosure proceedings could affect our ability to continue ouroperations. Prior to any such possible foreclosure proceedings, the Companywould consider various alternatives as indicated above.  As a result, the outstanding borrowings under the credit facility of $180.0million at September 30, 2005, have been classified as a currentliability.

 

**2. Summary of Significant Accounting Policies and Estimates**

 

***Interim Financial Statements***

 

In theopinion of management, the accompanying condensed consolidated balance sheetsand related interim consolidated statements of operations and comprehensiveloss and cash flows, include all adjustments, consisting of normal recurringitems necessary for their fair presentation in conformity with accountingprinciples generally accepted in the United States of America. Interim resultsare not necessarily indicative of results for a full year. These consolidatedfinancial statements should be read in conjunction with the auditedconsolidated financial statements and the notes to those statements for theyear ended December 31, 2004, included in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2004.

 

***Basis of Presentation***

 

The condensed consolidated financial statements includethe consolidated accounts of Crown Media Holdings, including those of itswholly owned subsidiaries. All significant intercompany balances andtransactions have been eliminated in consolidation.

 

In February 2005, the Company signed a definitive agreementto complete the sale of its international business and, accordingly, classifiedthe operating results of the international business as discontinued operationsin the accompanying statements of operations for all periods presented. TheCompany’s discontinued operations consisted of the international channeloperations and the international rights to the film library assets.

 

***Use of Estimates***

 

TheCompany’s condensed consolidated financial statements are prepared inaccordance with accounting principles generally accepted in the United Statesof America (“GAAP”). These accounting principles require the Company to makecertain estimates, judgments and assumptions. The Company believes that theestimates, judgments and assumptions made when accounting for items and matterssuch as customer retention patterns,

 

9

----

 

allowance for bad debts, useful lives of assets, ultimate revenue usedin the film asset amortization calculations, cash flow projections used in variousasset valuations, income taxes, reserves and other provisions for contingenciesare reasonable, based on information available at the time they are made. Theseestimates, judgments and assumptions can affect the reported amounts of assetsand liabilities as of the date of the consolidated financial statements, aswell as the reported amounts of revenue and expenses during the periodspresented. Actual results could differ from these estimates.

 

***FilmAssets and Film Library Impairment***

 

The Company amortizes itsfilm assets using the individual-film-forecast-computation method over amaximum period of 9.25 years from the date of acquisition. Theindividual-film-forecast-computation method amortizes such assets in the sameratio that current period actual revenue bears to estimated ultimate futurerevenues.

 

On a quarterly basis, theCompany assesses whether events or circumstances have changed indicating thatthe fair value of a film is lower than its unamortized cost or carrying value.If the carrying value of any individual film asset exceeds its fair value, thefilm asset is written-down to its estimated fair value. A discounted cash flowmodel, based on management’s anticipated ultimate future revenue of the film,is used to estimate the fair value of the individual films. The Companyconsiders the following factors, among others, in estimating ultimate futurerevenue for each film:  (*a*) the operating environment expected for the nextseveral years, (*b*) the size of the libraryas a whole, (*c*) historical license feerevenue per film, (*d*) eachtitle’s age, quality, and marketability, (*e*) existingsales plans including the amount of product desired to be sold each year, (*f*) future performance estimates, (*g*) assumptionsand estimates underlying past and future estimates, and (*h*) riskfactors that could effect future operations of the Library.  In estimatinga film’s fair value, the Company considers those cash outflows necessary togenerate the film’s cash inflows such as exploitation, residual and participationcosts and taxes.  The discount rate used in the Company’s discounted cashflow model is based upon management’s estimate of the rate a lender wouldrequire related to the risks and uncertainties surrounding the timing andprobability of the cash flow estimates.

 

TheCompany reviews its estimates of ultimate future revenues and participationcosts as of each reporting date to reflect currently available information.Estimated ultimate future revenues are based on the history of each film andsimilar films, sales and marketing plans, and other factors, all of whichrequire significant judgment and estimation by management. Differences between amortizationexpense determined using the new estimates and any amounts previously expensedduring that current fiscal year are charged or credited to the statement ofoperations in the period in which the estimates are revised.

 

Foruse of the film assets on the Hallmark Channel and the Hallmark Movie Channel,the Company estimates the fair value of the internal usage based upon theportion of the film’s ultimate revenues attributable to the term of the licensewindow. The Company first calculates the amount of cost attributable to theinternal use using the individual-film-forecast-computation method describedabove and then expenses such amounts ratably over the term of the licensewindow.

 

In thethird quarter of 2004, the Company bifurcated the carrying value of each filmbetween its international and domestic licensing rights using the relativediscounted cash flows for each film, internationally and domestically, assumingthe continued operations of both the international and domestic channel. Theestimated fair value of the domestic rights was based upon the discounted cashflows attributable to estimated future third party sales and internal use at September 30,2004. A non-cash impairment charge was recorded in the third quarter 2004 foreach film where the estimated fair value was less than its carrying value at September 30,2004.  The resulting non-cash impairmentcharge of $19.3 million is included in impairment of film assets on theaccompanying statement of operations for the three and nine months ended September 30,2004.

 

In thethird quarter of 2005, the Company reviewed each of its film asset titles forimpairment. The Company computed the fair value of the rights to each filmusing indications of fair value. The estimated fair value of the domesticrights was based upon the discounted cash flows attributable to estimatedfuture third party sales and internal use at September 30, 2005. Anon-cash impairment charge was recorded in the third quarter 2005 for each filmwhere the estimated fair value was less than its carrying value at September 30,2005.  The resulting non-cash

 

10

----

 

impairment charge of $22.9 million is included in impairment of filmassets on the accompanying statement of operations for the three and ninemonths ended September 30, 2005.

 

***Cash and Cash Equivalents***

 

Cashand cash equivalents include highly liquid investments with original maturitiesof three months or less that are readily convertible into cash and are notsubject to significant risk from fluctuations in interest rates. As a result,the carrying amount of cash and cash equivalents approximates fair value.

 

***Allowance for Doubtful Accounts***

 

The allowance for doubtful accounts is based upon theCompany’s assessment of probable loss related to uncollectible accountsreceivable.  The Company uses a number offactors in determining the allowance, including, among other things, collectiontrends.  The Company’s bad debt expensewas $183,000 for the three months ended September 30, 2004, and bad debt recoverywas $831,000 for the nine months ended September 30, 2004. The Company’sbad debt recovery was $115,000 for the three months ended September 30,2005, and bad debt expense was $1.0 million for the nine months ended September 30,2005.

 

***Program License Fees***

 

Program license fees are paid in connection with theacquisition of the rights to air programs acquired from others. Program rightsare generally deferred and then amortized on a straight-line basis over theircontractual license periods or anticipated usage. Crown Media Holdingsperiodically evaluates the realizability of these deferred license fees inrelation to the estimated future revenues.

 

Estimates of net realizable value for program licensefees are determined using future estimated advertising revenues and anticipatedpatterns of programming usage on a day part basis as it pertains to programminglicensed to the channel. These estimates of expected annual future estimatedrevenues are compared to net book value of the program license fee assets todetermine if the programming assets are expected to be recovered. Where the analysisindicates the costs are in excess of the estimated net realizable value,additional amortization is provided.

 

***Subscriber Acquisition Fees***

 

Subscriberacquisition fees are generally required to be paid to obtain carriage ondomestic pay distributors systems. Under certain of these agreements with paydistributors, Crown Media United States is obligated to pay subscriberacquisition fees if defined subscriber levels are met or in order to obtainadditional carriage of the Hallmark Channel by those pay distributors. Suchcosts are accrued when Crown Media United States receives notice from thedistributors that they have met the contractual penetration percentage orsubscriber count.

 

Subscriber acquisition fees are amortized over thecontractual life of the distribution agreements (ranging from 4 to 9years) as a reduction of subscriber feerevenue. If the amortization expense exceeds the subscriber fee revenuerecognized on a per distributor basis, the excess amortization is included as acomponent of cost of services. Crown Media Holdings assesses the recoverabilityof these costs periodically by comparing the net carrying amount to theestimates of future subscriber fee and advertising revenues. It also assessesthe recoverability when events such as changes in distributor relationshipsoccur or other indicators suggest impairment.

 

***Property and Equipment***

 

Property and equipment are stated at historical cost.Equipment under capital leases are initially recorded at the present value ofthe minimum lease payments.

 

Depreciation on equipment is calculated using thestraight-line method over the estimated useful lives of the assets. Equipmentheld under capital leases and leasehold improvements are amortizedstraight-line over the shorter of the lease term or estimated useful life ofthe asset.

 

11

----

 

When property and equipment is sold or otherwisedisposed of, the cost and related accumulated depreciation or amortization areremoved from the accounts and any resulting gain or loss is included in income.The costs of normal maintenance and repairs are charged to expense whenincurred.

 

***Long-Lived Assets***

 

TheCompany reviews long-lived assets, other than goodwill and other intangibleassets with indefinite lives, for impairment whenever facts and circumstancesindicate that the carrying amounts of the assets may not be recoverable. Animpairment loss is recognized if the carrying amount of the asset is notrecoverable and exceeds its fair value. Recoverability of assets to be held andused is measured by comparing the carrying amount of an asset to the estimatedundiscounted future net cash flows expected to be generated by the asset. Ifthe asset’s carrying value is not recoverable, an impairment charge is recognizedfor the amount by which the carrying amount of the asset exceeds its fairvalue. The Company determines fair values by using a combination of comparablemarket values and discounted cash flows, as appropriate.

 

Goodwillis reviewed for impairment annually on November 30 or whenever an eventoccurs or circumstances change that indicates fair value might be belowcarrying value. Goodwill is carried at historical cost if the estimated fairvalue is greater than the carrying amounts. However, if estimated fair value isless than the carrying amount, goodwill is reduced to estimated fair valuethrough an impairment charge to the Company’s consolidated statements ofoperations.

 

***Revenue Recognition***

 

Subscriber revenue from pay television distributors isrecognized as revenue when an agreement is executed, programming is provided,the price is determinable, and collectibility is reasonably assured. Subscriberfees from pay television distributors are recorded net of amortization ofsubscriber acquisition costs in accordance with Emerging Issues Task Force No. 01-9(“EITF No. 01-9”) , *Accounting forConsideration Given by a Vendor to a Customer (Including a Reseller of theVendor’s Products)*. If the amortization expense exceeds the revenuerecognized on a per distributor basis, the excess amortization is included as acomponent of cost of services. To more fully comply with EITF No. 01-9,$230,000 and $687,000, which previously were reported as subscriber acquisitionfee amortization expense, have been reclassified as components of subscriberfees revenue for the three and nine months ended September 30, 2004,respectively.

 

Advertisingrevenues are recognized as earned in the period in which the advertising istelecast. Revenue is recognized as commercial spots or long form programmingare aired and as ratings guarantees to advertisers are achieved. Advertisingrevenues are recorded net of agency commissions. Agency commissions arecalculated based on a stated percentage applied to gross billing revenue forthe Company’s broadcasting operations. Customers remit the gross billing amountto the agency and the agency remits gross billings less their commission to theCompany. Payments received in advance of being earned are recorded as deferredrevenue.

 

Revenue from film asset licensing agreements isrecognized in accordance with Statement of Position (“SOP”) 00-02,*Accounting by Producers or Distributors of Films*.Revenues are recognized when all of the following have occurred:  an agreement is executed, the film is availablefor exhibition by the licensee, the license fee is fixed or determinable,collectibility is reasonably assured and the cost of each film is known orreasonably determinable. Revenue from film asset licensing agreementscontaining multiple film titles is allocated among the various film titlesbased on their relative estimated fair values. Payments received from licenseesprior to the availability of a film are recorded as deferred revenue. Feespayable with terms in excess of one year are discounted for revenue recognitionpurposes at the customer’s estimated incremental borrowing rate in accordancewith Accounting Principles Board (“APB”) Opinion No. 21, *Interest on Receivables and Payables.*

 

***Taxes on Income***

 

Pursuant to the tax sharing agreement entered into withHallmark Cards in March 2003, the Company’s results of operations for taxpurposes became a part of the Hallmark Cards consolidated federal tax return asof and

 

12

----

 

subsequent to March 2003.  However, the Company continues to account forincome taxes on a separate return basis. Accordingly, the Company accounts forincome taxes using an asset and liability method which requires the recognitionof deferred tax assets and liabilities for the expected future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases and netoperating loss and tax credit carryforwards. Deferred tax assets and liabilitiesare measured using enacted tax rates expected to be applied to taxable incomein the years in which those temporary differences are expected to be recoveredor settled. The Company reduces deferred tax assets by a valuation allowance ifit is more likely than not that some portion or all of the deferred tax assetswill not be realized. Any payments received from Hallmark Cards underthe tax sharing agreement are recorded as an increase in additional paid-incapital and any future utilization of deferred tax assets generated after March 2003will be recorded as a reduction in paid-in capital, to the extent payments werepreviously received from Hallmark Cards for such benefits under the tax sharingagreement.

 

***Stock-Based Compensation***

 

The Company accounts for its stock-based employeecompensation plan using the intrinsic value method under the recognition andmeasurement principles of APB Opinion No. 25, *Accountingfor Stock Issued to Employees,* and related Interpretations.Accordingly, compensation cost for stock options issued to employees ismeasured as the excess, if any, of the quoted market price of the Company’sstock at the date of the grant over the exercise price of the underlying stockoptions. In December 2002, the Financial Accounting Standards Board (“FASB”)issued Statement of Financial Accounting Standards (“SFAS”) No. 148, *Accounting for Stock-Based Compensation – Transitionand Disclosure – an amendment of SFAS No. 123.*SFAS No. 148requires certain additional disclosures of the estimated fair value ofstock-based compensation. Such estimated fair value is determined through theuse of the Black-Scholes option pricing model. SFAS No. 123, *Accounting for Stock-Based Compensation,* encourages, butdoes not require, companies to record compensation cost for stock-basedemployee compensation plans at fair value.

 

Had compensation expense for these plans been determinedconsistent with SFAS No. 123, Crown Media Holdings’ net loss and loss pershare would have been increased to the following pro forma amounts for thethree and nine months ended September 30, 2004 and 2005:

 

**Pro Forma Effects**

**(In thousands, except per shareamounts)**

 
| ** **                                              | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended****September 30,** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                              | ** ** | **2004**                                   | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2005** | ** ** |
|                                                    |       |                                       |       |                                        |       |   |   |   |   |
| Net loss                                                |       | $                                          | (105,762   | )                                           | $          | (65,822 | ) | $ | (187,825 | ) | $ | (172,984 | ) |
| Pro forma stock options expense at estimated fair value |       | (660                                       | )          | (30                                         | )          | (1,983 | ) | (291 | ) |
| Stock plan expense included in net loss                 |       | —                                     |       | —                                      |       | — |   | 14 |   |
| Pro forma net loss                                      |       | $                                          | (106,422   | )                                           | $          | (65,852 | ) | $ | (189,808 | ) | $ | (173,261 | ) |
| Weighted average shares                                 |       | 104,533                                    |       | 104,656                                     |       | 104,533 |   | 104,580 |   |
| Pro forma net loss per share, basic and diluted         |       | $                                          | (1.02      | )                                           | $          | (0.63 | ) | $ | (1.82 | ) | $ | (1.66 | ) |

 

***Net Loss per Share***

 

Basic net loss per share is computed by dividing the netloss for the period by the weighted average number of common shares outstandingduring the period. Diluted net loss per share is computed based on the weightedaverage number of common shares and potentially dilutive common sharesoutstanding. The calculation of diluted net loss per share excludes potentialcommon shares if the effect would be antidilutive. Potential common sharesconsist of incremental common shares issuable upon the exercise of stockoptions. Approximately 1.4 million and 403,000 stock options for both the threeand nine months ended September 30, 2004 and 2005, respectively, have beenexcluded from the calculations of loss per share because their effect wouldhave been antidilutive.

 

13

----

 

***Translation of Foreign Currency***

 

Through April 26, 2005, the balance sheets andstatements of operations and comprehensive loss of certain Crown Media Holdings’foreign subsidiaries were measured using local currency as the functionalcurrency. Revenues, expenses and cash flows of such subsidiaries weretranslated into United States dollars at the average exchange rates prevailingduring the period. Assets and liabilities were translated at the rates ofexchange at the balance sheet date. Translation gains and losses were deferredas a component of accumulated other comprehensive income (loss). Foreigncurrency transaction gains and losses recorded upon the remeasurement offinancial assets and liabilities denominated in currencies other than thefunctional currency of the subsidiary were included in determining net loss forthe period. In conjunction with the sale of the international business, thecumulative foreign currency translation gain of approximately $3.1 million wasrealized as a component of the loss on sale of discontinued operations in theaccompanying consolidated statement of operations.

 

***Concentration of Credit Risk***

 

Financial instruments,which potentially subject Crown Media Holdings to a concentration of creditrisk, consist primarily of cash, restricted cash, cash equivalents and accountsreceivable. Generally, Crown Media Holdings does not require collateral tosecure receivables. Crown Media Holdings has no significant off-balance sheetfinancial instruments with risk of accounting losses.

 

***Reclassifications***

 

Certain reclassifications have been made to conformprior periods’ financial information to the current presentation.

 

***Recently Issued Accounting Pronouncements***

 

In December 2004, the FASBissued SFAS No. 153, *Exchanges of NonmonetaryAssets, an amendment of APB Opinion No. 29, Accounting for NonmonetaryTransactions*. The amendments made by SFAS No. 153 are based onthe principle that exchanges of nonmonetary assets should be measured based onthe fair value of the assets exchanged. Further, the amendments eliminate thenarrow exception for nonmonetary exchanges of similar productive assets andreplace it with a broader exception for exchanges of nonmonetary assets that donot have commercial substance. Previously, APB Opinion No. 29 requiredthat the accounting for an exchange of a productive asset for a similarproductive asset or an equivalent interest in the same or similar productiveasset should be based on the recorded amount of the asset relinquished. APBOpinion No. 29 provided an exception to its basic measurement principle(fair value) for exchanges of similar productive assets. The FASB believes thatexception required that some nonmonetary exchanges, although commerciallysubstantive, be recorded on a carryover basis. By focusing the exception onexchanges that lack commercial substance, the FASB believes SFAS No. 153produces financial reporting that more faithfully represents the economics ofthe transactions. SFAS No. 153 is effective for nonmonetary assetexchanges occurring in fiscal periods beginning after June 15, 2005.Earlier application is permitted for nonmonetary asset exchanges occurring infiscal periods beginning after the date of issuance. The provisions of SFAS No. 153shall be applied prospectively. The Company does not anticipate that theadoption of SFAS No. 153 will have a significant impact on the Company’soverall results of operations or financial position.

 

In December 2004, the FASB issued SFAS No. 123 (revised 2004), *Share-Based Payment*. SFAS No. 123R replaced SFAS No. 123, *Accounting  for  Stock-Based  Compensation*, and superseded Accounting  Principles  Board  Opinion No. 25,  *Accounting  for Stock  Issued to Employees*.  SFAS No. 123R will require compensation cost  related  to share-based payment  transactions to be recognized in the financial  statements. As permitted by SFAS No. 123, Crown Media Holdings elected to follow the guidance of APB Opinion No. 25, which allowed companies to use the intrinsic value method of accounting to value their share-based payment transactions with employees.  Based on this method, Crown Media Holdings did not recognize compensation expense in its financial statements as the stock options granted had an exercise price equal to the fair market value of the underlying  common  stock on the date of the grant.  SFAS No. 123R requires measurement of the cost of share-based payment transactions to employees at the fair value of the award on the grant date and  recognition  of expense  over the requisite service or vesting period. SFAS No. 123R allows implementation  using a modified version of prospective  application,  under which compensation  expense for the unvested portion of previously granted awards and all new

 

14

----

 

awards will be recognized on or after the date of adoption.  SFAS No. 123R also allows companies to adopt SFAS No. 123R by restating previously issued financial statements, basing the amounts on the expense  previously  calculated  and  reported in their pro forma footnote  disclosures  required under SFAS No. 123. The provisions of SFAS No. 123R will be adopted by Crown Media Holdings using the modified prospective method beginning January 1, 2006.

 

In March 2005,the SEC staff issued guidance on FASB Statement No. 123 (revised 2004), *Share-Based Payment,* SFAS No. 123R.Staff Accounting Bulletin (“SAB”) No. 107 was issued to assist preparersby simplifying some of the implementation challenges of SFAS No. 123Rwhile enhancing the information that investors receive.  SAB No. 107creates a framework that is premised on two overarching themes: (a) considerablejudgment will be required by preparers to successfully implement SFAS No. 123R,specifically when valuing employee stock options; and (b) reasonableindividuals, acting in good faith, may conclude differently on the fair valueof employee stock options. Key topics covered by SAB No. 107 include: (a) valuationmodels – SAB No. 107 reinforces the flexibility allowed by SFAS No. 123Rto choose an option-pricing model that meets the standard’s fair valuemeasurement objective; (b) expected volatility – the SAB provides guidanceon when it would be appropriate to rely exclusively on either historical orimplied volatility in estimating expected volatility; and (c) expectedterm – the new guidance includes examples and some simplified approaches todetermining the expected term under certain circumstances.  The Companywill apply the principles of SAB No. 107 in conjunction with its adoptionof SFAS No. 123R.

 

In May 2005,the FASB issued SFAS No. 154, *AccountingChanges and Error Corrections—Replacement of APB Opinion No. 20 and FASBStatement No. 3* (SFAS 154). SFAS 154 replaces APB Opinion No. 20,*Accounting Changes,* and FASBStatement No. 3, *Reporting AccountingChanges in Interim Financial Statements,* and changes therequirements for the accounting for and reporting of a change in accountingprinciple. Opinion No. 20 previously required that most voluntary changesin accounting principle be recognized by including in net income of the periodof the change the cumulative effect of changing to the new accountingprinciple. SFAS 154 requires retrospective application to prior periods’financial statements of changes in accounting principle. SFAS 154 definesretrospective application as the application of a different accountingprinciple to prior accounting periods as if that principle had always been usedor as the adjustment of previously issued financial statements to reflect achange in the reporting entity. SFAS 154 also requires that a change indepreciation, amortization, or depletion method for long-lived, non-financialassets be accounted for as a change in accounting estimate affected by a changein accounting principle. We are required to adopt the provisions of SFAS 154 asof January 1, 2006, although earlier adoption is permitted.

 

**3. Subscriber Acquisition Fees**

 

Subscriber acquisition fees are comprised of thefollowing:

 

| ** **                            | ** ** | **As of December 31,** | ** ** | **As of September 30,** | ** ** |
|---------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                            | ** ** | **2004**                    | ** ** | **2005**                     | ** ** |
| ** **                            | ** ** | **(In thousands)**          | ** ** |
| Subscriber acquisition fees,  at cost |       | $                           | 236,447    |                         | $          | 243,635 |   |
| Accumulated amortization              |       | (116,434                    | )          | (153,370                     | )          |
| Subscriber acquisition fees, net      |       | $                           | 120,013    |                         | $          | 90,265 |   |

 

*Of the net balance at September 30,2005, the Company expects $21.1 million will be recognized as a reduction ofsubscriber fee revenue and $69.2 million will be recognized as subscriberacquisition fee expense in future periods.*

* *

*As of December 31, 2004, and September 30,2005, the consolidated balance sheets also reflect subscriber acquisition feespayable of $35.9 million and $12.0 million, respectively. For the three monthsended September 30, 2004 and 2005, Crown Media United States made cashpayments of $10.7 million and $1.3 million, respectively. For the nine monthsended September 30, 2004 and 2005, Crown Media United States made cashpayments of $14.2 million and $31.1 million, respectively.*

 

15

----

 

**4. Program License Fees**

 

Program license fees are comprised of the following:

 
| ** **                                                      | ** ** | **As of December 31, 2004** | ** ** | **As of September 30, 2005** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|------------|-----------------------------------|------------|
| ** **                                                      | ** ** | **(In thousands)**               | ** ** |
| Program license fees — Hallmark Entertainment Distribution |       | $                                | 144,848    |                              | $          | 139,653 |   |
| Program license fees — NICC                                |       | 2,448                            |       | 9,465                             |       |
| Program license fees — other  affiliates                   |       | 5,906                            |       | 5,594                             |       |
| Program license fees —  non-affiliates                     |       | 329,021                          |       | 335,008                           |       |
| Program license fees, at cost                                   |       | 482,223                          |       | 489,720                           |       |
| Accumulated amortization                                        |       | (167,993                         | )          | (192,373                          | )          |
| Program license fees, net                                       |       | $                                | 314,230    |                              | $          | 297,347 |   |

 

Amortizationof program license fees for continuing operations, which is included as acomponent of programming cost in the accompanying consolidated statements ofoperations, was $21.6 million and $29.2 million for the three months ended September 30,2004 and 2005, respectively, and $60.7 million and $85.6 million for the ninemonths ended September 30, 2004 and 2005, respectively.

 

At December 31,2004, and September 30, 2005, $7.7 million and $4.8 million of programlicense fees, respectively, were included in prepaid and other assets on theaccompanying condensed consolidated balance sheets as the Company had madepayments, but the airing windows had not commenced.

 

License fees payable are comprised of the following:

 
| ** **                                                      | ** ** | **As of December 31, 2004** | ** ** | **As of September 30, 2005** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|------------|-----------------------------------|------------|
| ** **                                                      | ** ** | **(In thousands)**               | ** ** |
| License fees payable — Hallmark Entertainment Distribution |       | $                                | 151,980    |                              | $          | 146,414 |   |
| License fees payable — NICC                                |       | —                           |       | 1,453                             |       |
| License fees payable —  non-affiliates                     |       | 191,576                          |       | 195,827                           |       |
| Total license fees payable                                      |       | 343,556                          |       | 343,694                           |       |
| Less current maturities                                         |       | (79,815                          | )          | (67,360                           | )          |
| Long-term license fees payable                                  |       | $                                | 263,741    |                              | $          | 276,334 |   |

 

**5. Property and Equipment**

 

Property and equipment are comprised of the following:

 
| ** **                         | ** ** | **As of December 31,  2004** | ** ** | **As of September 30,  2005** | ** ** | **Depreciable Life  (In years)** | ** ** |
|------------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|----------------------------------|------------|
| ** **                         | ** ** | **(In thousands)**                | ** ** | ** **                         | ** ** |
| Technical equipment and  computers |       | $                                 | 38,947     |                               | $          | 14,628                           |       | 3-5 |   |
| Leased assets                      |       | 30,615                            |       | 17,363                             |       | 8-15                             |       |
| Furniture, fixtures and  equipment |       | 2,078                             |       | 1,219                              |       | 5                                |       |
| Leasehold improvements             |       | 10,402                            |       | 3,339                              |       | 3-7                              |       |
| Construction-in-progress           |       | 161                               |       | 404                                |       |                             |       |
| Property and equipment, at cost    |       | 82,203                            |       | 36,953                             |       |                             |       |
| Accumulated depreciation           |       | (49,374                           | )          | (17,217                            | )          |                             |       |
| Property and equipment, net        |       | $                                 | 32,829     |                               | $          | 19,736                           |       |   |   |

 

Depreciation expense related to property and equipmentwas $786,000 and $853,000 for the three months ended September 30, 2004and 2005, respectively. Depreciation expense related to property and equipmentwas $2.6 million for both the nine months ended September 30, 2004 and2005, respectively.

 

Softwareand other intangible assets of $3.2 million and $1.8 million as of December 31,2004, and September 30, 2005, respectively, have been included in prepaidand other assets in the accompanying condensed consolidated balance sheets.

 

16

----

 

**6. Reorganization**

 

In October 2002, theCompany reorganized its operations in order to concentrate its efforts on theHallmark Channel in the U.S.  Thefollowing table displays the activity and balances of the reorganizationaccrual account from December 31, 2003, to September 30, 2005, whichis included in the current portion of accounts payable and accrued liabilitiesin the accompanying condensed consolidated balance sheets.

 
| ** **                                            | ** ** | **Severance**      | ** ** | **Facilities** | ** ** | **Satellite and  Transponder** | ** ** | **Total** | ** ** |
|-------------------------------------------------------|------------|--------------------|------------|----------------|------------|--------------------------------|------------|-----------|------------|
| ** **                                            | ** ** | **(In thousands)** | ** ** |
|                                                  |       |               |       |           |       |                           |       |      |       |
| Balance at December 31,  2003                    |       | $                  | 4          |           | $          | 1,523                          |       | $         | 13,511     |   | $ | 15,038 |   |
|                                                  |       |               |       |           |       |                           |       |      |       |
| Adjustments due  to change in estimates, net          |       | (4                 | )          | (126           | )          | (301                           | )          | (431      | )          |
|                                                  |       |               |       |           |       |                           |       |      |       |
| Payments                                              |       | —             |       | (337           | )          | (3,550                         | )          | (3,887    | )          |
| Balance at  December 31, 2004                    |       | —             |       | 1,060          |       | 9,660                          |       | 10,720    |       |
|                                                  |       |               |       |           |       |                           |       |      |       |
| Payments                                              |       |               |       | (60            | )          | (880                           | )          | (940      | )          |
| Contracts  assumed by buyer of international business |       | —             |       | (1,000         | )          | (8,671                         | )          | (9,671    | )          |
| Balance at  September 30, 2005                   |       | $                  | —     |           | $          | —                         |       | $         | 109        |   | $ | 109 |   |

 

**7. Credit Facility**

 

 The Company hasa credit agreement with a syndicate of banks, led by JP Morgan Chase Bank,under which the banks have extended to the Company a secured revolving creditfacility of up to $220.0 million.  TheCompany and the lending banks originally entered into the facility in 2001 andhave subsequently amended the terms of this facility, with the most recentamendment on March 1, 2005.  Thefacility is guaranteed by the Company’s subsidiaries and is secured by alltangible and intangible property of Crown Media Holdings and itssubsidiaries.  The original bank creditfacility encompassed a term loan of $100.0 million and a revolving line ofcredit of $220.0 million, inclusive of up to $20.0 million of letters of creditavailable to be issued at the Company’s request.  Upon the consummation of sale of the internationalbusiness, the Company repaid and retired the $100.0 million term loan alongwith $95.0 million on the revolving line of credit under the credit facility.The credit facility now consists of the revolving line of credit of $220.0million, which includes up to $20.0 million of letters of credit.  In addition, following such closing, anyborrowings by the Company of amounts in excess of the $180.0 million under therevolving line of credit requires approval of Hallmark Cards.

 

Each loan under the bank credit facility bearsinterest at a Eurodollar rate or an alternate base rate as the Company mayrequest at the time of borrowing in accordance with the credit agreement.  The Eurodollar rate is based on the Londoninterbank market for Eurodollars, and remains in effect for the time period ofthe loan ranging from one, two, three, six or twelve months.  The alternate rate is based upon the primerate of JP Morgan Chase Bank, a certificate of deposit rate or the FederalFunds effective rate, which is adjusted whenever the rates change.  The Company is required to pay a commitmentfee of 0.2% per annum (0.5% prior to March 1, 2005) of the committed, butnot outstanding, amounts under the revolving credit facility, payable inquarterly installments.

 

On March 1,2005, we entered into Amendment No. 8 to the agreement for our bank creditfacility.  This amendment extended thematurity date to May 31, 2006, as well as made a number of othersignificant changes to the bank credit facility including elimination of certainfinancial covenants, changes to and waivers of financial covenants concerning2004 violations and the future compliance, and a reduction in the interestrates and commitment fees under the credit facility. See “Hallmark Letter ofCredit” in note 9 below regarding an irrevocable letter of credit of HallmarkCards issued as credit support for obligations under the credit facility.

 

Amendment No. 8 waived the Company’snon-compliance with the following financial covenants:  (1) capital expenditures in 2004; (2) cashprogram acquisition guarantees in 2004; (3) trailing 12-month EBITDA forthe

 

17

----

 

quarter ended December 31, 2004; (4) cash payments totelevision distributors for subscribers in 2004; (5) net worth at December 31,2004; (6) leverage ratio for the quarter ended December 31, 2004; and(7) interest coverage ratio for the 2004 year.  Amendment No. 8 also deleted the networth covenant; amended the limit on the Company’s cash program guarantees in 2005;amended the quarterly EBITDA requirements for the remainder of the loan term; revisedthe EBITDA definition, including adding all non-cash expenses to consolidatednet income in determining EBITDA; and amended the limit of cash payments totelevision distributors for subscribers, the minimum number of subscribers andthe minimum gross subscriber revenue. Further, pursuant to Amendment No. 8, the limitation on RestrictedPayments was amended to allow us to make certain payments to Hallmark Cards orits affiliates. The Company was in compliance with its debt covenants at September 30,2005.

 

At December 31,2004, and September 30, 2005, Crown Media Holdings had outstandingborrowings of $310.0 million and $180.0 million, respectively, under the creditfacility and there were no letters of credit outstanding. At September 30,2005, the entire outstanding balance bore interest at the Eurodollar rate (4.84%at September 30, 2005). Interestexpense on borrowings under the credit facility for the three months ended September 30,2004 and 2005, was $3.5 million, and $2.1 million, respectively, and for the ninemonths ended September 30, 2004 and 2005, interest expense was $9.9million, and $8.0 million, respectively.

 

**8.  Classification of CreditFacility as a Current Liability**

 

The outstanding borrowings under the creditfacility of $180.0 million at September 30, 2005, have been classified asa current liability.  Such balance sheetclassification was deemed necessary as the bank has the right, at the maturity date,at its discretion, to either draw upon the outstanding letter of creditsupplied by Hallmark Cards in order to receive payment in full of theoutstanding principal amount under the credit facility (see note 9) or toinitiate other actions including foreclosure of the Company’s assets. As thisis outside the control of the Company, the obligation does not meet therequirements as long-term debt even though Hallmark Cards has committed to notrequest reimbursement from the Company prior to October 31, 2006 in theevent the banks exercise their rights under the irrevocable letter of creditdescribed in note 9.

 

**9. Related Party Long-Term Obligations**

 

***Hallmark Letter of Credit***

 

Pursuantto Amendment No. 8 to the bank credit facility, Hallmark Cards provided anirrevocable letter of credit issued to JP Morgan Chase Bank by Citibank, N.A.in the amount of $320.0 million, as credit support for the Company’sobligations under the credit facility. The letter of credit was reduced to $220.0 million upon the consummationof the sale of the Company’s international business and the reduction of theaggregate outstanding credit exposure of its lenders to $220.0 million.  Drawdowns under the letter of credit may bemade for amounts due and payable under the credit facility. Amounts in excessof $180.0 million require the concurrence of Hallmark Cards.  Any proceeds received by JP Morgan Chase Bankfrom drawing under this support letter of credit will not be applied to repaythe Company’s obligations, but will be used to purchase on the part of HallmarkCards from the bank lenders subordinated participations in our obligationsunder its bank credit facility, junior in payment to the bank lenders under thebank credit facility.  The support letterof credit automatically expires on May 31, 2006. The Company pays toHallmark Cards, as compensation for the support letter of credit, the amountsresulting from the 2% reduction in the interest rate and the 0.3% reduction inthe commitment fee payable by the Company under the bank credit facility asprovided in Amendment No. 8.

 

***Senior Unsecured Note***

 

In August 2003,the Company issued a senior unsecured note to HC Crown for $400.0 million. Aportion of the proceeds was used to repurchase the Company’s outstanding trustpreferred securities, and the balance of the proceeds, after expenses, was usedto reduce amounts outstanding under its bank credit facility.

 

The senior unsecured note payable to HC Crown does notrequire cash payments until August 2007. Instead, the principal amount ofthe senior unsecured note accretes at 10.25% per annum, compoundingsemi-annually, to $596.6 million at August 5, 2007.  From that date, interest at 10.25% per annumwill be payable semi-annually on the accreted value of the senior unsecurednote to HC Crown.  The note matures on August 5,2011, and is pre-payable

 

18

----

 

by Crown Media Holdings at any time after August 5, 2004, withoutpenalty. At December 31, 2004 and September 30, 2005, $460.9 millionand $496.9 million, respectively, of principal and accrued interest wereincluded in the senior unsecured note payable in the accompanying condensed consolidatedbalance sheet. The note purchase agreement for the senior unsecured notecontains certain covenants which restrict on the part of the Company, amongother matters, from the incurrence of any additional indebtedness, therepurchase or other acquisitions of the Company’s stock, investments in otherparties and the incurrence of liens on the Company’s assets.  As a fee for the issuance of the notes, theCompany paid $3.0 million to HC Crown, which was initially capitalized and isbeing amortized as additional interest expense over the term of the notepayable.

 

***Line of Credit Payable to HC Crown***

 

On December 14, 2001, the Company executed a$75.0 million promissory note with HC Crown maturing on the earlier of sixmonths from the termination of the credit facility or December 21,2007.  This line of credit is subordinateto the bank credit facility. The rate of interest under this line of credit isequal to LIBOR plus three percent, payable quarterly. At both December 31,2004, and September 30, 2005, borrowings under the note were $75.0million. Accrued interest on the note of $6.1 million and $9.8 million areincluded in line of credit and interest payable to HC Crown as of December 31,2004, and September 30, 2005, respectively, on the accompanying condensedconsolidated balance sheets.

 

***Hallmark Obligations***

 

By a letter dated October 1, 2005, which supplementedprevious letters dated February 28, 2005, and August 1, 2005, HallmarkCards confirmed to the Company that neither Hallmark Cards nor any of itswholly-owned subsidiaries would demand payment from the Company until October 31,2006, at the earliest, on (1) license fees and intercompany debt and payablesoutstanding as of December 31, 2004, and September 30, 2005, and (2) anyreimbursements on the letter of credit supporting the bank line of credit ifdrawn to pay the bank credit facility which matures on May 31, 2006.Therefore, the Company has classified the license fees and payables to Hallmarkaffiliates as non-current liabilities on the accompanying condensed consolidatedbalance sheet.

 

**10. Related Party Transactions**

 

***Tax Sharing Agreement***

 

On March 11,2003, Crown Media Holdings became a member of Hallmark Cards consolidatedfederal tax group and entered into a federal tax sharing agreement withHallmark Cards (the “tax sharing agreement”). Hallmark Cards includes CrownMedia Holdings in its consolidated federal income tax return.  Accordingly, Hallmark Cards has benefitedfrom past tax losses and may benefit from future federal tax losses, which maybe generated by Crown Media Holdings. Based on the tax sharing agreement, Hallmark Cards has agreed to payCrown Media Holdings all of the benefits realized by Hallmark Cards as a resultof including Crown Media Holdings in its consolidated income tax return.  These benefits are estimated and paid 75% incash on a quarterly basis and the balance when Crown Media Holdings becomes afederal taxpayer.  A final true-upcalculation is completed within 15 days after Hallmark Cards files itsconsolidated federal income tax return for the year.  Pursuant to the true-up calculation, CrownMedia Holdings is obligated to reimburse Hallmark Cards the amount that anyestimated payments have exceeded the actual benefit realized by Hallmark Cardsand Hallmark Cards is obligated to pay Crown Media Holdings the amount that anyactual benefit exceeds the estimated payments. Under the tax sharing agreement, at Hallmark Cards’ option, thenon-interest bearing balance of the 25% in federal tax benefits may be appliedas an offset against any amounts owed by Crown Media Holdings to any member ofthe Hallmark Cards consolidation group under any loan, line of credit or otherpayable, subject to limitations under any loan indentures or contractsrestricting such offsets. During the third quarter of 2005, Hallmark Cards used$30.0 million of the approximately $40.0 million balance of this 25% balance tooffset intercompany debt.

 

TheCompany received $15.9 million and $34.7 million under the tax sharingagreement during the three months ended September 30, 2004 and 2005,respectively. The Company received $39.5 million and $56.1 million under thetax sharing agreement during the nine months ended September 30, 2004 and2005, respectively. These receipts have been recorded as an addition to paid-incapital. See “Liquidity” in Note 1 above.

 

19

----

 

***Costs Incurred on Crown Media Holdings’ Behalf***

 

Since inception, Hallmark Entertainment has at timespaid certain costs on behalf of Crown Media Holdings. Non-interest bearingunreimbursed costs of $4.5 million and $5.9 million are included in payable toaffiliates in the accompanying condensed consolidated balance sheets as of December 31,2004, and September 30, 2005, respectively.

 

***Services Agreement with Hallmark Cards***

 

CrownMedia Holdings entered into an Intercompany Services Agreement with HallmarkCards, effective January 1, 2003, under which Hallmark Cards agreed for aterm of three years to provide Crown Media Holdings with tax, risk management,health safety, environmental, insurance, legal, treasury and cash managementservices and real estate consulting services. Under the agreement, the Company agreed to pay Hallmark Cards $515,000per year for these services, plus out-of-pocket expenses and third party fees,payable in arrears on the last business day of each quarter. However, the Company has not been paying theseamounts as they are due. For each of the three months ended September 30,2004 and 2005, Crown Media Holdings had accrued $129,000 under the agreement. Foreach of the nine months ended September 30, 2004 and 2005, Crown MediaHoldings had accrued $386,000 under the agreement. At December 31, 2004,and September 30, 2005, non-interest bearing unpaid accrued service feesand unreimbursed expenses of $8.6 million and $9.8 million, respectively, wereincluded in payable to affiliates in the accompanying condensed consolidatedbalance sheets.

 

***Film Asset Services Agreement with Hallmark Entertainment***

 

The Company entered into a film asset services agreementwith Hallmark Entertainment, under which Hallmark Entertainment provides CrownMedia Holdings with services related to the administration, distribution andother exploitation of the Company’s film assets. In consideration for theservices provided by Hallmark Entertainment, Crown Media Holdings was, prior tothe sale of the Company’s international operations, obligated to pay a servicefee of $1.5 million per year, payable in quarterly installments of $375,000. AtDecember 31, 2004, and September 30, 2005, non-interest bearingunpaid accrued service fees of $375,000 and $188,000 were included in payableto affiliates in the accompanying condensed consolidated balance sheets. Followingthe sale of the Company’s international operations, the annual fee for theseservices was reduced to $750,000 per year and such amount has been prorated forthe period April 26, 2005, through December 31, 2005.

 

***Trademark Agreement with Hallmark Cards***

 

CrownMedia United States has a trademark license agreement with Hallmark Licensing, Inc.for use of the “Hallmark” mark for the Hallmark Channel and for the HallmarkMovie Channel.  During the third quarterof 2005, Hallmark Cards extended the trademark license agreements for theHallmark Channel and the Hallmark Movie Channel to September 1, 2006. TheCompany is not required to pay any fees under the trademark license agreements.

 

***Program License Agreements with Hallmark Entertainment Distribution***

 

Crown Media United States has licensed programming fordistribution in the United States from Hallmark Entertainment Distributionsince 1998.  Prior to October 11,2005, this programming was provided pursuant to a program license agreementdated January 1, 2001.  The term ofthis prior agreement would have automatically renewed on December 31, 2005for another three years. On October 11, 2005, the Company entered into anew program license agreement with Hallmark Entertainment Distribution whichsupersedes the prior agreement and is retroactive to January 1, 2005.

 

Underthe new agreement, Crown Media United States licenses certain television moviesand mini-series from Hallmark Entertainment Distribution for exhibition via allforms of television over the Hallmark Channel and the Hallmark Movie Channel inthe United States and its territories and possessions, including Puerto Rico.The prior agreement had limited the license to the Hallmark Channel and did notinclude Puerto Rico in the broadcast territory. The term of the new agreementexpires on December 31, 2008.  Thelicense is exclusive to Crown Media United States in the broadcast territoryduring the term against all forms of television. While the prior agreement

 

20

----

 

provided that Hallmark Entertainment Distribution was the exclusive source of original programming, under the new agreement Crown Media United States may freely license original programs from third party licensors during the term.

 

While the prior agreement did not require Hallmark Entertainment Distribution to produce and deliver a minimum number of original movies or original mini-series to Crown Media United States, under the new agreement, Hallmark Entertainment Distribution is required to produce and deliver to Crown Media United States, and Crown Media United States is required to order and license from Hallmark Entertainment Distribution, 13 original Movies and 3 original mini-series in 2005, 31 original movies and 6 original mini-series in 2006 and 18 original movies and 3 original mini-series in 2007.  Crown Media United States may elect to reduce the number of original movies required to be licensed under the new agreement in 2006 by up to six original movies (and, under certain conditions, to reduce the number of original mini-series to be licensed in 2006 by up to three) and may elect to completely cancel its obligation to license any original movies and original mini-series in 2007.  Under certain conditions, Hallmark Entertainment Distribution may similarly reduce or eliminate the number of original movies or original mini-series that it is required to produce under the new agreement in those years.

 

The license term for the original movies and original mini-series is three years (or five years with respect to certain holiday-themed programs and programs delivered in 2005), and Crown Media United States has the right to exhibit the programs on 30 days during the license term (with unlimited runs per exhibition day). The new agreement also grants Crown Media United States the right to an additional 15 exhibition days to six specified original movies during their initial license term. Hallmark Entertainment Distribution has an option to extend the license term of the original mini-series for an additional three-year period (thereby obligating Crown Media United States to pay an additional fee equal to 50% of the fee paid for the initial license term). Hallmark Entertainment Distribution’s option under the prior agreement to also extend the license term of the original movies for an additional three-year period was eliminated under the new agreement. Instead, Crown Media United States has a right of first negotiation on a product-by-product basis with respect to a potential second license term for original movies delivered on or after January 1, 2005.

 

In addition to the original movies and original mini-series referred to above, Crown Media United States also agreed to license from Hallmark Entertainment Distribution (a) specified previously-licensed programs for a second three-year license term as to which Hallmark Entertainment Distribution had the option to extend under the prior agreement, and (b) specified second run movies and mini-series (i.e. those previously broadcast by one other television network) for an initial three-year license term, with an option in favor of Hallmark Entertainment Distribution to extend the license term for an additional three-year period (for an additional licensee fee equal to 50% of the fee paid for the initial term). The new agreement limits the number of such pictures that Crown Media United States may be required to license from Hallmark Entertainment Distribution during 2006 through 2008 to a maximum of 15 per year, compared to a maximum of 50 per year under the prior agreement.

 

The new agreement provides for additional licensing fees for original movies and original mini-series, provided that the additional license fees payable by Crown Media United States to Hallmark Entertainment Distribution for such movies and mini-series delivered in 2005 are not payable by Crown Media United States to Hallmark Entertainment Distribution until July 1, 2006. The license fees payable for the remaining programming is unchanged from the prior agreement.

 

Under the new agreement, Crown Media United States for the first time is granted pay per view, video on demand and internet/interactive rights to original movies and original mini-series in their initial three-year term, subject to sharing the net revenues therefrom equally with Hallmark Entertainment Distribution. Crown Media United States may sublicense its rights to the programs licensed under the new agreement to a third party for exhibition in any television media, subject to Hallmark Entertainment Distribution’s prior approval, not to be unreasonably withheld; provided, however, that Crown Media United States has the right to sublicense its pay per view, video on demand or internet/interactive rights with respect to original movies and original mini-series during their initial license term to a third party without Hallmark Entertainment Distribution’s prior approval. If the total compensation Crown Media United States receives from such sublicenses for any program exceeds the license fee it is obligated to pay Hallmark Entertainment Distribution for the program, such excess is divided equally between Hallmark Entertainment Distribution and Crown Media United States.

 

21

----

 

CrownMedia United States did not sub-license any licensed programming to thirdparties during the three and nine months ended September 30, 2004 and2005.  Amounts due to HallmarkEntertainment Distribution as a result of these sub-licensing agreements havebeen included in license fees payable to affiliates in the accompanying balancesheets as noted below.

 

Programming costs related to the Hallmark EntertainmentDistribution program license agreements were $5.0 million and $7.6 million forthe three months ended September 30, 2004 and 2005, respectively. Programmingcosts related to the Hallmark Entertainment Distribution program license agreementswere $14.3 million and $21.5 million for the nine months ended September 30,2004 and 2005, respectively. As of December 31, 2004, and September 30,2005, $152.0 million and $146.4 million, respectively, are included in licensefees payable to affiliates in the accompanying condensed consolidated balancesheets. The Company obtained a letter from Hallmark Cards whereas HallmarkCards and its subsidiaries will not demand payment of these license fees priorto August 31, 2006.

 

**11. Company Obligated Mandatorily Redeemable Preferred Interest andNICC License Agreements**

 

VISN owns a $25.0 millioncompany obligated mandatorily redeemable preferred interest in Crown MediaUnited States (the “preferred interest”) issued in connection with aninvestment by the Company in Crown Media United States. On November 13,1998, the Company, Vision Group, VISN and Henson Cable Networks, Inc.signed an amended and restated company agreement governing the operation ofCrown Media United States, which agreement was further amended on February 22,2001, January 1, 2002, March 5, 2003, January 1, 2004 and November 15,2004  (the “company agreement”).

 

 Under the companyagreement, the members agreed that if during any year ending after January 1,2005 and prior to December 31, 2009, Crown Media United States has netprofits in excess of $10.0 million, and the preferred interest has not beenredeemed, Crown Media United States will redeem the preferred interest in anamount equal to the lesser of: (i) such excess net profits; (ii) $5.0million; or (iii) the amount equal to the preferred liquidation preferenceon the date of redemption.  Crown MediaUnited States may voluntarily redeem the preferred interest at any time,however, it is obligated to do so on the date of redemption (December 31,2010). Due to the mandatory redemption provision of the preferred interest, on July 1,2003, the preferred interest was remeasured at fair value and reclassified tonon-current liabilities in accordance with the provisions of SFAS No. 150.

 

Underthe company agreement, Crown Media United States is also obligated to makecertain payments for programming to NICC. Specifically, Crown Media United States may be required to pay licensefees to NICC or fund production costs consisting of: (i) a total of $5.3million per year, with consumer price index escalations, for two recurringprogramming blocks produced by NICC; (ii) up to $10.0 million per year foran additional recurring “signature” series program block co-produced by NICCand Crown Media United States; (iii) up to $600,000 per “non-dramatic”holiday special produced by NICC; and (iv) up to $1.0 million per “dramatic”holiday special co-produced by NICC and Hallmark Entertainment.

 

In addition, Crown Media United States agreed toadvance NICC $3.0 million per year in 2002 through 2005 to help fund NICC’scost of expanding its production operations to produce the aforementioned “signature”series.   These advances will berecovered from the license fees payable for this programming when suchprogramming is produced and accepted by Crown Media United States fordistribution on the channel. The Company is expensing these amounts as incurredgiven the uncertainty surrounding whether or not the programming will beproduced and/or accepted. These expenses are included as components ofaffiliate programming costs in the accompanying consolidated statements ofoperations.

 

In May 2005, we received a letter from NationalInterfaith Cable Coalition, Inc. threatening litigation. The letter claimsthat, among other things, the Company and Hallmark Entertainment have nothonored their commitments relating to the production and financing of NICCprogramming under the company agreement. NICC alleges that we and HallmarkEntertainment have materially breached the agreement, causing substantialdamages to NICC in an amount which exceeds $100.0 million.  The letter further indicated that NICCintended to file litigation for breaches of the Amendment unless we agreed, by June 1,2005, to enter into a new, extended agreement with NICC for the production,promotion and funding of programming. While we believe that the Company and Hallmark

 

22

----

 

Entertainment have not breached the company agreement, the Company hasbeen in negotiations with NICC to try to amicably resolve these issues and NICChas not yet filed litigation.  We cannot,however, predict at this time whether these negotiations will successfullyresolve NICC’s claims or whether there will be litigation. Accordingly, we havenot provided for any amount of loss in these condensed financial statements forthis matter.

 

During the three monthsended September 30, 2004 and 2005, Crown Media United States paid NICC $653,000and $4.5 million, respectively, and during the nine months ended September 30,2004 and 2005, $7.9 million and $9.7 million, respectively, related to thecompany agreement, as amended.

 

**12. Employee Incentives**

 

In April 2003, the Company’s Board of Directorsapproved actions to provide additional incentives to encourage retention of itsemployees. Crown Media Holdings’ then outstanding stock options held byemployees had exercise prices significantly above the market value of its Class Acommon stock.  The Company made an offerin May 2003 to senior management and vice presidents, totalingapproximately 55 persons, to exchange their options for restricted stock units(“RSUs”).  The exchange ratio was one RSUfor every 2.5 options for shares of the Company’s Class A common stock,resulting in a total of 5,126,732 options exchanged for 2,050,693 RSUs. EachRSU, upon vesting, represents the right to receive one share of Class Acommon stock or the value of the share in cash at the time of vesting.  The determination of whether RSUs will besettled in cash or common stock is made by the Company’s Board of Directors. TheRSUs vest over three years in one-third increments on the anniversary of thegrant date each year and the Company is accruing expense related to the RSUsratably over each increment’s vesting period using the price of our Class Acommon stock on the last day of the reporting period.

 

Options for 279,254 shares of common stock owned bycertain executives and vice presidents that were not exchanged are subject tovariable plan accounting in which compensation is remeasured at each reportingdate until the options are exercised, expire unexercised or are forfeited.

 

In May 2004, theCompany’s Board of Directors approved an additional grant to employees of1,065,000 RSUs. The Employment RSUs, which constitute 70% of the award grantedin 2004, vest in equal one-third installments over the next three years on theanniversary of the grant date each year. The Company is accruing expenserelated to the Employment RSUs ratably over each installment’s vesting periodusing the price of our Class A common stock on the last day of thereporting period. The Performance RSUs, constituting 30% of the award grantedin 2004, vest on the 3rd anniversary of the grant date, providedthat the price of the Crown common stock is $14 or higher on that date. TheCompany will begin to accrue compensation expense for the Performance RSUs whenit becomes probable that the price of the Company’s stock will be $14 or moreon the 3rd anniversary of the grant date or upon a change in control.

 

TheCompany is recording compensation expense based on the fair value of the commonstock or cash equivalent required to settle the RSUs at each reporting periodend during the vesting period of the RSUs. Such compensation expense iscalculated using variable plan accounting.

 

The Company recorded $2.5million and $3.0 million, of compensation expense associated with the RSUsduring the three months ended September 30, 2004 and 2005, respectively, and$8.3 million, of compensation expense during both the nine months ended September 30,2004 and 2005, respectively, which has been recorded as a liability for RSUs inthe accompanying consolidated balance sheet and is included in selling, generaland administrative expense in the accompanying consolidated statement ofoperations. The Companysettled certain RSUs during the three months ended March 31, 2005, forapproximately $4.2 million in cash. Additionally, in conjunction with the closeof the international transaction, the Company immediately vested and settledRSUs held by individuals employed by the international business in May 2005for approximately $4.0 million in cash.  In June 2005, the Company settled the contractuallyvested RSUs for approximately $3.8 million in cash. In August 2005, theCompany immediately vested and settled RSUs held by one employee of the Companyfor approximately $139,000 in cash.

 

In June 2005, the Company’s Board of Directorsapproved a grant to those Directors who were not employees of the Company or ofHallmark Cards or its affiliated companies, of 70,884 RSUs.  The grant was intended to satisfy

 

23

----

 

incentive compensation obligations to these Directors for2003 and 2004.  The grant was subject toapproval of the Company’s shareholders of a change in the Company’s Amended andRestated 2000 Long Term Incentive Plan to permit the grant of RSUs toDirectors. In July 2005, the shareholders approved this amendment to theLong Term Incentive Plan. The RSUs vest in equal one-third installments overthree years on the anniversary of the grant dates each year. The Company isaccruing expense related to the RSUs ratably over each installment’s vestingperiod using the price of our Class A common stock on the last day of thereporting period. Since the effective dates of these grants were in May 2003and May 2004 and some portions of the grants had, therefore, vested, in August 2005,the Company settled the vested RSUs held by these Directors for approximately$353,000 in cash.

 

In August 2005, theCompany’s Board of Directors approved an additional grant to employees of828,000 RSUs. The Employment RSUs, which constitute 50% of the award granted in2005, vest in equal one-third installments over the next three years on theanniversary of the grant date each year. The Company is accruing expenserelated to the Employment RSUs ratably over each installment’s vesting periodusing the price of our Class A common stock on the last day of thereporting period. The Performance RSUs, constituting 50% of the award grantedin 2005, vest on the 3rd anniversary of the grant date, providedthat the price of the Crown common stock is $14 or higher on that date. TheCompany will begin to remeasure compensation expense each period for thePerformance RSUs if and when it becomes probable that the price of the Company’sstock will be $14 or more on the 3rd anniversary of the grant dateor upon a change in control.

 

In August 2005, theCompany’s Board of Directors approved an additional grant to one executive of115,000 RSUs. The Employment RSUs, which constitute 50% of the award granted in2005, vest in equal one-third installments on dates which are three months, sixmonths and nine months, respectively, after the grant date. The Company isaccruing expense related to the Employment RSUs ratably over each installment’svesting period using the price of our Class A common stock on the last dayof the reporting period. The Performance RSUs, constituting the remaining 50%of the award granted in 2005, vest on the 3rd anniversary of thegrant date, provided that the price of the Crown common stock is $14 or higheron that date. The Company will begin remeasure compensation expense each periodfor the Performance RSUs if and when it becomes probable that the price of theCompany’s stock will be $14 or more on the 3rd anniversary of thegrant date or upon a change in control.

 

In August 2005,the Board of Directors authorized several contingent employee compensation benefitsin contemplation of a possible change in control of the Company. For thepurpose of these benefits, a “change in control” occurs upon (i) a 20%change in ownership of the Company, (ii) a change in a majority of theBoard of Directors, or (iii) a sale of all or substantially all of theassets of the Company.  A transactionbonus equal to 40% of employees’ base compensation will be paid upon a changein control.  At its discretion, theCompany may pay an unspecified portion of the transaction bonus in March 2006if a change in control has not yet occurred. A longevity-and title-based severance benefit provides for salary, wage andbonus payments, extended health insurance coverage, and outplacement servicesto employees who are terminated as a result of the change in control.  Most of the executive officers of the Companyare subject to employment contracts, some of which contain provisions forbenefits in addition to those referred to above.  Except for the portion of the transactionbonus that may be paid prior to a change in control, the Company will notrecognize the transaction bonuses and severance compensation as liabilitiesuntil a change in control, if any, occurs. Based on its personnel roster in October 2005, the Companyestimates that the cost of the transaction bonuses and severance benefits wouldbe approximately $25.0 million to $45.0 million.

 

**13. Segment Reporting**

 

TheCompany’s continuing operations are currently organized into two principaldivisions representing operating segments: domestic channel and filmdistribution. The Company evaluates performance and allocates resources based onthe results of these segments. The key operating performance criteria used inthis evaluation include revenue, segment income (loss) and total assets.  The results of operations of ourinternational channel operating segment are not included in the segmentreporting as they are classified separately as discontinued operations in theCompany’s consolidated financial statements (see note 14).

 

The following tables present theCompany’s segment information for the periods indicated (in thousands):

 

24

----

 

*Three Months Ended September 30, 2004*

 
| ** **                            | ** ** | **Domestic** | ** ** | **Film  Distribution** | ** ** | **Adjustments** | ** ** | **Consolidated** | ** ** |
|---------------------------------------|------------|--------------|------------|------------------------|------------|-----------------|------------|------------------|------------|
|                                  |       |         |       |                   |       |            |       |             |       |
| Total revenue                         |       | $            | 30,024     |                   | $          | 5,372           |       | $                | (4,101     | )(1) | $ | 31,295 |   |
|                                  |       |         |       |                   |       |            |       |             |       |
| Adjusted segment income (loss)        |       | $            | (2,633     | )                      | $          | (680            | )          | $                | (926       | )(2) | $ | (4,239 | ) |
| Depreciation and amortization expense |       | (1,573       | )          | 2,903                  |       | (2,861          | )(3)       | (1,531           | )          |
| Amortization of film assets           |       | —       |       | (8,940                 | )          | 5,075           | (5)        | (3,865           | )          |
| Impairment of film assets             |       |         |       | (19,321                | )          |            |       | (19,321          | )          |
| Subscriber acquisition fee expense    |       | (10,690      | )          | 846                    |       | 1               |       | (9,843           | )          |
| Interest expense                      |       | (657         | )          | (15,743                | )          | 1,260           | (2)        | (15,140          | )          |
| Loss from  continuing operations      |       | $            | (15,553    | )                      | $          | (40,935         | )          | $                | 2,549      |   | $ | (53,939 | ) |
|                                  |       |         |       |                   |       |            |       |             |       |
| Total assets                          |       | $            | 656,022    |                   | $          | 537,487         |       | $                | 286,138    | (4) | $ | 1,479,647 |   |

 

*Three Months Ended September 30, 2005*

* *
| ** **                            | ** ** | **Domestic** | ** ** | **Film  Distribution** | ** ** | **Adjustments** | ** ** | **Consolidated** | ** ** |
|---------------------------------------|------------|--------------|------------|------------------------|------------|-----------------|------------|------------------|------------|
|                                  |       |         |       |                   |       |            |       |             |       |
| Total revenue                         |       | $            | 51,685     |                   | $          | 2,403           |       | $                | (3,418     | )(1) | $ | 50,670 |   |
|                                  |       |         |       |                   |       |            |       |             |       |
| Adjusted segment income (loss)        |       | $            | 11,448     |                   | $          | (7,154          | )          | $                | 6          | (2) | $ | 4,300 |   |
| Depreciation and amortization expense |       | (8,578       | )          | 7,297                  |       | (1              | )          | (1,282           | )          |
| Amortization of film assets           |       |         |       | (13,830                | )          | —          |       | (13,830          | )          |
| Impairment of film assets             |       |         |       | (22,939                | )          | —          |       | (22,939          | )          |
| Subscriber acquisition fee expense    |       | (12,953      | )          | 846                    |       | 1               |       | (12,106          | )          |
| Income tax provision                  |       |         |       |                   |       | (4              | )          | (4               | )          |
| Interest expense                      |       | (1,228       | )          | (18,119                | )          | 1               |       | (19,346          | )          |
| Loss from  continuing operations      |       | $            | (11,311    | )                      | $          | (53,899         | )          | $                | 3          |   | $ | (65,207 | ) |
|                                  |       |         |       |                   |       |            |       |             |       |
| Total assets                          |       | $            | 781,394    |                   | $          | 468,577         |       | $                | —     | (4) | $ | 1,249,971 |   |

 

*Nine Months Ended September 30, 2004*

 
| ** **                            | ** ** | **Domestic** | ** ** | **Film  Distribution** | ** ** | **Adjustments** | ** ** | **Consolidated** | ** ** |
|---------------------------------------|------------|--------------|------------|------------------------|------------|-----------------|------------|------------------|------------|
|                                  |       |         |       |                   |       |            |       |             |       |
| Total revenue                         |       | $            | 91,011     |                   | $          | 17,481          |       | $                | (13,862    | )(1) | $ | 94,630 |   |
|                                  |       |         |       |                   |       |            |       |             |       |
| Adjusted segment income (loss)        |       | $            | (8,607     | )                      | $          | 1,466           |       | $                | (4,549     | )(2) | $ | (11,690 | ) |
| Depreciation and amortization expense |       | (4,412       | )          | 5,280                  |       | (5,710          | )(3)       | (4,842           | )          |
| Amortization of film assets           |       |         |       | (24,407                | )          | 11,865          | (5)        | (12,542          | )          |
| Impairment of film assets             |       |         |       | (19,321                | )          |            |       | (19,321          | )          |
| Subscriber acquisition fee expense    |       | (29,863      | )          | 2,539                  |       |            |       | (27,324          | )          |
| Interest expense                      |       | (1,732       | )          | (45,547                | )          | 3,528           | (2)        | (43,751          | )          |
| Loss from  continuing operations      |       | $            | (44,614    | )                      | $          | (79,990         | )          | $                | 5,134      |   | $ | (119,470 | ) |
|                                  |       |         |       |                   |       |            |       |             |       |
| Total assets                          |       | $            | 656,022    |                   | $          | 537,487         |       | $                | 286,138    | (4) | $ | 1,479,647 |   |

 

25

----

 

*Nine Months Ended September 30, 2005*

* *
| ** **                            | ** ** | **Domestic** | ** ** | **Film  Distribution** | ** ** | **Adjustments** | ** ** | **Consolidated** | ** ** |
|---------------------------------------|------------|--------------|------------|------------------------|------------|-----------------|------------|------------------|------------|
|                                  |       |         |       |                   |       |            |       |             |       |
| Total revenue                         |       | $            | 139,116    |                   | $          | 9,310           |       | $                | (11,495    | )(1) | $ | 136,931 |   |
|                                  |       |         |       |                   |       |            |       |             |       |
| Segment income (loss)                 |       | $            | 6,125      |                   | $          | (14,087         | )          | $                | (1,245     | )(2) | $ | (9,207 | ) |
| Depreciation and amortization expense |       | (24,790      | )          | 24,476                 |       | (4,079          | )(3)       | (4,393           | )          |
| Amortization of film assets           |       |         |       | (39,985                | )          | 6,810           | (5)        | (33,175          | )          |
| Impairment of film assets             |       |         |       | (22,939                | )          |            |       | (22,939          | )          |
| Subscriber acquisition fee expense    |       | (39,484      | )          | 2,539                  |       | 1               |       | (36,944          | )          |
| Income tax provision                  |       |         |       |                   |       | (10             | )          | (10              | )          |
| Interest expense                      |       | (3,421       | )          | (51,844                | )          | 1,579           | (2)        | (53,686          | )          |
| Loss from  continuing operations      |       | $            | (61,570    | )                      | $          | (101,840        | )          | $                | 3,056      |   | $ | (160,354 | ) |
|                                  |       |         |       |                   |       |            |       |             |       |
| Total assets                          |       | $            | 781,394    |                   | $          | 468,577         |       | $                | —     | (4) | $ | 1,249,971 |   |

 

----

(1) Adjustmentrepresents netting of certain subscriber acquisition fee expense againstrevenue not allocated to domestic segment and film asset license fees frominternational sources. Prior to the sale of the international business, film assetlicense fees earned from international sources were included in the Company’sFilm Distribution segment.

(2) Represents amountsnot allocated to the individual segments on the financial reports reviewed byour chief operating decision maker.

(3)  Representsprogramming amortization excluded from the individual segment income (loss)calculation.

(4) Represents assetsheld for sale from the international business sold in April 2005.

(5) Representsamortization associated with film asset license fees earned from internationalsources prior to the sale of the international business in April 2005.

 

Three individual paytelevision distributors accounted for more than 15% of the Company’sconsolidated subscribers for the three and nine months ended September 30,2004 and 2005.

 

**14.  Discontinued Operations**

 

On February 23,2005, the Company signed an agreement for the sale of its internationalbusiness and obtained other agreements enabling the Company to then conduct thesale.  The sale closed on April 26,2005. The accompanying condensed consolidated statements of operations and cashflows for each of the three and nine month periods ended September 30,2004 and 2005 present the associated results of operations and cash flows ofthe international assets as “discontinued operations” pursuant to SFAS No. 144*Accounting for the Impairment or Disposal of Long-Lived Assets*.

 

Thenet losses from discontinued operations during each of the three and nine monthperiods ended September 30, 2004 and 2005, were comprised of thefollowing:

 

| ** **                         | ** ** | **Three Months  Ending September 30,** | ** ** | **Nine Months  Ending September 30,** | ** ** |
|------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                         | ** ** | **2004**                                    | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                         | ** ** | **(In thousands)**                          | ** ** |
| ** **                         | ** ** | ** **                                  | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                            |       | $                                           | 24,250     |                                       | $          | — |   | $ | 74,630 |   | $ | 34,575 |   |
| Costs and expenses                 |       | (73,508                                     | )          | —                                     |       | (136,406 | ) | (42,358 | ) |
| Interest expense                   |       | (1,661                                      | )          | —                                     |       | (4,731 | ) | (2,081 | ) |
| Income tax provision               |       | (904                                        | )          | —                                     |       | (1,848 | ) | (802 | ) |
| Loss from  discontinued operations |       | $                                           | (51,823    | )                                          | $          | — |   | $ | (68,355 | ) | $ | (10,666 | ) |

 

26

----

 

EffectiveFebruary 23, 2005, the Company ceased depreciating and amortizing certainof the international assets held for sale. Had the Company not ceased such depreciation and amortization, the lossfor discontinued operations for the nine months ended September 30, 2005would have included an additional $1.8 million of depreciation and amortizationexpense and an additional $3.8 million of amortization of film assets.

 

Interestexpense includes an allocation of interest related to the Company’s bank creditfacility that was required to be paid as a result of the sale.  The allocation was required by EmergingIssues Task Force (“EITF”) Issue No. 87-24, *Allocationof Interest to Discontinued Operations*.  Such interest expense amounted to $1.3million and $0 for the three month periods ended September 30, 2004 and2005, respectively.  Such interestexpense amounted to $3.5 million and $1.6 million for the nine month periodsended September 30, 2004 and 2005, respectively.  Upon receipt of cash from the sale, theCompany was required to repay and retire the $100.0 million term loan under theCompany’s bank credit facility.

 

27

----

 

**ITEM 2.  *Management’s Discussion and Analysis of FinancialCondition and Results of Operations***

 

The following discussion and analysis of the Company’sfinancial condition and results of operations should be read in conjunctionwith the “Management’s Discussion and Analysis of Financial Condition andResults of Operations” beginning on page 29 of the Company’s Annual Reporton Form 10-K for the year ended December 31, 2004.

 

**Description of Business and Overview**

 

Crown Media Holdings, Inc. (“Crown Media Holdings,”“Crown Media” or the “Company”), through its subsidiaries, owns and operatespay television channels (collectively the “Hallmark Channel,” the “HallmarkMovie Channel,” the “channel” or the “channels”) dedicated to high quality,entertainment programming for adults and families, in the United States and,prior to the sale of its international business, in various countriesthroughout the world.

 

At theend of the third quarter of 2005, the Hallmark Channel was in 69.2 millionhomes in the United States.  Subsequentto the end of the quarter, distribution has continued to grow and currentlystands at 70.0 million.  In 2005, theHallmark Channel also increased overall ratings.  The growth in ratings during 2005 began withour Holiday campaign at the end of 2004. This campaign focused on Holiday themed movies and linked togetherpromotions with the Hallmark Gold Crown Stores. The result of this campaign was an increase in new viewers to theHallmark Channel.  To build upon thesuccess of the Holiday campaign, during the first quarter of 2005, a newprogramming concept, Hallmark Channel Mystery Movies, was introduced.  This new programming concept premiered onFriday nights during the first quarter of 2005 and each of the movies averageda household coverage rating of 1.3, which was a nearly 60% increase from thesame period in the prior year.  Duringthe second quarter, additional Mystery Movies were aired.  In addition, the Hallmark Channel premiered anumber of other original movies that also resulted in strong ratings.   Programming successes continued in the thirdquarter which was the highest rated quarter in the Channel’s history.  Similar to 2004, and in an effort to buildupon our year to date ratings performance, the Channel will have a Holidaycampaign in the fourth quarter of 2005.

 

On April 26,2005, the sale of our international business was completed for $222.0million.  Proceeds from the sale wereused to repay and retire $100.0 million of our bank credit facility and reducethe outstanding balance on our revolving credit facility by $95.0 million, paytransaction costs of approximately $5.0 million and to prepay approximately$12.6 million towards the technical services agreement with the buyer of theinternational business. The completion of the sale of the internationalbusiness has allowed Crown Media Holdings to focus on the growth and success ofthe Hallmark Channel in the United States.

 

Welaunched our second 24-hour linear channel, the Hallmark Movie Channel, duringthe first quarter of 2005.  The HallmarkMovie Channel focuses on movies and mini-series and utilizes content from ourfilm library for programming.  The launchof the Hallmark Movie Channel provides an opportunity for the Company to builda second programming asset, use this programming asset as a value addedenhancement to increase distribution of the Hallmark Channel, and further leveragethe content in our film library.

 

TheCompany also owns a film library comprised of approximately 640 titles.  Through our subsidiary, Crown MediaDistribution, we sell license rights in the United States to titles in thelibrary to a variety of customers. In addition, the Company utilizes the filmlibrary for programming content on the Hallmark Channel and Hallmark MovieChannel. We have increased the internal use of the film assets on the HallmarkChannel as a result of a shift to air more movies and the launch of theHallmark Movie Channel.

 

As theHallmark Channel and the Hallmark Movie Channel continue to develop, the corefocus for the business remains unchanged. First, distribution must continue to expand. While the ratingsperformance the Hallmark Channel ranks in the top ten of cable networksaccording to Nielsen, in terms of distribution, the Hallmark Channel is only inthe top 40 cable networks. Increased distribution can have a positive impact onour subscriber revenue (depending on any subscriber acquisition fees incurred)and should increase our advertising revenue. As noted

 

28

----

 

above, increased distribution in and of itself will enhance advertisingsales simply because of the increased viewer universe. However, combininggrowing distribution with increasing ratings is more powerful in terms ofadvertising revenue. As a result, the Hallmark Channel will continue to focuson enhancing its programming schedule through the acquisition of new series,additional original movies such as the recent Mystery Movies, and throughunique scheduling concepts.

 

Weplan to develop the Hallmark Movie Channel as an additional revenuesource.  While it can play a criticalrole in terms of contract renewals with the various distributors who believethat a 24 hour digital movie only service is value added, and can justifyitself on that basis, it can also stand on its own in terms of its businessmodel.  It will generate both subscriberand advertising revenue in 2005 and as distribution continues to expand, thefinancial contribution of the Hallmark Movie Channel may continue to grow.

 

Inaddition, we plan to focus on library sales. Our film library is a largecollection of award winning movies and mini-series, which is unique in that itis such a large collection of family oriented films.

 

All ofthe above needs to be accomplished in a cost efficient fashion. Cost managementwill continue to be a focus for the management of Crown Media Holdings.

 

TheHallmark Channel in the United States faces short-term and long-term challengeson the distribution front.  As notedabove, the near-term focus remains on growing the subscriber base.  One of the nine largest multiple systemoperators has been our largest source of subscriber growth over the last 18months due to contractual monetary incentives, and the incentives under thisAgreement were extended and revised during the second quarter of 2005. Webelieve that we will continue to grow our subscriber base with this multiplesystems operator in the future.  Thecurrent and long-term distribution challenges will be renewing our distributionarrangements with the multiple system operators as they expire.  While the economics of the renewals andpotential cash incentive payments are unknown and could have a significantimpact on our business, we believe that the success of the Hallmark Channel interms of ratings and the environment we have created with our programming schedule willenhance our renewal discussions. We also believe that our ability to offer tomultiple systems operators a second channel, the Hallmark Movie Channel, is avalue added component of the renewal equation. In October 2005, we entered into a renewal of our distributionagreement with one of the major distributors in the United States. The largestfactors contributing to the economics of the distribution agreements arelicense fees and subscriber acquisition fees.

 

Domestictelephone companies are entering into the business of distributing televisionchannels to households through their wire-lines. We have reached agreement withseveral telephone companies which permit the carriage of the Hallmark Channeland Movie Channel and are negotiating with others.  We expect that subscribers to these telephoneservices will in large part be customers previously served by existing cabletelevision companies and satellite television companies.  To date, subscribers and revenues throughtelephone companies has been insignificant.

 

Threefactors have contributed to the ratings improvements of the Channel: acquiredseries and movies, original productions and marketing.  Acquired series ranging from *Perry Mason* to *Walker, Texas Ranger*and *M*A*S*H* have consistently deliveredstrong ratings across all day-parts. Original productions are our most high profile programs and generate thechannel’s highest ratings.  Originalproductions are significant in helping our distribution and advertising salesteams sell the channel. Substantially, all of our original programming is providedby Hallmark Entertainment, a subsidiary of Hallmark Cards.

 

Tocontinue the ratings growth and enhance the demographics of our viewers, theHallmark Channel must continue to invest in programming and marketing.  For the Hallmark Channel to continue to increaseits attractiveness to distributors and advertisers, it has to increase itsratings and draw a younger more upscale audience, which is generally moreattractive to advertisers.

 

Deliveringstrong ratings growth to larger audiences has made it possible for ouradvertising sales to grow rapidly over the last few years.  To advertisers, the Hallmark Channel offers astrong brand, positive environment and family friendly programming with asuccessful growth pattern.  Thesecharacteristics have enabled the channel

 

29

----

 

to sell to advertisers in the packaged goods and pharmaceuticalindustries.  The next step for theHallmark Channel will be to deliver the younger more upscale audience needed togain advertisers from the more lucrative financial services and automotiveindustries.

 

**International Business**

 

As more fully described in the notes to condensedconsolidated financial statements included in this quarterly report on Form 10-Q,in April 2005, the Company completed the sale of its internationalbusiness. The international business is classified in the financial statementsfor the three and nine months ended September 30, 2004 and 2005, asdiscontinued operations.

 

**Strategic Alternatives for the Company**

 

TheCompany announced on August 18, 2005, that its Board of Directors hasauthorized the Company to explore strategic alternatives for the Company,including a potential sale of the Company to a third party.  In support ofthis initiative, a Special Committee of independent directors of the Board ofDirectors has been formed to oversee the process. Hallmark Cards, Incorporatedhas advised the Company’s Board of Directors that it fully supports the Board’sdetermination. Hallmark has also advised the Board that it would considerentering into a license agreement with respect to the Hallmark Channel name inconnection with the sale of the Company if requested by a potential acquirer.There can be no assurance that the Company will enter into or consummate any transaction,or as to the terms or timing thereof.

 

**Revenuefrom Continuing Operations**

 

*Our revenueconsists primarily of subscriber fees, advertising and film asset license fees.*

* *

*Subscriber Fees*

* *

Subscriber fees are generally payable to us on a persubscriber basis by distributors for the right to carry our channels. We havepaid certain distributors up-front subscriber acquisition fees to carry ourchannels. Subscriber acquisition fees that we pay are capitalized and amortizedover the contractual term of the applicable distribution agreement as areduction in subscriber fee revenue. If the amortization expense exceeds therevenue recognized on a per distributor basis, the excess amortization isincluded as a component of cost of services.

* *

Rateswe receive per subscriber vary according to:

 

•                                          the level ofsophistication and degree of competition in the market;

 

•                                          therelative position in the market of the distributor and the popularity of thechannel;

 

•                                          thepackaging arrangements for the channel; and

 

•                                          othercommercial terms and length of the contract term.

 

We arein continuous negotiations with our existing distributors to increase oursubscriber base in order to enhance our advertising results. We are oftensubject to requests by distributors to pay subscriber acquisition fees foradditional carriage or to waive or accept lower subscriber fees if certainnumbers of additional subscribers are provided. We also may help fund thedistributors’ efforts to market our channels or we may permit distributors tooffer limited promotional periods without payment of subscriber fees. As wecontinue our efforts to add subscribers, our subscriber revenue will continueto be negatively affected by subscriber acquisition fee amortization, waiver ofsubscriber fees and bulk discounts resulting from the attainment of certainsubscriber levels; however, we believe that as a result of these measures, oursubscriber levels will increase which in turn will allow us to attractadditional advertisers and command higher advertising rates.

 

30

----

 

Ourchannel is usually offered as one of a number of channels on either a basictier or part of other program packages and is not generally offered on a stand-alonebasis. Thus, while a cable or satellite customer may subscribe and unsubscribeto the tiers and program packages in which our channel is placed, thesecustomers do not subscribe and unsubscribe to our channel alone.  We are not provided with information from thedistributors on their overall subscriber churn and in what manner their churnrates affect our subscriber counts; instead, we are provided information on thetotal number of subscribers who receive the Hallmark Channel.

 

Oursubscriber count depends on the number of distributors carrying the HallmarkChannel and the size of such distributors as well as the program tiers on whichour channel is carried by these distributors. From time to time, we experiencedecreases in the number of subscribers as promotional periods end, or as adistributor arrangement is amended or terminated by us or the distributor. Anydecreases in subscribers due to these changes to distribution arrangements inthe third quarter of 2005 have not been significant. Management analyzes theestimated effect each new or amended distribution agreement will have onrevenues and costs. Based upon these analyses, management endeavors to achievea fair combination of subscriber commitments and subscriber acquisition feeswith each of our domestic distributors.

 

#### A*dvertising*

####  

Advertisingsales generally are made on the basis of a price per advertising spot or perunit of audience measurement (for example, a ratings point). Thus, ouradvertising revenues are heavily dependent on number of people viewing ourchannel. Rates vary on a market-by-market basis and differ amongst marketsdepending on audience demographics.

 

Ouradvertising rates are generally an agreed upon price per unit of audiencemeasurement in return for a guaranteed commitment by the advertiser. We commit toprovide advertisers certain rating levels and the resulting levels of viewerswatching their advertising material. Thus, our advertising revenue is afunction of the ratings garnered by the channel and the number of subscribersreceiving the channel. Revenue is recorded net of estimated deliveryshortfalls, which are usually settled by providing the advertiser additionaladvertising time. Advertising rates also vary by time of year due to seasonalchanges in television viewership.

 

*Film Asset License Fees*

 

The Company generates revenue from the film assets bygranting licenses to exhibit the films to third parties in the United States.We are also using the films as programming for the Hallmark Channel and theHallmark Movie Channel. Customers for our film assets consist of othertelevision channels, syndicators, home video distributors and brokers whoresell rights to our film assets. License fees for our film assets aregenerally negotiated based upon the perceived quality of the films, the size ofthe potential audience who will be viewing the programming and the length ofthe airing window. The market for our film library is typically seasonal, withover half of the annual sales occurring in the fourth quarter. This seasonalityis due to the timing of our customers’ program scheduling activities.

* *

**Costof Services**

 

Our cost of services consists primarily of programlicense fees, amortization of our film assets; subscriber acquisition feeexpense; the cost of signal distribution; administration, distribution andother exploitation of our film assets; and the cost of promotional segmentsthat are aired between programs. We expect cost of services to continue toincrease in the future as we expand our existing distribution universe andthird party programming to support our advertising strategy.

* *

**CriticalAccounting Policies, Judgments and Estimates**

 

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States requires usto make estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosure of contingent liabilities at the date of thefinancial statements and the reported amounts of revenues

 

31

----

 

and expenses during the reporting period. Actualresults could differ from those estimates.

 

For further information regarding our criticalaccounting policies, judgments and estimates, please see the Notes to UnauditedCondensed Consolidated Financial Statements contained in this Report and “CriticalAccounting Policies, Judgments and Estimates” beginning on page 32 of theCompany’s Annual Report on Form 10-K for the year ended December 31,2004, filed with the SEC and Note 2 to the Consolidated Financial Statements inthis Report.

 

**Effectsof Transactions with Related and Certain Other Parties**

 

In 2005 and in prioryears, we entered into a number of significant transactions with Hallmark Cardsand its subsidiaries. These transactions include, among other things,programming, trademark licenses, administrative services, a line of credit, atax sharing agreement and the issuance of a $400.0 million seniorunsecured note. For information regarding such transactions and transactionswith other related parties, please see “Effects of Transactions with Relatedand Certain Other Parties” beginning on page 34 of the Company’s AnnualReport on Form 10-K for the year ended December 31, 2004, filed withthe SEC and Notes 9 and 10 to the Consolidated Financial Statements in thisReport. During the third quarter of 2005 and in October 2005, HallmarkCards or related companies and the Company extended the expiration date of thetrademark license agreements for use of the name Hallmark to September 1,2006, entered into a new programming agreement and offset a portion of taxbenefits against intercompany debt owed by the Company.

 

## **SelectedHistorical Consolidated Financial Data of Crown Media Holdings**

##  

In the table below, we provide selected historicalconsolidated financial and other data of Crown Media Holdings and itssubsidiaries. The following selected consolidated statement of operations datafor three and nine months ended September 30, 2004 and 2005, are derivedfrom the unaudited condensed consolidated financial statements of Crown MediaHoldings and its subsidiaries. This data should be read together with theconsolidated financial statements and related notes included elsewhere in this Form 10-Q.  Dollar amounts are in thousands.

 
| ** **                                               | ** ** | ** **                   | ** ** | ** **   | ** ** | **Percentage**               | ** ** | ** **   | ** ** | ** ** | ** ** | **Percentage** | ** ** |
|----------------------------------------------------------|------------|------------------------------|------------|--------------|------------|------------------------------|------------|--------------|------------|------------|------------|----------------|------------|
| ** **                                               | ** ** | **Three Months**             | ** ** | **Change**   | ** ** | **Nine Months**              | ** ** | **Change**   | ** ** |
| ** **                                               | ** ** | **Ended September 30,** | ** ** | **2005 vs.** | ** ** | **Ended September 30,** | ** ** | **2005 vs.** | ** ** |
| ** **                                               | ** ** | **2004**                     | ** ** | **2005**     | ** ** | **2004**                     | ** ** | **2004**     | ** ** | **2005**   | ** ** | **2004**       | ** ** |
| Revenues:                                                |       |                         |       |         |       |                         |       |         |       |       |       |           |       |
| Subscriber fees                                          |       | $                            | 2,398      |         | $          | 4,554                        |       | 90           | %          | $          | 7,285      |           | $          | 13,357 |   | 83 | % |
| Advertising                                              |       | 24,561                       |       | 33,560       |       | 37                           | %          | 74,756       |       | 105,553    |       | 41             | %          |
| Film asset  license fees                                 |       | 4,336                        |       | 2,102        |       | -52                          | %          | 12,589       |       | 7,354      |       | -42            | %          |
| Sublicense fees  and other revenue                       |       | 0                            |       | 10,454       |       | 100                          | %          | 0            |       | 10,667     |       | 100            | %          |
| Total revenues                                           |       | 31,295                       |       | 50,670       |       | 62                           | %          | 94,630       |       | 136,931    |       | 45             | %          |
| Cost of Services:                                        |       |                         |       |         |       |                         |       |         |       |       |       |           |       |
| Programming  costs                                       |       | 21,636                       |       | 29,196       |       | 35                           | %          | 60,712       |       | 85,631     |       | 41             | %          |
| Amortization of  film assets                             |       | 3,865                        |       | 13,830       |       | 258                          | %          | 12,542       |       | 33,175     |       | 165            | %          |
| Impairment of  film assets and technical equipment       |       | 19,321                       |       | 22,939       |       | 19                           | %          | 19,321       |       | 22,939     |       | 19             | %          |
| Subscriber  acquisition fee amortization                 |       | 6,780                        |       | 8,688        |       | 28                           | %          | 18,355       |       | 26,891     |       | 47             | %          |
| Operating costs                                          |       | 2,953                        |       | 3,212        |       | 9                            | %          | 7,126        |       | 9,738      |       | 37             | %          |
| Total cost of services                                   |       | 54,555                       |       | 77,865       |       | 43                           | %          | 118,056      |       | 178,374    |       | 51             | %          |
| Selling, general and administrative expense              |       | 14,627                       |       | 16,830       |       | 15                           | %          | 41,045       |       | 46,133     |       | 12             | %          |
| Marketing expense                                        |       | 912                          |       | 1,832        |       | 101                          | %          | 11,248       |       | 19,082     |       | 70             | %          |
| Loss from  continuing operations before interest expense |       | (38,799                      | )          | (45,857      | )          | 18                           | %          | (75,719      | )          | (106,658   | )          | 41             | %          |
| Interest expense                                         |       | (15,140                      | )          | (19,346      | )          | 28                           | %          | (43,751      | )          | (53,686    | )          | 23             | %          |
| Income tax provision                                     |       | 0                            |       | (4           | )          | 100                          | %          | 0            |       | (10        | )          | 100            | %          |
| Loss from continuing operations                          |       | (53,939                      | )          | (65,207      | )          | 21                           | %          | (119,470     | )          | (160,354   | )          | 34             | %          |
| Loss from discontinued operations                        |       | (51,823                      | )          | 0            |       | -100                         | %          | (68,355      | )          | (10,666    | )          | -84            | %          |
| Loss on sale of discontinued operations                  |       | 0                            |       | (615         | )          | 100                          | %          | 0            |       | (1,964     | )          | 100            | %          |
| Net Loss                                                 |       | $                            | (105,762   | )            | $          | (65,822                      | )          | -38          | %          | $          | (187,825   | )              | $          | (172,984 | ) | -8 | % |
|                                                     |       |                         |       |         |       |                         |       |         |       |       |       |           |       |
| **Other  Data:**                                         |       |                         |       |         |       |                         |       |         |       |       |       |           |       |
| Net cash used in  operating activities                   |       | $                            | (5,929     | )            | $          | (30,987                      | )          | 423          | %          | $          | (21,612    | )              | $          | (128,798 | ) | 496 | % |
| Capital  expenditures                                    |       | $                            | 93         |         | $          | (290                         | )          | -412         | %          | $          | (590       | )              | $          | (848 | ) | 44 | % |
| Proceeds from  disposition of international business     |       | $                            | —     |         | $          | —                       |       |         |       | $          | —     |           | $          | 221,979 |   | 100 | % |
| Net cash  provided by (used in) financing activities     |       | $                            | 15,865     |         | $          | 42,452                       |       | 168          | %          | $          | 49,465     |           | $          | (72,643 | ) | -247 | % |
| Net cash used in  discontinued operations                |       | $                            | (11,848    | )            | $          | —                       |       | -100         | %          | $          | (24,357    | )              | $          | (14,758 | ) | -39 | % |
| Total domestic  day household ratings (1)(3)             |       | 0.562                        |       | 0.720        |       | 28                           | %          | 0.588        |       | 0.695      |       | 18             | %          |
| Total domestic  primetime household ratings (2)(3)       |       | 0.862                        |       | 1.093        |       | 27                           | %          | 0.851        |       | 0.988      |       | 16             | %          |
| Total  subscribers at year end:                          |       |                         |       |         |       |                         |       |         |       |       |       |           |       |
| Hallmark Channel  – International                   |       | 60,653                       |       | —       |       | -100                         | %          | 60,653       |       | —     |       | -100           | %          |
| Hallmark Channel  – U.S.                            |       | 63,422                       |       | 69,243       |       | 9                            | %          | 63,422       |       | 69,243     |       | 9              | %          |
| Total  subscribers                                       |       | 124,075                      |       | 69,243       |       | -44                          | %          | 124,075      |       | 69,243     |       | -44            | %          |

 

32

----

 

----

(1)  Total day is the time period measured from the time each daythe broadcast of commercially sponsored programming commences to the time suchcommercially sponsored programming ends.

(2)  Primetime is defined as 8:00 - 11:00 P.M. in the UnitedStates.

(3)  These Nielsen ratings are for the time period January 1through September 30.

 

33

----

 

### ***Results of Operations***

 

#### *Three andNine Months Ended September 30, 2004 Compared to Three and Nine MonthsEnded September 30, 2005*

####  

*Revenue.*

 

Our revenue from continuingoperations, which is comprised of subscriber fees, advertising, film assetlicense fees and sublicense fees and other revenue, increased 62% and 45%, forthe three and nine months ended September 30, 2005, respectively, asexplained below. Our 90% and 83%increases in subscriber fee revenue for the three and nine months ended September 30,2005, respectively, were primarily the result of the expiration of waivedsubscriber fee periods for certain of our domestic distributors and an increasein subscribers. Many of our distribution arrangements require us to provide aperiod of waived license fees to the distributor. As these waived license feeperiods end and the number of subscribers increase, our subscriber revenue isexpected to increase. Subscriber acquisition fee expense recorded as a reductionof revenue was $3.5 million and $10.1 million for the three and nine monthsended September 30, 2005, respectively, and $3.0 million and $9.0 millionfor the comparable periods in 2004, respectively. Subscriber counts haveincreased as a result of previously amended distribution agreements in theUnited States, which provide for financial incentives for distribution growth,as well as the ratings success of the Hallmark Channel. The ability to increaseour subscriber base is important both in terms of growing our subscriber andadvertising revenues.

 

The increases in advertising revenue to $33.6 millionand $105.6 million for the three and nine months ended September 30, 2005,respectively, compared to $24.6 million and $74.8 million for the three and ninemonths ended September 30, 2004, were due to increased advertising ratesand volume. The increases in advertising revenue reflect the 9% growth insubscribers and an increase in total day household ratings of 18%. As wecontinue to grow distribution and ratings, we are also able to attractadditional advertisers to our Channel and increase our advertising rates. Thenumber of our advertisers was 380 at September 30, 2004, and 402 at September 30,2005. The three factors noted above, subscriber universe, ratings andadvertising rates are the three critical drivers of increases in advertisingsales. We anticipate additional revenue growth to continue at similar rates.

 

Amongthe 52 ad-supported cable channels in the United States market, the HallmarkChannel ranked9th in total day with a 0.720 householdrating for the third quarter of 2005 and 12th for primetime with a1.093 household rating for the same quarter based on Nielsen ratings. Thisratings performance is significant, particularly because the Hallmark Channelis not a fully distributed network. Most of the channels that rate above theHallmark Channel have higher levels of distribution.

 

Revenuefrom the sale of our film assets totaled $2.1 million and $7.4 million for the three and ninemonths ended September 30, 2005, respectively, compared with $4.3million and $12.6 million for the comparable periods in 2004.  During thefirst quarter of 2004, we signed a large sale agreement with one customer,which did not occur during the first quarter of 2005. Generally, our librarysales occur in the second half of the year as this coincides with our customersscheduling of the upcoming programming schedules.

 

Sublicensefees and other revenue for the three months ended September 30, 2005, was$10.5 million primarily due to the sub-licensing of *Little Houseon the Prairie* to a third party. Sublicense fees and other revenuefor the nine months ended September 30, 2005, was $10.7 million primarilydue to the same sub-licensing of *Little House on thePrairie*.

 

*Cost of services. *Cost of services as apercent of revenue decreased to 154% for the three months ending September 30,2005, as compared to 174% for the comparable period in 2004. Cost of servicesas a percent of revenue increased to 130% for the nine months ending September 30,2005, as compared to 125% for the comparable periods in 2004. These changeswere due to the increased revenue and the changes in operating expensesexplained below.

 

34

----

 

Totalprogramming costs for the three and nine months ended September 30, 2005,increased 35% and 41%, respectively, due toour focus on retaining higher quality series programming such as *M*A*S*H*, *Judging Amy,*and *J.A.G*.  and the related amortization. In addition,the Hallmark Channel introduced the Mystery Movies in the first quarter of2005. The series and new original Mystery Movies have been important to theHallmark Channel in driving our ratings. In addition, the new programming schedule hasbeen important in terms of driving increased distribution.

 

As aresult of the Company’s analysis of its film assets based upon currentprojections for sales and internal use, the Company recorded a non-cashimpairment charge of $22.9 million in the third quarter of 2005 and $19.3million in the third quarter of 2004. Each quarter we are required to assesswhether due to changing events or circumstances, there is an indication of animpairment of our film assets. If an indication exists, a determination is madeof the estimated fair value of those assets. Any film where the net book valueis less than the fair value is written down to fair value.  Films where the net book value is greaterthan the fair value, however, are not adjusted upwards.  The determination of fair value involvesexamining historical sales performance, future sales expectations, generalmarket conditions and the Crown Library sales strategy.

 

Theincrease in amortization of film assets was primarily due to an increase in theinternal use of the library assets for the three and nine months ended September 30,2005, on our new Hallmark Movie Channel and a recalculation of the amortizationfrom January 1, 2005, through September 30, 2005, as a result of therevisions to the estimates of ultimate revenue on certain products describedabove.

 

Generally, our distribution agreements require theCompany to pay subscriber acquisition fees to distributors for additionalsubscribers. Our subscribers increased from 63.4 million at September 30,2004, to 69.2 million at September 30, 2005, and the Company incurredadditional subscriber acquisition fees for this increase in subscribers. TheCompany amortizes these costs over the remaining life of the distributionagreement, which has resulted in 28% and 47% increases in our subscriberacquisition fee amortization expense for the three and nine months ended September 30,2005, as compared to the prior year period.

 

Operating costs increased by $2.6 million for the ninemonths ended September 30, 2005, primarily due to the $1.8 millionincrease in bad debt expense and $868,000 of depreciation expense related to anew capital lease.

 

*Selling, general andadministrative expense.* For the three and nine months ended September 30,2005, our selling, general and administrative expense increased 15% and 12%,respectively, primarily due to an increase in consulting expense, audit feesassociated with our regulatory requirements under the Sarbanes-Oxley Act andcompensation expense associated with our RSUs from our increased stock price.

 

*Marketing expense. *For the three and ninemonths ended September 30, 2005, our marketing expense increased 101% and70%, respectively, primarily due to the 2005 Mystery Movie marketing campaignfor the Hallmark Channel. In order to build upon the success of our 2004Holiday promotion and to assist with the sale of our advertising inventory inthe upfront market, the Company commenced the Mystery Movie franchise in thefirst quarter of 2005. The prior year’s marketing activity was significantlyless as there were not as many special programming events in the first half of2004.

 

*Interest expense. *Interest expense increasedfor the three and nine months ended September 30, 2005, compared to September 30,2004, by $4.2 million and $9.9 million. This increase was due to interest on our $400.0 million senior unsecurednote payable, which increased by $1.2 million and $3.4 million for the threeand nine months ended September 30, 2005, as compared to the prior yearperiods, and interest on our $75.0 million promissory note, which increased by$466,000 and $1.3 for the three and nine months ended September 30, 2005,as compared to the prior year periods.

 

*Lossfrom Continuing Operations. *Lossfrom continuing operations for the three and nine months ended September 30,2005, was $65.2 million and $160.4 million, respectively. Loss from continuingoperations for the three and nine months ended September 30, 2004, was$53.9 million and $119.5 million, respectively. Our loss from continuingoperations increased primarily due to (1) a $920,000 and $7.8 millionincrease in marketing expenses to

 

35

----

 

continue to driveratings; (2) increases in loss generated from library sales and theinternal use of the library product on the Channel and a $3.6 increase in filmasset impairment; (3) increase in selling, general and administrativeexpense of $2.2 million  and $5.1million; and (4) and an increase in interest expense of $4.2 million and$9.9 million due to relatively higher borrowings during the nine months of 2005as compared to the prior year period. These increases are partially offset bysubscriber and advertising revenue increasing greater than programming costs.

 

*Lossfrom Discontinued Operations. *Lossfrom discontinued operations for the three and nine months ended September 30,2005, was $0 and $10.7 million, respectively. Loss from discontinued operationsfor the three and nine months ended September 30, 2004, was $51.8 millionand $68.4 million, respectively. Loss from discontinued operations was less forthe three and nine months ended September 30, 2005, as compared to thecomparable period for 2004, because the Company sold the international businesson April 26, 2005.

 

## **Liquidityand Capital Resources**

##  

Cash used in operating activities from continuingoperations was $21.6 million and $128.8 million for the nine months ended September 30,2004 and 2005, respectively. This increase in cash used in operating activitieswas due to approximately $31.1 million of subscriber acquisition fee paymentsand $47.5 million of affiliate programming payments made during the nine monthsended September 30, 2005.  It wasalso due to the $40.9 million increase in loss from continuing operationsduring the nine months ended September 30, 2005.

 

Cash used in investingactivities was $590,000 for the nine months ended September 30, 2004.  Cash provided by investing activities was$213.8 million for the nine months ended September 30, 2005. This increaseis due to the proceeds from the sale of our international business of $222.0million.

 

Cash provided by financing activities was $49.5 millionfor the nine months ended September 30, 2004. Cash used in financingactivities was $72.6 million for the nine months ended September 30, 2005.During the nine months ending September 30, 2005, we repaid $195.0 millionunder our bank credit facility. Additionally, we borrowed $65.0 million underour credit facility to repay certain programming obligations to Hallmark Cardsaffiliates, pay severance and RSU settlements for certain employees of theinternational business and to meet our operating demands during the nine monthsof 2005.

 

Cash used in discontinued operations was $24.4 millionand $14.8 million for the nine months ended September 30, 2004 and 2005,respectively.  Cash used in discontinuedoperations decreased as the international sale was completed in April 2005.

 

The following table aggregates all of our contractualcommitments as of September 30, 2005.

 
| ** **                                               | ** ** | **Scheduled Payments by Period** | ** ** |
|----------------------------------------------------------|------------|----------------------------------|------------|
| **Contractual Obligations**                              | ** ** | **Total**                        | ** ** | **Less than 1  Year** | ** ** | **2-3 Years** | ** ** | **4-5 Years** | ** ** | **After 5 Years** | ** ** |
| Credit Facility  and Interest Payable                    |       | $                                | 180.2      |   | $ | 180.2 |   | $ | — |   | $ | — |   | $ | — |   |
| Company  Obligated Mandatorily Redeemable                |       |                             |       |   |   |   |   |   |   |   |   |
| Preferred  Interest                                      |       | 25.0                             |       | 2.6 |   | 10.0 |   | 10.0 |   | 2.4 |   |
| HC Crown Line of  Credit                                 |       | 86.0                             |       | — |   | 86.0 |   | — |   |   |   |
| Senior Unsecured  Note to HC Crown, including accretion  |       | 596.6                            |       | — |   | — |   | — |   | 596.6 |   |
| Capital Lease  Obligations                               |       | 17.0                             |       | 0.6 |   | 1.4 |   | 1.7 |   | 13.3 |   |
| Operating Leases                                         |       | 15.1                             |       | 4.3 |   | 6.7 |   | 3.5 |   | 0.6 |   |
| Other  Obligations                                       |       |                             |       |   |   |   |   |   |   |   |   |
|                                                     |       |                             |       |   |   |   |   |   |   |   |   |
| Program license  fees payable to non-affiliates and NICC |       | 197.2                            |       | 67.4 |   | 65.0 |   | 50.1 |   | 14.7 |   |
| Program license  fees payable to HED                     |       | 146.4                            |       | — |   | 146.4 |   | — |   | — |   |
| Program license  fees payable for future windows         |       | 120.4                            |       | 59.9 |   | 45.8 |   | 11.8 |   | 2.9 |   |
| Subscriber  acquisition fees (a)                         |       | 12.0                             |       | 12.0 |   | — |   | — |   | — |   |
| Deferred  compensation and interest                      |       | 3.0                              |       | — |   | 3.0 |   | — |   | — |   |
| Payable to buyer  of international business              |       | 19.1                             |       | 9.8 |   | 8.2 |   | 1.1 |   | — |   |
| Other payables to  buyer of international business       |       | 6.6                              |       | 0.9 |   | 2.1 |   | 1.7 |   | 1.9 |   |
| Payable to  Hallmark Entertainment affiliates            |       | 70.0                             |       | — |   | 70.0 |   | — |   | — |   |
| Total Contractual Cash Obligations                       |       | $                                | 1,494.6    |   | $ | 337.7 |   | $ | 444.6 |   | $ | 79.9 |   | $ | 632.4 |   |

 

36

----

 

----

(a)  Current domestic distributionagreements could significantly increase subscriber acquisition fees payable inthe future by a 

maximum amount of $33.4 million, which wouldresult if 32.3 million additional subscribers were added to the HallmarkChannel subscriber base.

 

*Cash Flows*

 

As of September 30,2005, the Company had $9.4 million in cash and cash equivalents on hand and$40.0 million available under its bank credit facility. The $40.0 million ofthe availability under the bank credit facility is subject to the approval ofHallmark Cards prior to the Company being able to draw such funds. As of September 30,2005, the Company had borrowed $180.0 million under its bank credit facility,which matures May 31, 2006.

 

The Company’s principal sources of funds are currentlyavailable cash on hand, cash generated by operations, amounts available forborrowing under its bank credit facility and potentially, tax sharing payments.As noted above, the Company’s ability to access the remaining $40.0 millionunder the bank credit facility is subject to Hallmark’s approval.  There can be no assurance that Hallmark Cardswill approve such additional drawings and, if such drawings are not approved,the Company will need alternative sources of funding or will need tosignificantly curtail expenses. The Company expects that additional paymentsunder the tax sharing agreement, if any, will be less in the future than theyhave been in the past assuming that the Company’s financial performance improvesas indicated by internal projections. Furthermore, the tax sharing payments canbe affected by Hallmark Cards’ tax position and its ability to utilize theCompany’s tax losses.

 

The Company’s liquidity is also impacted by theresults of its operations.   The abilityof the existing sources of liquidity to be sufficient to fund the Company’soperations, depend upon the Company’s future operating results meetingexpectations.  In particular, continuedgrowth in subscriber revenue, advertising revenue, and library sales arerequired.  As a result, any decline inthe popularity of the Hallmark Channel, any significant future modifications tothe Company’s distribution agreements, an economic decline in the advertisingmarket, an increase in program acquisition costs, an increase in competition orother adverse operating conditions would impact the Company’s liquidity and itsability to fund the current level of operations.  To the extent that the Company requiresadditional capital and additional drawings on the bank credit facility areeither not available or insufficient, the Company would seek additionalfinancing from the issuance of debt or equity securities or from strategictransactions which provide capital.

 

TheCompany expects to continue making investments in programming, marketing anddistribution during the next twelve months ending September 30, 2006.However, the Company’s liquidity position has demanded that all areas ofexpenses, including programming, marketing and distribution be closely reviewedand monitored.  The Company reducedexpenses in certain areas during the third quarter of 2005 and expects thatsimilar expense reductions will occur in the fourth quarter of 2005. TheCompany’s principal uses of funds for the remainder of 2005 are expected toinclude the payment of operating expenses, licensing of programming, subscriberacquisition fees and interest under its bank credit facility.

 

TheCompany currently believes that cash on hand, cash generated by operations andthe remaining availability under its bank credit facility (assuming thatHallmark Cards approves additional borrowings and assuming that the banks drawdown on an irrevocable letter of credit provided by Hallmark Cards whichsupports the bank credit facility, or the banks extend such facility beyond May 31,2006), which are currently its principal sources of funds, will be sufficientto fund the current level of operations and meet its liquidity needs through September 30,2006.

 

37

----

 

TheCompany’s bank credit facility will expire on May 31, 2006.   If the Company is not able to arrange forthe extension, refinancing or replacement of the bank credit facility prior toits maturity and the bank draws down on the irrevocable letter of credit,Hallmark Cards would acquire all obligations and the rights of the lendingbanks under the bank credit facility.  Inthat event, Hallmark Cards could demand payment of outstanding amounts at anytime.  However, Hallmark Cards has alsoconfirmed to the Company that it will not request any reimbursement of amountsdrawn on such letter of credit prior to October 31, 2006.  Hallmark Cards also confirmed that it and itswholly-owned subsidiaries will not request payment of the license fees andother amounts payable to affiliates of Hallmark Cards prior to October 31,2006 (see note 9).

 

Asconsideration for extending the demand period for the possible reimbursement ofamounts drawn on the letter of credit supporting the credit facility, theCompany agreed to convert its license fees payable to Hallmark affiliates,which were approximately $133.0 million, to a promissory note bearing interestat LIBOR plus 3% per annum.  The term ofthe promissory note began on October 1, 2005 and is payable in full on October 31,2006.

 

Due tothe Company’s liquidity needs, the Company anticipates that prior to October 31,2006, it will be necessary to either extend or refinance (i) the bankcredit facility and (ii) the license fees ($133.0 million) and (iii) otheramounts ($70.0 million) payable to affiliates of Hallmark Cards. In thealternative or as part of a combination of actions, the Company would considervarious alternatives as indicated above, including refinancing the bank creditfacility, raising additional capital through the issuance of equity or debtsecurities or entering into strategic alternatives.

 

Upon maturity of the creditfacility on May 31, 2006, the lending group led by JP Morgan Chase has theright to elect to forego the receipt of cash to pay the principal amount of thecredit facility in full, which is provided for under the terms of anirrevocable letter of credit provided by Hallmark Cards described innote 9, butinstead can elect to initiate a process to foreclose on the Company’s assets.Such foreclosure proceedings could affect our ability to continue ouroperations. Prior to any such possible foreclosure proceedings, the Companywould consider various alternatives as indicated above.  As a result, the outstanding borrowings under the credit facility of $180.0million at September 30, 2005, have been classified as a currentliability.

 

***Bank Credit Facility, HC Crown Loans, and Tax Sharing Agreement***

 

For information regardingour Bank Credit Facility, HC Crown Loans and Tax Sharing Agreement, please see “BankCredit Facility, HC Crown Loans, and Tax Sharing Agreement” beginning on page 45of the Company’s Annual Report on Form 10-K for the year ended December 31,2004, filed with the SEC and Notes 8 and 9 to the Consolidated FinancialStatements in this Report.

 

Asindicated the “Liquidity and Capital Resources” above, we entered into arevised letter agreement of October 1, 2005 with Hallmark Cards.  In the letter, Hallmark Cards confirmed to usthat neither Hallmark Cards nor any of its wholly-owned subsidiaries woulddemand payment from us on any of the following obligations until October 31,2006, at the earliest:

 

•                  $75.0 million note payable to HCCrown plus accrued interest thereon from time to time ($84.8 million includinginterest at September 30, 2005).

 

•                  $400.0 million note payable to HCCrown plus accrued interest thereon from time to time ($496.9 million includinginterest at September 30, 2005).

 

•                  $70.0 million payables to HallmarkEntertainment Holdings incurred in conjunction with the film librarytransaction in 2001.

 

•                  $133.0 million of license feespayable to Hallmark Entertainment Distribution Company ($146.4 millionincluding activity at September 30, 2005).

 

## FurtherHallmark Cards stated that, in the event at any time prior to May 31, 2006our banks draw on the letter

 

38

----

 

## of credit provided insupport of the bank line of credit, Hallmark Cards will not requestreimbursement from us for such amounts prior to October 31, 2006.  Hallmark also stated its intent tore-evaluate these repayment schedules if all or substantially all of our assetswere sold to a third party prior to October 31, 2006.

##  

**Classification of Credit Facility as a Current Liability**

 

The outstanding borrowings under the creditfacility of $180.0 million at September 30, 2005, have been classified asa current liability.  Such balance sheetclassification was deemed necessary in order to recognize the remote andimprobable possibility that, upon maturity of the credit facility on May 31,2006, the lending group led by JP Morgan Chase might elect to forego thereceipt of cash to pay the principal amount of the credit facility in full,which is provided for under the terms of an irrevocable letter of creditprovided by Hallmark Cards, but instead might elect to initiate a process toforeclose on the Company’s assets.

 

## **Risk Factors and Forward-Looking Statements**

##  

Thediscussion set forth in this Form 10-Q contains statements concerningpotential future events. Such forward-looking statements are based onassumptions by Crown Media Holdings management, as of the date of this Form 10-Qincluding assumptions about risks and uncertainties faced by Crown MediaHoldings. Readers can identify these forward-looking statements by their use ofsuch verbs as “expects,” “anticipates,” “believes,” or similar verbs orconjugations of such verbs. If any of management’s assumptions prove incorrector should unanticipated circumstances arise, Crown Media Holdings’ actualresults, levels of activity, performance, or achievements could materiallydiffer from those anticipated by such forward-looking statements. Among thefactors that could cause actual results to differ materially are thosediscussed in this Report below and in the Company’s filings with the Securitiesand Exchange Commission, including the Risk Factors stated in the Company’s Form 10-KReport for the year ended December 31, 2004, and the Form 10-Q Reportfor the quarter ended June 30, 2005. Such Risk Factors include among others:  Competition for distribution of channels,viewers, advertisers and the acquisition of programming; fluctuations in theavailability of programming; fluctuations in demand for programming which weair on our channels; our ability to address our liquidity needs; our incurrenceof losses; and our substantial indebtedness affecting our financial conditionand results.

 

Thereare stated below certain Risk Factors which contain significant changes fromthose stated in the Company’s Form 10-Q Report for the quarter ended June 30,2005. Crown Media Holdings will not update any forward-looking statementscontained in this Form 10-Q to reflect future events or developments.

 

If we do not successfullyaddress the risks described below and in our prior Reports mentioned above, ourbusiness, prospects, financial condition, results of operations or cash flowcould be materially adversely affected. The trading price of our Class Acommon stock could decline because of any of these risks.

 

**Risks Relating to Our Business**

 

***Our liquidity is dependent on external funds.***

 

Because we currently operate at a loss, we may have anegative cash flow and any unanticipated significant expense or any developmentthat hampers our growth in revenue or decreases any of our revenue, wouldresult in the need for additional external funds in order to continueoperations. We have no arrangements for any such additional externalfinancings, whether debt or equity, and are not certain whether any such newexternal financing would be available on acceptable terms. Any new debtfinancing would require the cooperation and agreement of existing lenders.

 

Further, as discussed in this report under “Liquidityand Capital Resources” above, we need to extend, refinance or replace our bankline of credit on or prior to May 31, 2006, or to extend or replaceborrowings from Hallmark Cards by October 31, 2006, that would result fromthe banks drawing upon the irrevocable letter of credit (see note 9) supportingthe bank credit facility, and to extend or refinance license fees and payablesto Hallmark Cards and its subsidiaries on or prior to October 31, 2006.

 

39

----

 

***HallmarkEntertainment Distribution may not deliver to us as many programs as it hashistorically delivered.***

 

Wecurrently acquire library programming, new productions and first-runpresentations pursuant to our program license agreement with HallmarkEntertainment Distribution, which agreement was revised on October 11,2005. The revised agreement expires December 31, 2008, Under the revisedagreement, Hallmark Entertainment Distribution is required to produce anddeliver to us, and we are required to order and license, a minimum number oforiginal television movies and original mini-series in each of 2005, 2006 and2007. We may elect to reduce the number of original movies and mini-series tobe licensed by us in 2006 and elect to reduce or cancel our obligation tolicense these productions in 2007. Under certain conditions, HallmarkEntertainment Distribution may similarly reduce in 2006 or eliminate in 2007the number of original movies or original mini-series that it is required toproduce in those years. We could be forced to develop and produce or acquirealternative programming if we no longer receive as many programs from HallmarkEntertainment Distribution as we have in prior years, and this could negativelyimpact our ability to effectively program our Channels.

 

### **Available Information**

 

**We will make available free of chargethrough our website, www.hallmarkchannel.com, the Annual Report, our quarterlyreports on Form 10-Q, our current reports on Form 8-K, and amendmentsto such reports, as soon as reasonably practicable after we electronically fileor furnish such material with the Securities and Exchange Commission.**

 

**Additionally, we will make available,free of charge upon request, a copy of our Code of Business Conduct and Ethics,which is applicable to all of our employees, including our senior financialofficers. Requests for a copy of this code should be addressed to the GeneralCounsel at 12700 Ventura Boulevard, Studio City, California  91604.**

 

**Item 3.  *Quantitativeand Qualitative Disclosures About Market Risk***

 

We only invest in instruments that meet high credit andquality standards, as specified in our investment policy guidelines. Theseinstruments, like all fixed income instruments, are subject to interest raterisk. The fixed income portfolio will decline in value if there is an increasein interest rates. If market interest rates were to increase immediately anduniformly by 10% from levels as of September 30, 2005, the decline of thefair value of the fixed income portfolio would not be material.

 

As of September 30, 2005, our cash, cashequivalents and short-term investments had a fair value of $9.4 million, whichwere invested in cash and short-term commercial paper. The primary purpose ofthese investing activities has been to preserve principal until the cash isrequired to fund operations. Consequently, the size of this portfolio fluctuatessignificantly as cash is provided by and used in our business.

 

The value of certain investments in this portfolio canbe impacted by the risk of adverse changes in securities and economic marketsand interest rate fluctuations. At September 30, 2005, all of ourinvestments in this category were in fixed rate instruments or money markettype accounts. A decrease in interest rates has the effect of reducing ourfuture annual interest income from this portfolio, since funds would bereinvested at lower rates as the instruments mature. Over time, any netpercentage decrease in our interest rates could be reflected in a correspondingnet percentage decrease in our interest income. For the three and nine monthsended September 30, 2005, the impact of interest rate fluctuations,changed business prospects and all other factors did not have a material impacton the fair value of this portfolio, or on our income derived from thisportfolio.

 

We have not used derivative financial instruments forspeculative purposes. As of September 30, 2005, we are not hedged orotherwise protected against risks associated with any of our investing orfinancing activities.

 

40

----

 

***We are exposed to market risk.***

 

We are exposed to market risk, including changes tointerest rates. To reduce the volatility relating to these exposures, we mayenter into various derivative investment transactions in the near term pursuantto our investment and risk management policies and procedures in areas such ashedging and counterparty exposure practices. We have not and will not usederivatives for speculative purposes.

 

Though we intend to use risk management controlpolicies, there will be inherent risks that may only be partially offset by ourhedging programs should there be any unfavorable movements in interest rates orequity investment prices.

 

The estimated exposure discussed below is intended tomeasure the maximum amount we could lose from adverse market movements ininterest rates and equity investment prices, given a specified confidencelevel, over a given period of time. Loss is defined in the value at riskestimation as fair market value loss.

 

***Our interest income and expense is subject to fluctuations in interestrates.***

 

Our material interest bearing assets consisted of cashequivalents and short-term investments. The balance of our interest bearingassets was $9.4 million, or less than 1% of total assets, as of September 30,2005. Our material liabilities subject to interest rate risk consisted ofcapital lease obligations, our bank credit facility, our line of credit with HCCrown and our note payable to HC Crown. The balance of those liabilities was$779.9 million, or 59% of total liabilities, as of September 30, 2005. Netinterest expense for the three and nine months ended September 30, 2005,was $19.3 million and $53.7 million, 38% and 39%, of our total revenue,respectively. Our net interest expense of these liabilities is sensitive tochanges in the general level of interest rates, primarily U.S. and LIBORinterest rates. In this regard, changes in U.S. and LIBOR interest rates affectthe fair value of interest bearing liabilities.

 

**Item4.  *Controls and Procedures.***

 

***a. Disclosure Controls and Procedures***

 

The Company, under the supervision and with theparticipation of the Company’s management, including its Chief ExecutiveOfficer and Chief Financial Officer, carried out an evaluation of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934) as of September 30, 2005.  Based upon this evaluation,the Company’s Chief Executive Officer and Chief Financial Officer concludedthat the Company’s disclosure controls and procedures were not effectiveas of that date for purposes of recording, processing, summarizing andtimely reporting material information required to be disclosed in reports thatthe Company files under the Exchange Act.

 

***b. Changes in Internal Control over Financial Reporting***

 

There were changes in the Company’s internal control over financial reporting  that  occurred  during the quarter ended September 30, 2005, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting, as described below.

 

In the second quarter of 2005, the Company commenced the implementation of the following remediation steps to address the material weaknesses outlined in our Annual Report on Form 10-K:

 

•       TheCompany engaged consultants to assist with the first quarter 2005 accountingfor complex non-recurring transactions and to review calculations, includingcalculations imbedded in spreadsheets. The Company also plans to retainconsulting services to serve as contemporaneous, technical resources to review,evaluate and provide guidance on the most appropriate accounting treatment forcomplex, non-recurring transactions.

 

•       TheCompany will adopt more stringent procedures for the review of computationaland mathematical accuracy of valuation spreadsheets.

 

41

----

 

Although the Company has commenced the implementation of the remediation steps described above, at September 30, 2005, material weaknesses continue to impact the Company’s ability to account for non-routine, complex transactions in accordance with accounting principles generally accepted in the United States of America.

 

**PART II.  OTHER INFORMATION**

 

**Item 2.  *UnregisteredSales of Equity Securities and Use of Proceeds***

 

In August 2005,we issued restricted stock units as described in Note 12 to the Condensed Notesto the Unaudited Consolidated Financial Statements in Part I, Item 1, ofthis Report under the heading “Employee Incentives and Retention.”

 

**Item 4.  *Submissionof Matters to a Vote of Security Holders***

 

Our 2005 annual meeting of stockholders was held on July 11,2005.  The following proposals were votedupon at the meeting, with the following number of votes cast for, against orwithheld:

 

*Proposal One* – Elect 15 directors to our Board ofDirectors.

 

| **Name**                     | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** | **Abstentions and  Broker Non-Votes** | ** ** |
|------------------------------|------------|---------------|------------|--------------------|------------|---------------------------------------|------------|
|                         |       |          |       |               |       |                                  |       |
| Robert A. Halmi, Jr.    |       | 377,483,967   |       | 1,557,614          |       | -0-                                   |       |
| David J. Evans               |       | 377,659,713   |       | 1,381,868          |       | -0-                                   |       |
| Wilford V. Bane, Jr.    |       | 377,451,723   |       | 1,589,858          |       | -0-                                   |       |
| Arnold L. Chavkin            |       | 377,403,952   |       | 1,637,629          |       | -0-                                   |       |
| Glenn Curtis                 |       | 378,057,632   |       | 983,949            |       | -0-                                   |       |
| Robert J. Druten             |       | 377,436,467   |       | 1,605,114          |       | -0-                                   |       |
| Brian E. Gardner             |       | 377,483,967   |       | 1,557,614          |       | -0-                                   |       |
| Herbert Granath              |       | 378,166,432   |       | 875,149            |       | -0-                                   |       |
| David E. Hall                |       | 377,436,467   |       | 1,605,114          |       | -0-                                   |       |
| Donald J. Hall, Jr.     |       | 377,549,813   |       | 1,491,768          |       | -0-                                   |       |
| Irvine O. Hockaday, Jr. |       | 377,548,813   |       | 1,492,768          |       | -0-                                   |       |
| Anil Jagtiani                |       | 377,549,813   |       | 1,491,768          |       | -0-                                   |       |
| Peter A. Lund                |       | 378,094,058   |       | 947,523            |       | -0-                                   |       |
| John P. Mascotte             |       | 377,961,143   |       | 1,080,438          |       | -0-                                   |       |
| Deanne R. Stedem             |       | 377,549,813   |       | 1,491,768          |       | -0-                                   |       |

 

All 15 persons listed abovewere existing directors and were re-elected as our directors at that meeting.

 

*Proposal Two*– Ratification of amendment of the 2000Long Term Incentive Plan.

 

| **Votes For** | ** ** | **Votes Against** | ** ** | **Abstentions and Broker  Non-Votes** | ** ** |
|---------------|------------|-------------------|------------|---------------------------------------|------------|
|          |       |              |       |                                  |       |
| 369,680,643   |       | 1,273,368         |       | 8,087,570                             |       |

 

42

----

 

**Item 6.  *Exhibits***

 

(a)

 

43

----

 

**INDEX TO EXHIBITS**

 
| **Exhibit Number** |   | **Exhibit Title**                                                                                                                                                                                                                                                                                                                                                                          |
|-------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                     |   | Purchase and Sale Agreement, dated as of February 23, 2005, by and  among CM Intermediary, LLC, Bagbridge Limited and, solely with respect to  Section 10.14 of the Agreement, Crown Media Holdings, Inc.  (previously filed as Exhibit 2.1 to our Current Report on Form 8-K,  filed on February 23, 2005 and incorporated herein by reference).                 |
| 2.2                     |   | Asset Purchase and Sale Agreement, dated as of February 23, 2005,  by and among Crown Media Distribution, LLC, Bagbridge Limited and, solely  with respect to Section 10.14 of the Agreement, Crown Media  Holdings, Inc. (previously filed as Exhibit 2.2 to our Current  Report on Form 8-K, filed on February 23, 2005 and incorporated  herein by reference). |
| 3.1                     |   | Amended and Restated Certificate of Incorporation (previously filed as  Exhibit 3.1 to our Registration Statement on Form S-1/A (Amendment  No. 2), Commission File No. 333-95573, and incorporated herein by  reference).                                                                                                                                                  |
| 3.2                     |   | Amendment to the Amended and Restated Certificate of Incorporation  (previously filed as Exhibit 3.2 to our Quarterly Report on  Form 10-Q filed on July 31, 2001 and incorporated herein by  reference).                                                                                                                                                                        |
| 3.3                     |   | Amended and Restated By-Laws (previously filed as Exhibit 3.2 to  our Registration Statement on Form S-1/A (Amendment No. 3),  Commission File No. 333-95573, and incorporated herein by reference).                                                                                                                                                                        |
| 10.1                    |   | Letter Agreement  dated October 1, 2005 between Hallmark Cards, Incorporated and Crown  Media Holdings, Inc.                                                                                                                                                                                                                                                                          |
| 10.2                    |   | Second Amended  and Restated Program License Agreement, dated as of January 1, 2005,  (previously filed as Exhibit 99 to our Form 8-K filed on  October 17, 2005 and incorporated herein by reference).                                                                                                                                                                     |
| 10.3                    |   | Trademark  License Extension Agreement, dated as of August 1, 2005, by and between  Hallmark Licensing, Inc. and Crown Media United States, LLC.                                                                                                                                                                                                                                      |
| 10.4                    |   | Trademark  License Extension Agreement, dated as of August 1, 2005, by and between  Hallmark Licensing, Inc. and Crown Media United States, LLC.                                                                                                                                                                                                                                      |
| 31.1                    |   | Rule 13a-14(a) Certification  executed by the Company’s President and Chief Executive Officer.                                                                                                                                                                                                                                                                                   |
| 31.2                    |   | Rule 13a-14(a) Certification  executed by the Company’s Executive Vice President and Chief Financial  Officer.                                                                                                                                                                                                                                                                   |
| 32                      |   | Section 1350  Certifications.                                                                                                                                                                                                                                                                                                                                                              |

 

44

----

 

**SIGNATURES**

 

Pursuant to the requirements of the Securities ExchangeAct of 1934, this report has been signed below by the following persons onbehalf of the registrant and in the capacities and on the dates indicated.

 
| ** ** | CROWN MEDIA HOLDINGS, INC. | ** **            | ** ** | ** ** |
|------------|----------------------------|-----------------------|------------|------------|
| ** ** |                       | ** **            | ** ** | ** ** |
| ** ** | **Signature**              | ** **            | **Title**  | ** ** | **Date** | ** ** | ** ** |
|       |                       |                  |       |       |   |   |   |
|       | By:                        | /s/ DAVID J. EVANS    |       |       | Director and Principal |   | November 7, 2005 |   |   |
|       |                       | David J. Evans        |       |       | Executive Officer |   |   |   |   |
|       |                       |                  |       |       |   |   |   |
|       | By:                        | /s/ WILLIAM J. ALIBER |       |       | Principal Financial and |   | November 7, 2005 |   |   |
|       |                       | William J. Aliber     |       |       | Accounting Officer |   |   |   |   |
|            |                            |                       |            |            |  |  |  |  |  |  |

 

45

----