** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**Form 10-Q**
| **(Mark One)** |       |                                                                                                                                        |
|----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------|
| ** **     |       |                                                                                                                                        |   |   |
| x              | ** ** | **QUARTERLY REPORT PURSUANT  TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                |   |   |
| ** **     |       |                                                                                                                                        |   |   |
| ** **     |       | **For the quarterly period ended September 30, 2006**                                                                                       |   |   |
| ** **     |       | ** **                                                                                                                                  |   |   |
| ** **     |       | **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 asSpecified in Its Charter)

 

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

 

**12700 Ventura Boulevard,**

**Suite 200**

**Studio City, California 91604**

(Address of Principal ExecutiveOffices and Zip Code)

**(818) 755-2400**

(Registrant’s Telephone Number,Including Area Code)

(Former Name, Former Address, and Former Fiscal Year,

if Changed Since Last Report.)

Indicate by checkmark whether the registrant:  (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  Yes  x     No  o

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

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o   No x

As of November 6,2006, the number of shares of Class A Common Stock, $.01 par value outstandingwas 74,117,654, 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,  2005 andSeptember 30, 2006  (Unaudited) |       |       |
|         |       | Condensed Consolidated Statements of Operations and  Comprehensive Loss (Unaudited)                |       |       |
|         |       | - Three and Nine Months Ended September 30, 2005 and  2006                                         |       |       |
|         |       | Condensed Consolidated Statements of Cash Flows  (Unaudited)                                       |       |       |
|         |       | - Three and Nine Months Ended September 30, 2005 and  2006                                         |       |       |
|         |       | 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  1A     |       | Risk  Factors                                                                                      |       |       |
|         |       |                                                                                               |       |       |
| Item 2       |       | Unregistered Sales of Equity Securities and Use of  Proceeds                                       |       |       |
|         |       |                                                                                               |       |       |
| Item 6       |       | Exhibits                                                                                           |       |       |
|         |       |                                                                                               |       |       |
| Signatures   |       |                                                                                               |       |       |

 

1

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*In this Form 10-Q the terms “Crown Media Holdings” orthe “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 requires otherwise.*

*Thenames Hallmark and other product or service names are trademarks or registeredtrademarks of their owners.*

**PART I. FINANCIAL INFORMATION**

**Item 1.  *FinancialStatements (Unaudited)***

**CROWN MEDIA HOLDINGS, INC. AND SUBSIDIARIES**

**UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS**

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

** **

|                                                                                             | ** ** | **As of**        | ** ** | **As of**         | ** ** |
|---------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                                                                  | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
| ** **                                                                                  | ** ** | **2005**              | ** ** | **2006**               | ** ** |
|                                                                                        |       |                  |       |                   |       |
| ASSETS                                                                                      |       |                  |       |                   |       |
|                                                                                        |       |                  |       |                   |       |
| Cash  and cash equivalents                                                                  |       | $                     | 15,926     |                   | $          | 9,798 |   |
| Accounts  receivable, less allowance for doubtful accounts of $1,565 and $411, respectively |       | 65,935                |       | 43,771                 |       |
| Program  license fees — affiliates                                                     |       | 2,656                 |       | 8,559                  |       |
| Program  license fees — non-affiliates                                                 |       | 106,542               |       | 97,048                 |       |
| Receivable  from RHI Entertainment                                                          |       | 1,815                 |       | —                 |       |
| Prepaid  and other assets                                                                   |       | 6,051                 |       | 4,056                  |       |
| Receivable  from buyer of international business                                            |       | 422                   |       | 33                     |       |
| Prepaid  program license fee assets                                                         |       | 30,377                |       | 34,028                 |       |
| Current  assets held for sale                                                               |       | —                |       | 144,890                |       |
| Total current assets                                                                        |       | 229,724               |       | 342,183                |       |
|                                                                                        |       |                  |       |                   |       |
| Accounts  receivable                                                                        |       | 9,101                 |       | 1,478                  |       |
| Program  license fees — affiliates                                                     |       | 5,036                 |       | 7,710                  |       |
| Program  license fees — non-affiliates                                                 |       | 222,861               |       | 172,373                |       |
| Film  assets, net                                                                           |       | 380,322               |       | —                 |       |
| Subscriber  acquisition fees, net                                                           |       | 80,594                |       | 51,023                 |       |
| Property  and equipment, net                                                                |       | 18,560                |       | 16,591                 |       |
| Goodwill                                                                                    |       | 314,033               |       | 314,033                |       |
| Prepaid  and other assets                                                                   |       | 13,595                |       | 12,467                 |       |
| Total  assets                                                                               |       | $                     | 1,273,826  |                   | $          | 917,858 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

2

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**CROWN MEDIA HOLDINGS, INC. AND SUBSIDIARIES**

**UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS**

**(In thousands, except par value and number of shares)**

**(continued)**

 

|                                                                                                                                                                 | ** ** | **As of**        | ** ** | **As of**         | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                                                                                                                                      | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
| ** **                                                                                                                                                      | ** ** | **2005**              | ** ** | **2006**               | ** ** |
|                                                                                                                                                            |       |                  |       |                   |       |
| LIABILITIES AND STOCKHOLDERS’ DEFICIT                                                                                                                      |       |                  |       |                   |       |
|                                                                                                                                                            |       |                  |       |                   |       |
| LIABILITIES:                                                                                                                                                    |       |                  |       |                   |       |
| Accounts  payable and accrued liabilities                                                                                                                       |       | $                     | 29,876     |                   | $          | 34,011 |   |
| Accrued  restricted stock units                                                                                                                                 |       | 9,299                 |       | 1,336                  |       |
| Subscriber  acquisition fees payable                                                                                                                            |       | 12,238                |       | 2,167                  |       |
| License  fees payable to affiliates                                                                                                                             |       | 2,730                 |       | 3,398                  |       |
| License  fees payable to non-affiliates                                                                                                                         |       | 50,460                |       | 89,568                 |       |
| Payables  to affiliates                                                                                                                                         |       | 12,071                |       | 13,318                 |       |
| Payables  to RHI Entertainment                                                                                                                                  |       | 755                   |       | —                 |       |
| Payable  to buyer of international business                                                                                                                     |       | 10,050                |       | 5,117                  |       |
| Interest  payable                                                                                                                                               |       | 169                   |       | 119                    |       |
| Capital  lease obligation                                                                                                                                       |       | 612                   |       | 657                    |       |
| Deferred  revenue                                                                                                                                               |       | 1,149                 |       | —                 |       |
| Deferred  credit from technical services agreement                                                                                                              |       | 1,323                 |       | 1,282                  |       |
| Current  liabilities held for sale                                                                                                                              |       | —                |       | 1,211                  |       |
| Total current liabilities                                                                                                                                       |       | 130,732               |       | 152,184                |       |
|                                                                                                                                                            |       |                  |       |                   |       |
| Accrued  liabilities                                                                                                                                            |       | 24,427                |       | 17,570                 |       |
| License  fees payable to affiliates                                                                                                                             |       | 586                   |       | 2,096                  |       |
| License  fees payable to non-affiliates                                                                                                                         |       | 186,268               |       | 97,035                 |       |
| Note  and interest payable to HC Crown                                                                                                                          |       | 86,309                |       | 91,540                 |       |
| Note  and interest payable to Hallmark Cards affiliate                                                                                                          |       | —                |       | 52,309                 |       |
| Payable  to Hallmark Cards affiliates                                                                                                                           |       | 70,000                |       | —                 |       |
| Payable  to buyer of international business                                                                                                                     |       | 8,395                 |       | 5,720                  |       |
| Senior  unsecured note to HC Crown, including accrued interest                                                                                                  |       | 509,386               |       | 548,333                |       |
| Credit  facility                                                                                                                                                |       | 210,000               |       | 221,500                |       |
| Note  and interest payable to Hallmark Cards affiliate                                                                                                          |       | 135,187               |       | 143,254                |       |
| Capital  lease obligation                                                                                                                                       |       | 16,170                |       | 15,672                 |       |
| Company  obligated mandatorily redeemable preferred interest                                                                                                    |       | 14,537                |       | 15,996                 |       |
| Deferred  credit from technical services agreement                                                                                                              |       | 5,018                 |       | 3,605                  |       |
| Total liabilities                                                                                                                                               |       | 1,397,015             |       | 1,366,814              |       |
| Commitments  and contingencies                                                                                                                                  |       |                  |       |                   |       |
| STOCKHOLDERS’  DEFICIT:                                                                                                                                    |       |                  |       |                   |       |
| Class  A common stock, $.01 par value; 200,000,000 shares authorized; 74,117,654  shares issued and outstanding as of December 31, 2005, and September 30, 2006 |       | 741                   |       | 741                    |       |
| Class  B common stock, $.01 par value; 120,000,000 shares authorized; 30,670,422 shares issued and  outstanding as of December 31, 2005, and September 30, 2006 |       | 307                   |       | 307                    |       |
| Additional  paid-in capital                                                                                                                                     |       | 1,423,815             |       | 1,457,032              |       |
| Accumulated  deficit                                                                                                                                            |       | (1,548,052            | )          | (1,907,036             | )          |
| Total stockholders’ deficit                                                                                                                                |       | (123,189              | )          | (448,956               | )          |
| Total  liabilities and stockholders’ deficit                                                                                                               |       | $                     | 1,273,826  |                   | $          | 917,858 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

3

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**CROWN MEDIA HOLDINGS, INC. AND SUBSIDIARIES**

**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS ANDCOMPREHENSIVE LOSS**

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

** **
| ** **                                                                                                                 | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                                                 | ** ** | **2005**                                                 | ** ** | **2006**                                                | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                                                                                                 | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                                                                                                                   |       |                                                     |       |                                                    |       |   |   |   |   |
| Subscriber fees                                                                                                            |       | $                                                        | 4,554      |                                                    | $          | 6,022 |   | $ | 13,357 |   | $ | 18,633 |   |
| Advertising                                                                                                                |       | 33,275                                                   |       | 40,229                                                  |       | 104,243 |   | 121,228 |   |
| Advertising by Hallmark Cards                                                                                              |       | 285                                                      |       | 2                                                       |       | 1,310 |   | 945 |   |
| Film asset license fees                                                                                                    |       | 2,102                                                    |       | 989                                                     |       | 7,354 |   | 1,777 |   |
| Sublicense fees and other revenue                                                                                          |       | 10,454                                                   |       | 76                                                      |       | 10,667 |   | 230 |   |
| Total revenue, net                                                                                                         |       | 50,670                                                   |       | 47,318                                                  |       | 136,931 |   | 142,813 |   |
| Cost  of Services:                                                                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| Programming costs:                                                                                                         |       |                                                     |       |                                                    |       |   |   |   |   |
| Affiliates                                                                                                                 |       | 2,700                                                    |       | 3,652                                                   |       | 8,388 |   | 9,154 |   |
| Non-affiliates                                                                                                             |       | 26,496                                                   |       | 31,404                                                  |       | 77,243 |   | 93,462 |   |
| Amortization of film assets                                                                                                |       | 13,830                                                   |       | 4,560                                                   |       | 33,175 |   | 21,703 |   |
| Impairment of film assets                                                                                                  |       | 22,939                                                   |       | 40,946                                                  |       | 22,939 |   | 225,832 |   |
| Subscriber acquisition fee amortization expense                                                                            |       | 8,688                                                    |       | 7,747                                                   |       | 26,891 |   | 23,260 |   |
| Amortization of capital lease                                                                                              |       | 289                                                      |       | 289                                                     |       | 868 |   | 868 |   |
| Other cost of services                                                                                                     |       | 2,923                                                    |       | 1,786                                                   |       | 8,870 |   | 8,838 |   |
| Total cost of services                                                                                                     |       | 77,865                                                   |       | 90,384                                                  |       | 178,374 |   | 383,117 |   |
| Selling,  general and administrative expense                                                                               |       | 15,837                                                   |       | 10,682                                                  |       | 42,608 |   | 32,489 |   |
| Marketing  expense                                                                                                         |       | 1,832                                                    |       | 3,483                                                   |       | 19,082 |   | 8,851 |   |
| Depreciation  and amortization expense                                                                                     |       | 993                                                      |       | 635                                                     |       | 3,525 |   | 2,317 |   |
| Loss from continuing operations before interest expense                                                                    |       | (45,857                                                  | )          | (57,866                                                 | )          | (106,658 | ) | (283,961 | ) |
| Interest  expense                                                                                                          |       | (19,346                                                  | )          | (26,461                                                 | )          | (53,686 | ) | (73,077 | ) |
| Loss before discontinued operations and cumulative effect of change in accounting principle                                |       | (65,203                                                  | )          | (84,327                                                 | )          | (160,344 | ) | (357,038 | ) |
| Loss  from discontinued operations, net of tax                                                                             |       | (4                                                       | )          | —                                                  |       | (10,676 | ) | — |   |
| (Loss)  gain from sale of discontinued operations, net of tax                                                              |       | (615                                                     | )          | (1                                                      | )          | (1,964 | ) | 153 |   |
| Loss before cumulative effect of change in accounting principle                                                            |       | (65,822                                                  | )          | (84,328                                                 | )          | (172,984 | ) | (356,885 | ) |
| Cumulative  effect of change in accounting principle                                                                       |       | —                                                   |       | —                                                  |       | — |   | (2,099 | ) |
| Net loss                                                                                                                   |       | $                                                        | (65,822    | )                                                       | $          | (84,328 | ) | $ | (172,984 | ) | $ | (358,984 | ) |
| Other  comprehensive income (loss):                                                                                        |       |                                                     |       |                                                    |       |   |   |   |   |
| Foreign currency translation adjustment                                                                                    |       | —                                                   |       | —                                                  |       | (3,434 | ) | — |   |
| Comprehensive loss                                                                                                         |       | $                                                        | (65,822    | )                                                       | $          | (84,328 | ) | $ | (176,418 | ) | $ | (358,984 | ) |
| Weighted  average number of Class A and Class B shares outstanding, basic and diluted                                      |       | 104,656                                                  |       | 104,788                                                 |       | 104,580 |   | 104,788 |   |
| Loss  per share before discontinued operations and cumulative effect of change in accounting principle, basic  and diluted |       | (0.62                                                    | )          | (0.80                                                   | )          | (1.53 | ) | (3.41 | ) |
| Loss  per share from discontinued operations, basic and diluted                                                            |       | (0.01                                                    | )          | (0.00                                                   | )          | (0.12 | ) | (0.00 | ) |
| Cumulative  effect of change in accounting principle, basic and diluted                                                    |       | (0.00                                                    | )          | (0.00                                                   | )          | (0.00 | ) | (0.02 | ) |
| Net  loss per share, basic and diluted                                                                                     |       | $                                                        | (0.63      | )                                                       | $          | (0.80 | ) | $ | (1.65 | ) | $ | (3.43 | ) |

 

See accompanying notes tounaudited condensed consolidated financial statements.

4

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**CROWN MEDIA HOLDINGS, INC. AND SUBSIDIARIES**

**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

** **
| ** **                                                                                   | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2005**                                                | ** ** | **2006** | ** ** |
|                                                                                         |       |                                                    |       |   |   |
| CASH  FLOWS FROM OPERATING ACTIVITIES:                                                       |       |                                                    |       |   |   |
| Net loss                                                                                     |       | $                                                       | (172,984   | ) | $ | (358,984 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities:                 |       |                                                    |       |   |   |
| Loss from discontinued operations                                                            |       | 10,676                                                  |       | — |   |
| Loss (gain) on sale from discontinued operations                                             |       | 1,964                                                   |       | (153 | ) |
| Impairment of film assets                                                                    |       | 22,939                                                  |       | 225,832 |   |
| Depreciation and amortization                                                                |       | 160,127                                                 |       | 156,484 |   |
| Accretion on company obligated mandatorily redeemable preferred  interest                    |       | 2,180                                                   |       | 1,460 |   |
| Provision for allowance for doubtful accounts                                                |       | 1,002                                                   |       | 254 |   |
| Cumulative effect of change in accounting principle                                          |       | —                                                  |       | 2,099 |   |
| Loss (gain) on sale of property and equipment                                                |       | (24                                                     | )          | 205 |   |
| Stock-based compensation                                                                     |       | 8,279                                                   |       | (3,306 | ) |
| Changes in operating assets and liabilities:                                                 |       |                                                    |       |   |   |
| (Increase) decrease in accounts receivable                                                   |       | (5,194                                                  | )          | 18,879 |   |
| (Increase) decrease in receivable from buyer of international business                       |       | (428                                                    | )          | 389 |   |
| Additions to program license fees                                                            |       | (113,981                                                | )          | (52,264 | ) |
| Additions to subscriber acquisition fees                                                     |       | (7,187                                                  | )          | (224 | ) |
| Increase in prepaid and other assets                                                         |       | (14,282                                                 | )          | (2,571 | ) |
| Decrease in accounts payable and accrued liabilities.                                        |       | (11,986                                                 | )          | (57,819 | ) |
| Increase in interest payable                                                                 |       | 40,839                                                  |       | 55,200 |   |
| Decrease in subscriber acquisition fees payable                                              |       | (23,873                                                 | )          | (10,071 | ) |
| Increase in license fees payable to affiliates                                               |       | 1,453                                                   |       | 2,178 |   |
| Increase in payables to affiliates                                                           |       | 1,222                                                   |       | 1,247 |   |
| Increase (decrease) in deferred revenue                                                      |       | 470                                                     |       | (254 | ) |
| Net cash used in continuing operating activities                                             |       | (98,788                                                 | )          | (21,419 | ) |
| CASH  FLOWS FROM INVESTING ACTIVITIES:                                                       |       |                                                    |       |   |   |
| Purchases of property and equipment                                                          |       | (848                                                    | )          | (400 | ) |
| Payments to buyer of international business                                                  |       | (7,405                                                  | )          | (7,451 | ) |
| Proceeds from the disposition of property and equipment                                      |       | 25                                                      |       | — |   |
| Proceeds from disposition of international business, net of funds  transfer fee              |       | 221,979                                                 |       | — |   |
| Net cash provided by (used in) investing activities                                          |       | 213,751                                                 |       | (7,851 | ) |
| CASH  FLOWS FROM FINANCING ACTIVITIES:                                                       |       |                                                    |       |   |   |
| Proceeds from the issuance of common stock upon exercise of stock  options                   |       | 1,693                                                   |       | 114 |   |
| Proceeds from tax sharing agreement with Hallmark Cards                                      |       | 26,100                                                  |       | 11,982 |   |
| Borrowings under the credit facility                                                         |       | 65,000                                                  |       | 15,000 |   |
| Principal payments under the credit facility                                                 |       | (195,000                                                | )          | (3,500 | ) |
| Principal payments under capital lease obligations                                           |       | (436                                                    | )          | (454 | ) |
| Net cash (used in) provided by financing activities                                          |       | (102,643                                                | )          | 23,142 |   |
| CASH  FLOWS FROM DISCONTINUED OPERATIONS (Revised  — See Note 2):                       |       |                                                    |       |   |   |
| Net cash used in discontinued operating activities                                           |       | (15,320                                                 | )          | — |   |
| Net cash used in discontinued investing activities                                           |       | (60                                                     | )          | — |   |
| Net cash used in discontinued financing activities                                           |       | (411                                                    | )          | — |   |
| Effect of exchange rate changes on cash                                                      |       | 734                                                     |       | — |   |
| Net  cash used in discontinued operations                                                    |       | (15,057                                                 | )          | — |   |
| Net (decrease) increase in cash and cash equivalents                                         |       | (2,737                                                  | )          | (6,128 | ) |
| Cash  and cash equivalents, beginning of period                                              |       | 12,102                                                  |       | 15,926 |   |
| Cash  and cash equivalents, end of period                                                    |       | $                                                       | 9,365      |   | $ | 9,798 |   |
| Supplemental  disclosure of cash and non-cash activities:                                    |       |                                                    |       |   |   |
| Interest paid                                                                                |       | $                                                       | 11,668     |   | $ | 14,221 |   |
| Income taxes paid                                                                            |       | $                                                       | 850        |   | $ | 4 |   |
| Tax sharing payment from Hallmark Cards applied to payable to Hallmark Cards affiliate       |       | $                                                       | 30,000     |   | $ | — |   |
| Tax sharing payment from Hallmark Cards applied to note payable to  Hallmark Cards affiliate |       | $                                                       | —     |   | $ | 17,999 |   |
| Payment from Hallmark Cards applied to note payable to Hallmark Cards affiliate              |       | $                                                       | —     |   | $ | 3,111 |   |
| Payable to buyer of international business                                                   |       | $                                                       | 26,803     |   | $ | — |   |
| Deferred  credit from technical services agreement                                           |       | $                                                       | 7,644      |   | $ | — |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

5

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**CROWN MEDIA HOLDINGS, INC. AND SUBSIDIARIES**

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**For the Three and Nine MonthsEnded September 30, 2005 and 2006**

**1. Business and Organization**

***Organization***

Crown Media Holdings, Inc. (“Crown Media Holdings,” “CrownMedia” or the “Company”), through its subsidiaries, owns and operates paytelevision channels (collectively the “Hallmark Channel” or the “channel”)dedicated to high quality, entertainment programming for adults and families,in the United States. The Hallmark Channel is operated and distributed by CrownMedia United States, LLC (“Crown Media United States”). Significant investorsin Crown Media Holdings include Hallmark Entertainment Investments Co. (“HallmarkEntertainment Investments”), a subsidiary of Hallmark Cards, Incorporated (“HallmarkCards”), the National Interfaith Cable Coalition, Inc. (“NICC”), and,indirectly through their investments in Hallmark Entertainment Investments,Liberty Media Corporation (“Liberty Media”) and J.P. Morgan Partners (BHCA),L.P. (“J.P. Morgan”).

***Saleof the International Business***

In April 2005, theCompany completed the sale of  its international business to a group ofinvestors comprised of Equity Partners, 3i and U.K. executive David Elstein(collectively, “Sparrowhawk,” the “buyer” or the “buyer of  internationalbusiness”). The sale included the international versions of the HallmarkChannel distributed outside the United States, the international rights to over580 titles in the Crown Media film library, and the Network Operations Centerbased in Denver, Colorado.  The Company received cash proceeds of $209.3million, net of the prepayment described below, and recognized an accountingloss of $6.5 million from the sale. Approximately $4.7 million of transactioncosts were incurred by the Company in connection with the sale.

Subsequent to thesale, the Company has no continuing economic involvement with the operations ofthe international business.

***Saleof Membership Interests in Crown Media Distribution***

The Companyannounced on October 5, 2006, that it has entered into a definitive agreementfor the sale of the domestic rights to its film library to RHI Enterprises, LLC(“RHI”). The sale includes all rights in the United States to the approximately620 television movies, mini-series and series in the Crown Media Distributionlibrary.  The Company will have the rightto continue to broadcast selected titles from the library on the Hallmark MovieChannel for up to two yearsfor atotal license fee of $100,000.

The Purchase andSale Agreement between the parties (the “Transaction Agreement”) provides forRHI’s acquisition of the Company’s membership interests in Crown MediaDistribution, LLC, the entity which owns the Crown Media Distribution library,for $160.0 million, subject to a purchase price adjustment.  The purchaseprice will be adjusted in the amount by which accounts receivable from CrownMedia Distribution library at closing are either greater or less than $16.5million, after further adjustments for doubtful accounts, trade payables, cashreceipts and current liabilities.

The membershipinterests of Crown Media Distribution sold to RHI include all accountsreceivable and rights and obligations under existing domestic licenses to whichCrown Media Distribution is a party, as well as the copyright interests in theCrown Media Distribution library films, interests in the underlying productionagreements and physical film materials. The Company will indemnify RHI for its future obligations to pay residualsand profit participations based on the domestic exploitation of the Crown MediaDistribution library by RHI for a period of ten years following the closing ofthe sale.  The Company will retain theobligation for all unpaid residual and participation obligations that wereincurred prior to closing of the sale. The cost to the Company of paying futureresiduals and profit participations will depend on the level of library salesduring the ten year period and has been

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estimated at $13.0million in determining an impairment of the Crown Media Distribution Filmlibrary as discussed in Note 3 below.  Aspart of the transaction, Hallmark Cards Incorporated and the Company haveentered into an “Intercreditor Agreement” with RHI providing that in the eventof bankruptcy of the Company or similar events, the above-mentioned residualand participation obligations that exceed $25.0 million, if any, will be paidbefore any loan, debt or other credit extension payable by the Company toHallmark Cards.

Completion of thetransaction is subject to termination of a May 2006 Crown Media Distributionlibrary license agreement with a major studio. Under the terms of that license agreement, the Company will be obligatedto refund a $6.0 million distribution advance upon the termination.  See Note 16 below.  The transaction is also subject to othercustomary closing conditions including approval by the applicable regulatoryauthorities and the release of bank liens on the Crown Media Distributionassets.  RHI has obtained the necessaryequity and debt financing commitments for the transaction, which are subject tocustomary conditions.

The TransactionAgreement contains customary representations and warranties of the parties,indemnification and termination provisions.

The Company hasother existing agreements with RHI Entertainment LLC, an affiliate of RHI, andone of its subsidiaries.  One of theseagreements is a film asset service agreement under which RHI Entertainment LLCprovides services to Crown Media Distribution related to the administration,distribution and other exploitation of the Crown Media Distributionlibrary.  This agreement will beterminated upon closing of the transaction. See Note 11 below.

Proceeds from thetransaction will be used by the Company to reduce outstanding indebtednessunder its bank credit facility. At September 30, 2006, the Company classifiedthe film library related assets and liabilities as assets and liabilities heldfor sale and recognized an additional impairment of the film assets ofapproximately $40.9 million, reflecting the expected consideration at the closeof the proposed transaction.

The closing of the transaction is anticipated to occur in thefourth quarter of 2006. There can be no assurance that any ofthe conditions to the transaction will be satisfied or that the transactionwill be completed, however, the Company has no reason to believe it will notbe.

During thependency of the sale discussed above, all sales efforts for the Library havebeen suspended.    If the transaction isnot consummated, we expect that there would be a low level of library salesuntil the Company can restart its sales activities. The failure to consummatethe transaction would also severely impact the ability of the Company tocontinue as a going concern (see “Liquidity” below).

***Liquidity***

As of September30, 2006, the Company had $9.8 million in cash and cash equivalents on hand. Asof September 30, 2006, the Company had borrowed $221.5 million from a $240.0million revolving bank credit, which matures May 31, 2007.

The Company’s principal sources of funds are cash onhand, cash generated by operations, tax sharing payments from Hallmark Cardsand amounts available under the Company’s revolving bank credit facility.Payments under the tax sharing agreement are affected by Hallmark Cards’ taxposition and its ability to utilize the Company’s tax losses.  The Company has received $12.0 million in taxsharing payments in 2006 and does not currently expect to receive anyadditional cash payments during the remainder of 2006 or 2007. The Companycurrently has $18.5 million of unused revolving credit commitments, subject toapproval from the Board of Directors.

The ability of the existing sources of liquidity to besufficient to fund the Company’s operations depends upon the Company’s abilityto achieve its forecasts, however, management has not always been able toaccurately forecast future operations. In particular, continued growth in subscriber revenue and advertisingrevenue, as well as completion of the sale of the Crown Media Distribution filmlibrary or in the alternative, increasing the cash flow from library sales willbe required to maintain liquidity.  Anydecline in the popularity of the Hallmark Channel, any significant futuremodifications to the Company’s distribution agreements, an economic decline inthe advertising market, an increase in program acquisition costs (the extent ofsuch increase subject to the sale discussed above), an

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increasein competition or other adverse operating conditions would impact the Company’sliquidity and its ability 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 are insufficient, the Company would be forced to seekadditional funding from the issuance of debt or equity securities, a sale ofcertain assets or strategic transactions which provide capital. There can be noassurance that the Company would be able to secure additional financing orcomplete any such transactions.

The Company expects tocontinue making investments in programming, marketing and distribution duringthe next twelve months ending September 30, 2007. However, the Company’sliquidity position has demanded that all areas of expenses, includingprogramming, marketing and distribution be closely monitored andcontrolled.  The Company has and willcontinue to seek to sublicense certain of its programming rights but expects thatprogramming expenses and cost of services will increase when compared to theseitems for the prior twelve month period.

The Companyanticipates that its principal uses of funds for the remainder of 2006 willcontinue to include the payment of operating expenses, accounts payable andaccrued expenses, license fees for programming (including the prepayment ofcertain license fees for 2007), and interest under its bank credit facility.

As part of theseefforts to improve the capital structure, the Company has entered into anagreement to sell its membership interests in Crown Media Distribution asdescribed in “Sale of Membership Interests in Crown Media Distribution” above.

The Company currentlybelieves that cash on hand, cash generated by operations and the sale of itsmembership interests in Crown Media Distribution, and availability on its bankcredit facility, will be sufficient to fund the Company’s operations and meetits liquidity needs through September 30, 2007. However, if the Company does not consummate the sale of its membershipinterests in Crown Media Distribution, its ability to continue as a goingconcern would be dependent upon the continued financial support of HallmarkCards. However, at this point in time, Hallmark Cards has no obligation toprovide any further funding to the Company.

The Company’s bank creditfacility will expire on May 31, 2007.   The Company plans tosignificantly reduce the amounts outstanding under the credit facility with theproceeds of the sale of the membership interests in Crown Media Distribution. Atthe same time as making these repayments on the credit facility, the Companyintends to reduce the size of the credit facility and, with the lenders’concurrence, extend the term of the credit facility.  Even if the sale of the film library were notconsummated, the Company would intend to extend or refinance the Bank creditfacility prior to or upon its maturity. Any such extension or refinancing might require a continuation of aletter of credit from Hallmark Cards or other steps by the Company and is notassured.

If the Company is notable to arrange for the extension, refinancing or replacement of the bankcredit facility prior to its maturity and the bank draws down on theirrevocable letter of credit provided by Hallmark Cards in support of the bankcredit facility, or alternatively Hallmark Cards purchases the interests of thelending banks, Hallmark Cards would have all obligations and the rights of thelending banks under the bank credit facility.  In that event, HallmarkCards could demand payment of outstanding amounts at any time after November15, 2007, under the terms of the waiver and standby purchase agreement (“WaiverAgreement”) described below.

Upon maturity of the creditfacility on May 31, 2007, 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, but instead can elect toinitiate a process to foreclose on the Company’s assets. Suchforeclosure proceedings, which we view as a remote possibility, would affectour ability to continue our operations. Prior to any such possible foreclosureproceedings, however, the Company, if it has not secured an extension of thecredit facility or alternative financing, would cause Hallmark Cards pursuantto the terms of the Waiver Agreement to exercise its option to purchase all ofthe outstanding indebtedness under the credit facility and the credit facilitywould then be subject to terms of the Waiver Agreement not to demand paymentprior to November 15, 2007.

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Due to the Company’sliquidity issues and its possible inability to meet its obligations when theycome due in November 2007, the Company anticipates that prior to November 15,2007, it will be necessary to either extend or refinance (i) the bank creditfacility and (ii) the promissory notes payable to affiliates of Hallmark Cardsdescribed in the Notes below. As part of a combination of actions and in orderto obtain additional funding, the Company may consider various alternatives,including refinancing the bank credit facility, raising additional capitalthrough the issuance of equity or debt securities, a sale of certain assets orother strategic alternatives.

**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 cash flowsinclude all adjustments, consisting of normal recurring items necessary fortheir fair presentation in conformity with accounting principles generallyaccepted in the United States. Interim results are not necessarily indicativeof results for a full year. These consolidated financial statements should beread in conjunction with the audited consolidated financial statements and thenotes to those statements for the year ended December 31, 2005, included in theCompany’s Annual Report on Form 10-K for the year ended December 31, 2005.

***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 and transactionshave been eliminated in consolidation.

In February 2005, the Company signed a definitiveagreement to complete the sale of its international business and, accordingly,classified the operating results of the international business as discontinuedoperations in the accompanying statements of operations for all periodspresented. The Company’s discontinued operations consisted of the internationalchannel operations and the international rights to the film library assets. TheCompany closed such sale in April 2005.

In October 2006, the Company signed a definitiveagreement for the sale of the domestic rights to the film library assets and,accordingly, classified the related assets and liabilities as held for sale inthe accompanying balance sheet as of September 30, 2006. The accompanyingstatements of operations and cash flows do not reflect associated revenue andexpenses as discontinued operations, because the portions of advertisingrevenue and related cash collections that are derived from the Company’s use ofthe film library assets to meet programming requirements of the Channel cannotbe distinguished from advertising revenue and cash collections derived from theuse of programming licensed from third parties.

***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, allowance for bad debts, useful lives ofassets, ultimate revenue used in the film asset amortization calculations, cashflow projections used in various asset valuations, income taxes, reserves andother provisions for contingencies are reasonable, based on informationavailable at the time they are made. These estimates, judgments and assumptionscan affect the reported amounts of assets and liabilities as of the date of theconsolidated financial statements, as well as the reported amounts of revenueand expenses during the periods presented. Actual results could differ fromthese estimates.

***FilmAssets and Film Library Impairment***

The Company amortizes itsfilm assets using the individual-film-forecast-computation method over amaximum

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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.

Ona quarterly basis, the Company assesses whether events or circumstances havechanged indicating that the fair value of a film is lower than its unamortizedcost or carrying value. If the carrying value of any individual film assetexceeds its fair value, the film asset is written-down to its estimated fairvalue. Usually, a discounted cash flow model, based on management’s anticipatedultimate future revenue of the film, is used to estimate the fair value of theindividual films. The Company considers the following factors, among others, inestimating ultimate future revenue for each film:  (*a*) theoperating environment expected for the next several years, (*b*) the size of the library as a whole, (*c*) historical license fee revenue perfilm, (*d*) each title’s age,quality, and marketability, (*e*)existing sales plans including the amount of product desired to be sold eachyear, *(f)* future performance estimates, *(g)* assumptions and estimates underlying past and futureestimates, and *(h)* risk factors that couldeffect future operations of the Library.  In estimating a film’s fairvalue, the Company considers those cash outflows necessary to generate the film’scash inflows such as exploitation, residual and participation costs andtaxes.  The discount rate used in the Company’s discounted cash flow modelis based upon management’s estimate of the rate a purchaser would requirerelated to the risks and uncertainties surrounding the timing and probabilityof 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 betweenamortization expense determined using the new estimates and any amountspreviously expensed during that current fiscal year are charged or credited tothe statement of operations 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.

At June 30, 2006,and September 30, 2006, the Company recorded impairments related to its filmassets as described in Note 3 below.

***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’s bad debtrecovery was $115,000 for the three months ended September 30, 2005. TheCompany’s bad debt expense was $1.0 million for the nine months ended September30, 2005. The Company’s bad debt recovery was $1.0 million for the three monthsended September 30, 2006. The Company’s bad debt expense was $254,000 for thenine months ended September 30, 2006.

***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

 

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revenues and anticipated patterns of programming usage on a day partbasis as it pertains to programming licensed to the channel. These estimates ofexpected annual future estimated revenues are compared to the net book value ofthe program license fee assets to determine if the programming assets areexpected to be recovered. Where the analysis indicates the costs are in excessof the estimated net realizable value, an impairment is recognized.

***Subscriber Acquisition Fees***

TheCompany has been required to pay subscriber acquisition fees to obtain initialcarriage on major domestic pay distributors’ systems. Under some of theseagreements with pay distributors, Crown Media United States has been obligatedto pay subscriber acquisition fees if defined subscriber levels were met or inorder to obtain additional carriage of the Hallmark Channel by those paydistributors. Such costs are accrued when Crown Media United Statesreceives notice from the distributors that they have met the contractualpenetration percentage or subscriber 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 cumulative subscriber feerevenue recognized, or to be recognized, on a per distributor basis, the excessamortization is included as a component of cost of services. Crown MediaHoldings assesses the recoverability of these costs periodically by comparingthe net carrying amount to the estimates of future subscriber fee andadvertising revenues. It also assesses the recoverability when events such aschanges in distributor relationships occur or other indicators suggestimpairment.

***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.

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 isrecognized for the amount by which the carrying amount of the asset exceeds itsfair value. The Company determines fair values by using a combination ofcomparable market values and discounted cash flows, as appropriate.

Goodwill is reviewed for impairment annually on November 30 or wheneveran event occurs or circumstances change that indicates fair value might bebelow carrying 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 its estimated fair valuethrough an impairment charge to the Company’s consolidated statements ofoperations.

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***Revenue Recognition***

Subscriber revenue from pay television distributors is recognized asrevenue when an agreement is executed, programming is provided, the price isdeterminable, and collectibility is reasonably assured. Subscriber fees frompay television distributors are recorded net of amortization of subscriberacquisition costs in accordance with Emerging Issues Task Force No. 01-9 (“EITFNo. 01-9”), *Accounting for Consideration Given by a Vendor to aCustomer (Including a Reseller of the Vendor’s Products)*. If theamortization expense exceeds the cumulative subscriber fee revenue recognized,or to be recognized, on a per distributor basis, the excess amortization isincluded as a component of cost of services.

Advertisingrevenues are recognized as earned in the period in which the advertising istelecast. Revenue is recognized as commercial spots or long form programming isaired 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 00-2,*Accounting by Producers or Distributors of Films*.Revenues are recognized when all of the following have occurred:  an agreement is executed, the film isavailable for exhibition by the licensee, the license fee is fixed ordeterminable, collectibility is reasonably assured and the cost of each film isknown or reasonably 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. Feesreceivable with terms in excess of one year are discounted for revenuerecognition purposes at the customer’s estimated incremental borrowing rate inaccordance with 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 subsequent to March 2003. However, the Company continues to account for income taxes on a separatereturn basis. Accordingly, the Company accounts for income taxes using an assetand liability method, which requires the recognition of deferred tax assets andliabilities for the expected future tax consequences attributable todifferences between the financial statement carrying amounts of existing assetsand liabilities and their respective tax bases and net operating loss and taxcredit carryforwards. Deferred tax assets and liabilities are measured usingenacted tax rates expected to be applied to taxable income in the years inwhich those temporary differences are expected to be recovered or settled. TheCompany reduces deferred tax assets by a valuation allowance if it is morelikely than not that some portion or all of the deferred tax assets will not berealized. Any payments received fromHallmark Cards or offsets applied to Hallmark Cards or Hallmark relatedobligations under the tax sharing agreement are recorded as an increase inadditional paid-in capital and any future utilization of deferred tax assetsgenerated after March 2003 will be recorded as a reduction in paid-in capital,to the extent payments were previously received from Hallmark Cards for suchbenefits under the tax sharing agreement.

***Stock-Based Compensation***

During the firstquarter of fiscal 2006, we adopted the provisions of, and account forstock-based compensation in accordance with, the Financial Accounting StandardsBoard’s (“FASB”) Statement of Financial Accounting StandardsNo. 123—revised 2004 (“SFAS 123R”), *Share-Based Payment*which replaced Statement of Financial Accounting Standards No. 123 (“SFAS123”), *Accounting for Stock-Based Compensation*and supersedes APB Opinion No. 25 (“APB 25”), *Accountingfor Stock Issued to Employees*. Under the fair value recognitionprovisions of this statement, stock-based compensation cost is measured at thegrant date based on the fair value of the award and is recognized as expense ona straight-line basis over the period during which the holder is required toprovide services in exchange for the award, i.e., usually the vesting period.We elected the modified-prospective method, under which prior periods are notrevised for comparative purposes. The valuation provisions of SFAS 123R applyto new grants and to grants that were outstanding as of the effective date andare subsequently modified. Estimated 

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compensation for grantsthat were outstanding as of the effective date is recognized over the remainingservice period using the compensation cost estimated for the SFAS 123 pro formadisclosures.

Inconnection with the adoption of SFAS 123R, we recorded a cumulative catch-up adjustment of $2.1 million related to restrictedstock units (“RSUs”) granted under the Amended and Restated Crown MediaHoldings, Inc. 2000 Long Term Incentive Plan (the “Plan”). See Note 12for further information regarding our stock-based compensation assumptions andexpenses.

Thefollowing table sets forth the pro forma amounts of net income and net loss pershare, for the three and nine months ended September 30, 2005, that would haveresulted if we had accounted for our employee stock options under the fairvalue recognition provisions of SFAS 123:

**Pro Forma Effects**

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

** **

|                                                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                              | ** ** | **September 30, 2005** | ** ** |
|                                                    |       |                             |       |                            |       |
| Net loss                                                |       | $                                | (65,822    | )                               | $          | (172,984 | ) |
| Pro forma stock options expense at estimated fair value |       | (30                              | )          | (291                            | )          |
| Stock option expense included in net loss               |       | —                           |       | 14                              |       |
| Pro forma net loss                                      |       | $                                | (65,852    | )                               | $          | (173,261 | ) |
| Weighted average shares                                 |       | 104,656                          |       | 104,580                         |       |
| Pro forma net loss per share, basic and diluted         |       | $                                | (0.63      | )                               | $          | (1.66 | ) |

 

Uponexercise of outstanding stock options, we have and will continue to issuecommon stock.

***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 shares consistof incremental common shares issuable upon the exercise of stock options andrestricted stock units. For the three and nine months ended September 30, 2005and 2006, respectively, approximately 883,000 and 845,000 stock options havebeen excluded from the calculations of earnings per share because their effectswould have been antidilutive.

***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. Revenue, expenses and cash flows of such subsidiaries were translatedinto United States dollars at the average exchange rates prevailing during theperiod. Assets and liabilities were translated at the rates of exchange at thebalance sheet date. Translation gains and losses were deferred as a componentof accumulated other comprehensive income (loss). Foreign currency transactiongains and losses recorded upon the remeasurement of financial assets andliabilities denominated in currencies other than the functional currency of thesubsidiary were included in determining net loss for the period.

***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.

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***Reclassifications***

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

***Cash Flows***

In 2005, the Company has separately disclosed theoperating, investing and financing portions of the cash flows attributable toits discontinued operations, which in prior periods were reported on a combinedbasis as a single amount.

***Recently Issued Accounting Pronouncements***

In July2006, the FASB issued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes* (“FIN 48”). FIN 48 is aninterpretation of FASB Statement No. 109, *Accountingfor Income Taxes*, and it seeks to reduce the diversity in practiceassociated with certain aspects of measurement and recognition in accountingfor income taxes. In addition, FIN 48 requires expanded disclosure with respectto the uncertainty in income taxes and is effective as of the beginning of our2007 fiscal year. We are currently evaluating the impact, if any, that FIN 48will have on the Company’s financial statements.

InSeptember 2006, the FASB issued SFAS No. 157, *Fair Value Measurements* (“SFAS No. 157”). SFASNo. 157 defines fair value, establishes a framework for measuring fairvalue and expands disclosures about fair value measurements. SFAS No. 157is effective for the Company as of January 1, 2008. The Company is currentlyevaluating the potential impact of adopting SFAS No. 157.

In September 2006, the SEC issued SABNo. 108, *Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements* (“SAB No. 108”). SAB 108 establishes a singlequantification framework wherein the significance measurement is based on theeffects of the misstatements on each of the financial statements as well as therelated financial statement disclosures. If a company’s existing methodsfor assessing the materiality of misstatements are not in compliance with theprovisions of SAB 108, the initial application of the provisions may be adoptedby restating prior period financial statements under certain circumstances orotherwise by recording the cumulative effect of initially applying theprovisions of SAB 108 as adjustments to the carrying values of assets andliabilities as of January 1, 2006 with an offsetting adjustment recordedto the opening balance of retained earnings. SAB No. 108 is effectivefor the first annual period ending after November 15, 2006. The Companydoes not expect that the adoption of SAB 108 will have a material effect on itsresults of operations or financial position.

**3. Film Library Impairment**

In the secondquarter of 2006 the Company retained an investment banking firm to solicitexpressions of interest from third parties for the potential purchase of theCompany’s film library.  As a result ofnon-binding bids received in the second quarter and an agreement datedOctober 5, 2006 for the sale of the library, management deemed itnecessary to review its film assets for impairment as of both June 30, 2006 andSeptember 30, 2006.  The fair values usedin the impairment analyses were derived by management taking into account thefollowing: (1)  an implied purchase prices from bid parties and acontractual sales price at June 30, 2006 and September 30, 2006, respectively,with adjustments to take into account the terms of the proposed sale includingthe estimated future cost of the Company’s indemnification of the buyer forretention of residual and participation liabilities arising from the buyer’suse of the library for a 10-year period following the closing of the sale;(2) the estimated fair value of rights for the Company’s retained,non-exclusive use of certain films for showing on its Hallmark Movie Channelfor a limited period of time; and (3) the amount of accounts receivablerelated to the film library, which are part of the membership interests inCrown Media Distribution being sold. The resulting non-cash impairment chargesof $40.9 million and $225.8 million for the three and nine months endedSeptember 30, 2006, respectively, are included in impairment of film assets onthe accompanying statement of operations.

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The bids used in management’s valuation of the filmassets at June 30, 2006 and the purchase price and related terms of theproposed sale of the film library at September 30, 2006 involve lump sumamounts with no values applied to individual films or groups of films.  However, under applicable accountingrequirements the impairment analyses must be prepared on a film-by-film basis.Having concluded that since August 31, 2005, the date of the most recentfilm-by-film valuation, each individual film has retained its relative valuewith respect to the film library taken as a whole as of June 30 and September30, 2006, management has allocated the total estimated fair value at thosedates on the basis of the estimated relative fair values of each film as ofAugust 31, 2005.  Non-cashimpairment charges were recorded at both June 30, 2006 and September 30, 2006to reflect the amounts by which the carrying values of individual filmsexceeded the respective estimated fair values.

In preparing theimpairment analyses management relied upon various estimates, including thosemade by consultants retained by the Company, which were based on informationknown at the time of the analyses. Estimates are subject to risks and uncertainties which could causeactual results to differ materially from those projected or implied in thedetermination of the fair values of the film library as of June 30, 2006 andSeptember 30, 2006.  There is nocertainty that a sale of the film library will occur.

In the thirdquarter of 2005, the Company reviewed each of its film asset titles forimpairment. The Company computed the fair value of the rights to each filmusing the discounted cash flows attributable to estimated future third partysales and internal use at September 30, 2005. A non-cash impairment charge wasrecorded in the third quarter of 2005 toreflect the amounts by which the carrying values of individual films exceededthe respective estimated fair values. The resulting non-cash impairment charge of $22.9 million is included inimpairment of film assets on the accompanying statement of operations for thethree and nine months ended September 30, 2005.

**4. Subscriber Acquisition Fees**

Subscriber acquisition fees are comprised of thefollowing:

 

|                                      | ** ** | **As of December 31,** | ** ** | **As of September 30,** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|----------------------------------------|------------|
| ** **                           | ** ** | **2005**                              | ** ** | **2006**                               | ** ** |
| ** **                           | ** ** | **(In thousands)**               | ** ** |
| Subscriber acquisition fees, at cost |       | $                                     | 221,594    |                                   | $          | 192,890 |   |
| Accumulated amortization             |       | (141,000                              | )          | (141,867                               | )          |
| Subscriber acquisition fees, net     |       | $                                     | 80,594     |                                   | $          | 51,023 |   |

 

*Of the net balance at September 30,2006, the Company expects $12.2 million will be recognized as a reduction ofsubscriber fee revenue and $38.8 million will be recognized as subscriberacquisition fee expense in future periods.*

*As of December 31, 2005, andSeptember 30, 2006, the consolidated balance sheets also reflect subscriberacquisition fees payable of $12.2 million and $2.2 million, respectively. Forthe three months ended September 30, 2005 and 2006, Crown Media United Statesmade cash payments of $1.3 million and $0, respectively. For the nine monthsended September 30, 2005 and 2006, Crown Media United States made cash paymentsof $31.1 million and $10.3 million, respectively.*

**5. Program License Fees**

Program license fees are comprised of the following:

 

|                                                            | ** ** | **As of December 31,** | ** ** | **As of September 30,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------|------------|----------------------------------------|------------|
| ** **                                                 | ** ** | **2005**                              | ** ** | **2006**                               | ** ** |
| ** **                                                 | ** ** | **(In thousands)**               | ** ** |
| Program license fees — RHI Entertainment Distribution |       | $                                     | 164,752    |                                   | $          | 174,262 |   |
| Program license fees — NICC                           |       | 9,411                                 |       | 22,634                                 |       |
| Program license fees — other affiliates               |       | 368                                   |       | 368                                    |       |
| Program license fees — non-affiliates                 |       | 365,429                               |       | 330,886                                |       |
| Program license fees, at cost                              |       | 539,960                               |       | 528,150                                |       |
| Accumulated amortization                                   |       | (202,865                              | )          | (242,460                               | )          |
| Program license fees, net                                  |       | $                                     | 337,095    |                                   | $          | 285,690 |   |

 

 

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Programming costs for the three months ended September30, 2005 and 2006, were $29.2 million and $35.1 million, respectively.Programming costs for the nine months ended September 30, 2005 and 2006, were$85.6 million and $102.6 million, respectively.

At December 31, 2005, and September 30, 2006, $30.4million and $34.0 million of program license fees were included in prepaidprogram license fee assets on the accompanying condensed consolidated balancesheets as the Company had made payments, but the airing windows had notcommenced.

License fees payable are comprised of the following:

 

|                                                             | ** ** | **As of December 31,** | ** ** | **As of September 30,** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------|------------|----------------------------------------|------------|
| ** **                                                  | ** ** | **2005**                              | ** ** | **2006**                               | ** ** |
| ** **                                                  | ** ** | **(In thousands)**               | ** ** |
| License  fees payable — RHI Entertainment Distribution |       | $                                     | 22,704     |                                   | $          | 16,152 |   |
| License  fees payable — NICC                           |       | 3,315                                 |       | 5,494                                  |       |
| License  fees payable — non-affiliates                 |       | 214,025                               |       | 170,451                                |       |
|  Total license fees payable                            |       | 240,044                               |       | 192,097                                |       |
| Less  current maturities                                    |       | (53,190                               | )          | (92,966                                | )          |
|  Long-term license fees payable                        |       | $                                     | 186,854    |                                   | $          | 99,131 |   |

 

**6. Property and Equipment**

Property and equipment are comprised of the following:

 

|                                    | ** ** | **As of December 31,** | ** ** | **As of September 30,** | ** ** | **Depreciable Life** | ** ** |
|------------------------------------|------------|---------------------------------------|------------|----------------------------------------|------------|---------------------------|------------|
| ** **                         | ** ** | **2005**                              | ** ** | **2006**                               | ** ** | **(In years)**       | ** ** |
| ** **                         | ** ** | **(In thousands)**               | ** ** |
| Technical  equipment and computers |       | $                                     | 14,650     |                                   | $          | 14,958                    |       | 3-5 |   |
| Leased  assets                     |       | 17,363                                |       | 17,363                                 |       | 15                        |       |
| Furniture,  fixtures and equipment |       | 1,235                                 |       | 1,241                                  |       | 5                         |       |
| Leasehold  improvements            |       | 3,344                                 |       | 2,853                                  |       | 3-7                       |       |
| Construction-in-progress           |       | 18                                    |       | 86                                     |       |                      |       |
| Property and equipment, at cost    |       | 36,610                                |       | 36,501                                 |       |                      |       |
| Accumulated  depreciation          |       | (18,050                               | )          | (19,910                                | )          |                      |       |
| Property  and equipment, net       |       | $                                     | 18,560     |                                   | $          | 16,591                    |       |   |   |

 

Depreciation expense related to property and equipmentwas $853,000 and $640,000 for the three months ended September 30, 2005 and2006, respectively. Depreciation expense related to property and equipment was$2.6 million and $2.2 million for the nine months ended September 30, 2005 and2006, respectively.

Software and other intangible assets of $2.0 millionand $1.1 million as of December 31, 2005, and September 30, 2006, respectively,have been included in prepaid and other assets in the accompanying condensedconsolidated balance sheets.

**7. Credit Facility**

The Company has a credit agreement with a syndicate ofbanks, led by JP Morgan Chase Bank, under which the banks have extended to theCompany a secured revolving credit facility of up to $240.0 million. Borrowingsunder the revolving credit facility are contingent upon the approval of theCompany’s Board of Directors.  TheCompany and the lending banks originally entered into the facility in 2001 andhave subsequently amended the terms of this facility, with the most recentamendment dated as of April 28, 2006. The facility is guaranteed by the Company’s subsidiaries and is securedby all tangible and intangible property of Crown Media Holdings and itssubsidiaries.

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

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fromone, two, three, six or twelve months. The alternate rate is based upon the prime rate of JP Morgan Chase Bank,a certificate of deposit rate or the Federal Funds effective rate, which isadjusted whenever the rates change.  TheCompany is required to pay a commitment fee of 0.15% per annum (0.2% from March1, 2005, to April 27, 2006) of the committed, but not outstanding, amountsunder the revolving credit facility, payable in quarterly installments.

AtDecember 31, 2005, and September 30, 2006, Crown Media Holdings had outstandingborrowings of $210.0 million and $221.5 million, respectively, under the creditfacility. At December 31, 2005, $210.0 million of the outstanding balance boreinterest at the Eurodollar rate (5.39% at December 31, 2005). At September 30,2006, $221.5 million of the outstanding balance bore interest at the Eurodollarrate (6.07% at September 30, 2006). Interestexpense on borrowings under the credit facility for the three months endedSeptember 30, 2005 and 2006, was $2.1 million, and $3.5 million, respectively.Interest expense on borrowings under the credit facility for the nine monthsended September 30, 2005 and 2006, was $8.0 million, and $9.7 million,respectively.

***Covenants***

The creditfacility, as amended, contains a number of affirmative and negativecovenants.  The Company’s Annual Reporton Form 10-K contains a detailed description of these covenants.

By an AmendmentNo. 9 dated as of March 21, 2006, to the agreement for the bank creditfacility, Hallmark Cards has been provided the right, by giving five businessdays written notice, to purchase all of the bank lenders’ interest in the loansunder the bank credit facility for an amount equal to the principal plusaccrued, unpaid interest and other amounts owing to any of the lendingbanks.  Under the Waiver Agreementdescribed below, we can cause Hallmark Cards to complete such a purchase.  We view this purchase right as an alternativeto the lending banks drawing down on the letter of credit described below.

By an Amendment No. 10, dated as of April 28,2006, to the credit agreement, the maturity date of the credit facility hasbeen extended to May 31, 2007 and the size of the revolving credit facility hasbeen increased from $220.0 million to $240.0 million.  Additionally, the amendment provided for thefollowing: (1) 0.25% reduction in the interest rate in the case of Eurodollar Loans,from 1.0% per annum to 0.75% per annum, (2) 0.05% reduction in the commitmentfee from 0.20% per annum to 0.15% per annum and (3) amendment to the limitationon Restricted Payments to allow us to issue common stock or make paymentspursuant to employees’ restricted stock unit agreements.  Amendment No. 10 also deleted certain eventsof defaults no longer relevant and the following negative covenants: (1)changing the location of the Company’s chief executive office or the Company’sname, (2) making capital expenditures, (3) incurring cash program acquisitionguarantees in excess of a certain amount, (4) using the proceeds of the loansfor any purpose other than set forth in the Credit Agreement, (5) permittingEBITDA (as defined in the Credit Agreement) to be less than specified amountsper quarter and (6) permitting payments to television distributors forsubscribers to be greater than certain amounts.

The Company was in compliance with its debt covenants at September 30,2006.

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

***Waiver and Standby Purchase Agreement***

 Under theWaiver Agreement dated March 21, 2006, as amended through November 6, 2006,Hallmark Cards agreed to defer all payments due on any of the followingobligations and, except where noted, payment of interest thereon until November15, 2007 or an earlier date as described below as the waiver termination date,whereupon all of these amounts become immediately due and payable (the “WaiverPeriod”):

·                                          Note,dated December 14, 2001, in the original principal amount of $75.0 million,payable to HC Crown. (Total amount outstanding at September 30, 2006, includingaccrued interest was $91.5 million. See *Note Payable to HC Crown*below.)

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·                                          10.25% senior unsecured discount note, dated August5, 2003, in the initial accreted value of $400.0 million, payable to HCCrown.  (Total amount outstanding atSeptember 30, 2006, including accrued interest was $548.3 million. See *Senior Unsecured Note*below.)

·                                          $70.0 million account payable to HallmarkEntertainment Holdings arising out of the saleto Crown Media Holdings of the Hallmark Entertainment film library. (Totalamount outstanding at September 30, 2006, including accrued interest was $52.3million. See *Promissory Note with Hallmark EntertainmentHoldings*below.)

·                                          Note, dated as ofOctober 1, 2005, in the principal amount of $132.8 million, payable to Hallmark EntertainmentHoldings. (Total amount outstanding at September 30, 2006, including accruedinterest was $143.3 million. See *Promissory Note withHallmark Entertainment Holdings*below.)

·                                          Allobligations of the Company under the bank credit facility to Hallmark Cards,Incorporated by virtue of Hallmark Cards’ deemed purchase of participations inall of the obligations under a letter of credit which Hallmark Cards has givenin support of the facility or the purchase by Hallmark Cards of all theseobligations pursuant to Amendment No. 9 to the bank credit facility.

Hallmark Cards has agreed that it will not acceleratethe maturity of any of the foregoing obligations or initiate collectionproceedings during the Waiver Period. Interest will continue to accrue on these obligations during the WaiverPeriod. The Company will continue to pay the banks and/or Hallmark Cardsinterest on the credit facility during the Waiver Period.

The waivertermination date is November 15, 2007 or earlier upon occurrence of any of thefollowing events:  (a) the Company failsto pay any principal or interest, regardless of amount, due on any indebtednesswith an aggregate principal amount in excess of $5.0 million or any other eventor condition occurs that results in any such indebtedness becoming due prior toits scheduled maturity, provided that the waiver will not terminate if theCompany reduces the principal amount of such indebtedness to $5.0 million orless within five business days of a written notice of termination from HallmarkCards; (b) certain bankruptcy events occur; (c) the Company defaults in itspayment of licensing fees under the Second Amended and Restated Program LicenseAgreement with RHI Entertainment Distribution (formerly known as HallmarkEntertainment Distribution at which time it was a wholly-owned subsidiary ofHallmark Cards); (d) a representation and warranty of the Company in the WaiverAgreement is false or misleading in any material respect; or (e) the Companyfails to pay interest on the bank credit facility described above to the extentthat Hallmark Cards has purchased all or a portion of the indebtednessthereunder or to perform any covenants in the Waiver Agreement.

Under the WaiverAgreement, if the bank’s lenders under the bank credit facility accelerate anyof the indebtedness under the bank credit facility or seek to collect anyindebtedness under it, then the Company may elect to exercise its right torequire that Hallmark Cards or its designated subsidiary exercise an option topurchase all the outstanding indebtedness under the bank credit facility asprovided in the bank credit facility. All expenses and fees in connection with this purchase would be added tothe principal amount of the credit facility obligations.

The WaiverAgreement does not limit any existing rights of Hallmark Cards or itsaffiliates to offset amounts owed to us under the Hallmark Tax SharingAgreement and Hallmark Cards’ share of the amounts payable under the December1, 2005, agreement with NICC (described in Note 10) against theseobligations.  On September 1, 2006,Hallmark Cards elected to apply its $3.1 million share of the NICC obligationsagainst the amounts due under the $70.0 million Promissory  Note to Hallmark Entertainment Holdings(described below), thereby reducing the principal amount of that Note by $3.1million. Additionally, during the third quarter of 2006, Hallmark Cards applied$18.0 million of benefit from the Tax Sharing Agreement against the principalamount due under the March 21, 2006, promissory note with HallmarkEntertainment Holdings. Pursuant to the Waiver Agreement, the Company must makeprepayments on the outstanding debt from 100% of any “Excess Cash Flow” duringthe Waiver Period.   “Excess Cash Flow”is defined as 1) the net proceeds of any debt or equity financings or sale ofassets; 2) the net cash proceeds from the incurrence by the Company ofindebtedness; 3) the net cash proceeds from the sale, transfer

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or release by the Companyof assets outside the ordinary course of business; and 4) if positive, the consolidated net cash flow from operations ofCrown Holdings for any calendar quarter as shown in an SEC report, less cashfunds used to pay current operating expenses and to pay or establish reasonablereserves for future expenses, indebtedness payments, and capital improvementsand replacements as determined by the Board of Directors of the Company.

As considerationfor the Waiver Agreement in March 2006, we converted the $70.0million account payable to Hallmark Entertainment Holdings arising outof our purchase of the Hallmark Entertainment film library to apromissory note described below, bearing interest at LIBOR plus 3% perannum.  This note is payable in full on November 15, 2007, and accrued butunpaid interest is added to the outstanding principal amount on an annualbasis.   We also agreed in March 2006 to:

·        amendthe 2001 and 2005 notes described above to add the accrued but unpaid interest,currently and annually, to the outstanding principal amounts ;

·        use  our commercially reasonable efforts to refinance all of  our obligations to Hallmark Cards and affiliates noted above;  and

·        complywith  our  covenants and obligations under the bank creditfacility .

In addition,we provided in March 2006 a release to Hallmark Cards and relatedparties for any matters prior to the date of the Waiver Agreement and relatingto the capacity of the released parties as beneficiariesof  our obligations under the Waiver Agreement or the deferredobligations listed above. This release was extended in the August 8, 2006,and November 6, 2006, amendments to matters prior to the dates of theamendments.

***Hallmark Letterof Credit                                      ***

Pursuant to Amendment No. 8 to the bank creditfacility, Hallmark Cards has provided an irrevocable letter of credit issued byCitibank, N.A. to JP Morgan Chase Bank in the original amount of $320.0million, as credit support for our obligations under the Company’s credit facility(the “credit facility”).  The supportletter of credit was reduced to $220.0 million upon the consummation of thesale of the Company’s international business and the reduction of the aggregateoutstanding 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 and upon theoccurrence of certain other events.  Anyproceeds received by JP Morgan Chase Bank from drawing under this supportletter of credit will be used to purchase from the bank lenders, on behalf ofHallmark Cards, subordinated participations in our obligations under the bankcredit facility.  We agreed to payHallmark Cards’ the amounts resulting from the 2.0% reduction in the interestrate and the 0.3% reduction in the commitment fee payable by the Company underthe bank credit facility as provided in Amendment No. 8.  In addition, we agreed to pay the fee chargedby Citigroup for the letter of credit which was 0.625% of the amount of the letterof credit.

In conjunction with Amendment No. 10, Hallmark Cardsextended its letter of credit to correlate to the maturity date of the creditfacility and also increased the size of the letter of credit from $220.0million to $240.0 million.  In considerationof this extension and increase in the size of the letter of credit, the Companyagreed to continue to pay Hallmark Cards the difference between the interestrate formerly charged the Company before the letter of credit was available andthe rate now charged with the backing of the letter of credit.  Since the interest rate was further reducedin Amendment No. 10 to LIBOR plus 0.75%, the interest differential now payableto Hallmark Cards is 2.25% of the outstanding indebtedness under the credit facility.In addition, the Company agreed to continue to pay the fee charged by Citigroupfor the letter of credit which was increased to 0.875% of the amount of theletter of credit.

***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.

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The principal amount of the senior unsecured noteaccretes at 10.25% per annum, compounding semi-annually, to $596.6 million atAugust 5, 2007.  From that date, interestat 10.25% per annum will be payable semi-annually in arrears on the accreted valueof the senior unsecured note to HC Crown. The senior unsecured note payable toHC Crown does not require cash payments until August 2007. The note matures onAugust 5, 2011, and is pre-payable by Crown Media Holdings at any timeafter August 5, 2004, without penalty. At December 31, 2005, and September 30,2006, $509.4 million and $548.3 million, respectively, of principal andaccreted interest were included in the senior unsecured note payable in theaccompanying consolidated balance sheets. The note purchase agreement for thesenior unsecured note contains certain covenants which restrict on the part ofthe Company, among other matters, from the incurrence of any additionalindebtedness, the repurchase or other acquisitions of the Company’s stock, investmentsin other parties 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.

***Promissory Note  with HC Crown***

On December 14, 2001, the Company executed a $75.0million promissory note with HC Crown maturing on the earlier of six monthsfrom the termination of the bank credit facility or December 21, 2007.  Due to the Waiver Agreement, the promissorynote and related interest are not due until November 15, 2007. This promissorynote is subordinate to the bank credit facility. The rate of interest underthis promissory note is equal to LIBOR plus three percent. At December 31,2005, and September 30, 2006, the principal amounts of the note were $75.0million and $86.3 million, respectively. Accrued interest on the note of $11.3million (which was subsequently added to the principal amount of the note) and $5.2million are included in promissory note and interest payable to HC Crown as ofDecember 31, 2005, and September 30, 2006, respectively, on the accompanyingcondensed consolidated balance sheets. At December 31, 2005, and September 30,2006, the outstanding balances bore interest at the Eurodollar rates of 7.08%and 8.48%, respectively.

***PromissoryNotes with Hallmark Entertainment Holdings***

As consideration for extending the demand period forthe possible reimbursement of amounts drawn on the letter of credit supportingthe credit facility, the Company agreed in October 2005 to convert a portion ofits license fees payable to Hallmark affiliates, which were approximately$132.8 million, to a promissory note bearing interest at LIBOR plus 3% perannum.  The term of the promissory notebegan on October 1, 2005 and is payable in full on August 31, 2006 (amended toNovember 15, 2007, by the Waiver Agreement). Accrued interest on the note of $2.4 million and $10.5 million,respectively, is included in note and interest payable to Hallmark Cardsaffiliate as of December 31, 2005, and September 30, 2006, on the accompanyingcondensed consolidated balance sheets. Due to the Waiver Agreement, interest isnot due until November 15, 2007. At December 31, 2005, and September 30, 2006,$132.8 million of the outstanding balance bore interest at the Eurodollar ratesof 7.08% and 8.48%. This note was transferred to a subsidiary of Hallmark Cardsprior to the sale by Hallmark Cards of its interests in Hallmark EntertainmentLLC, now called RHI Entertainment LLC (“RHI Entertainment”).

As consideration for extending the demand period forthe possible reimbursement of amounts drawn on the letter of credit supportingthe credit facility, the Company agreed in March 2006 to convert its payable toa Hallmark Cards affiliate, which was approximately $70.4 million, to apromissory note bearing interest at LIBOR plus 3% per annum.  The term of the promissory note began onMarch 21, 2006, and is payable in full on November 15, 2007. Accrued intereston the note of $3.0 million is included in note and interest payable toHallmark Cards affiliate as of September 30, 2006, on the accompanyingcondensed consolidated balance sheets. Due to the Waiver Agreement, interest isnot due until November 15, 2007. At September 30, 2006, $49.3 million of theoutstanding balance bore interest at the Eurodollar rates of 8.48%.

Duringthe third quarter of 2006, Hallmark Cards used $18.0 million of theapproximately $18.0 million non-interest bearing balance of the 25% in federaltax benefits held by Hallmark Cards to offset the $70.4 million promissory noteof the Company with Hallmark Entertainment Holdings. On September 1, 2006, Hallmark Cards also net $3.1 million against the$70.4 million promissory note with Hallmark Entertainment Holdings, whichoffset was related to the December 1, 2005, agreement with NICC.

***Interest Paid to HC Crown***

Interest expense payable to HC Crown, which formerlywas payable to the Company’s bank syndicate and

 

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resultedfrom a reduction in the interest rate and commitment fee payable to the Company’sbank syndicate in Amendment No. 8 to the Company’s credit facility, was $3.2million and $25,000 at December 31, 2005 and September 30, 2006,respectively.  Such interest expensepayable to HC Crown was $1.9 million and $1.1 million for the three monthsended September 30, 2005 and 2006, respectively. Such interest expense payableto HC Crown was $3.4 million and $3.3 million for the nine months endedSeptember 30, 2005 and 2006, respectively.

**9. 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 consolidated 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 estimated $45.7 million balance of this 25% balance tooffset intercompany debt.  During thethird quarter of 2006, Hallmark Cards used $18.0 million of the approximately$18.0 million balance of this 25% balance to reduce the principal amount dueunder the March 21, 2006, promissory note with Hallmark Entertainment Holdings.

Excludingthe $30.0 million and $18.0 million that were part of the 25% balance and wereoffset against the promissory note as described above, the Company receivedunder the tax sharing agreement $4.7 million and $7.0 million during the threemonths ended September 30, 2005, and September 30, 2006, and received $26.1million and $12.0 million during the nine months ended September 30, 2005, andSeptember 30, 2006.  Any paymentsreceived from Hallmark Cards or credited against amounts owed by Crown MediaHoldings to any member of the Hallmark Cards consolidated group under the taxsharing agreement are recorded as an addition to paid-in capital in theaccompanying consolidated statements of stockholders’ equity.

***Services Agreement with Hallmark Cards***

TheCompany has an intercompany services agreement with Hallmark Cards, which wasentered into in 2003 for a term of three years and then extended for anadditional year through January 1, 2007. Under the agreement, Hallmark Cards provides Crown Media Holdings withtax, risk management, health safety, environmental, insurance, legal, treasuryand cash management services and real estate consulting services.  Under the agreement, the Company agreed topay Hallmark Cards $515,000 per year for these services, plus out-of-pocketexpenses and third party fees, payable in arrears on the last business day ofeach quarter. This amount was increased to $530,000for 2006. However, the Company has not been paying these amounts as they aredue. For the three months ended September 30, 2005 and 2006, Crown MediaHoldings had accrued $129,000 and $133,000, respectively, under the agreement.For the nine months ended September 30, 2005 and 2006, Crown Media Holdings hadaccrued $386,000 and $398,000, respectively, under the agreement. At December31, 2005, and September 30, 2006, non-interest bearing unpaid accrued servicefees and unreimbursed expenses of $10.1 million and $13.3 million,respectively, were included in payable to affiliates in the accompanyingcondensed consolidated balance sheets.

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***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 theHallmark Movie Channel.  During thesecond quarter of 2006, Hallmark Cards extended the trademark licenseagreements for the Hallmark Channel and the Hallmark Movie Channel to September1, 2007. The Company is not required to pay any fees under the trademarklicense agreements.

***IntercreditorAgreement***

For information regarding an intercreditor agreementthat deals with residual and participation liabilities for the use of filmassets by the proposed buyer of the Company’s domestic film library, see Note 1above.

***Payment from Hallmark Cards***

On September 1, 2006, Hallmark Cards net $3.1 millionagainst the $70.4 million promissory note of the Company with HallmarkEntertainment Holdings.  The $3.1 millionwas related to the December 1, 2005, agreement with NICC.

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

VISN (a subsidiary ofNICC) owns a $25.0 million company obligated mandatorily redeemable preferredinterest in Crown Media United States (the “preferred interest”) issued inconnection with an investment by the Company in Crown Media United States. OnNovember 13, 1998, the Company, Vision Group, VISN and Henson Cable Networks, Inc.signed an amended and restated agreement governing the operation of Crown MediaUnited States, as amended at various times through December 1, 2005 (the “companyagreement”).

 Under the companyagreement, the members agreed that if during any year ending afterJanuary 1, 2005 and prior to December 31, 2009, Crown Media UnitedStates has net profits in excess of $10.0 million, and the preferred interesthas not been redeemed, Crown Media United States will redeem the preferredinterest in an amount equal to the lesser of (i) such excess net profits; (ii)$5.0 million; 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, onJuly 1, 2003, the preferred interest was remeasured at fair value andreclassified to non-current liabilities in accordance with the provisions ofSFAS No. 150. The preferred interest has a liquidation preference of $25.0million.

ADecember 2005 agreement between Crown Media Holdings and NICC replaced aprior program production agreement and settled various disputes which hadarisen under the prior agreement.  In thenew agreement, the Company agreed to fund and license the following programmingproduced by NICC through the end of 2007:

·                                          ASunday Morning one-hour series entitled “New Morning with Naomi Judd” at a costof $3.5 million in 2005, $4.6 million in 2006 and $5.6 million in 2007. The 2006 and 2007 amounts are payable quarterly in those years.

·                                          Aweekday one-hour daily series entitled “New Morning” at a cost of $1.9 millionin 2005, $4.2 million in 2006 and $5.1 million in 2007.  The 2005 amountincludes a deferred amount of $535,000 to be paid as indicated below fordeferred payments.  The 2006 and 2007 amounts are payable quarterly inthose years.

·                                          ASunday morning programming block, broadcast from 6 a.m. to 12 noon, at acost of approximately $485,000 in 2005, $5.8 million in 2006 and $5.8 million,increased by a percentage equal to the increase in the Consumer Price Index, in2007.  These amounts include deferred payments of $125,000 for 2005 and $1.5million for each of 2006 and 2007.  The 2006 and 2007 amounts not deferredare payable quarterly in those years.

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In addition, CrownMedia Holdings agreed to finish funding four specials, the production of whichhad been commenced prior to the amendment, at a total additional cost of $1.4million in 2005 and 2006, and to fund an additional two non-dramatic specials,to be produced in 2006 and 2007, at a total cost of $1.3 million.  Aquarter of the amounts for the additional two specials was paid in January 2006,another quarter was paid in June 2006 and the remaining one-half is payable inJune 2007, or upon a change in control (that is, a sale or merger where theaggregate ownership of Crown Media Holdings by the current owners becomes lessthan 50%).  The Hallmark Channel is not obligated to broadcast the lattertwo specials.  Crown Media Holdings will also provide or has provided $2.0million in each of 2005, 2006 and 2007 to fund the development by NICC of “madefor television” movies and will pay NICC an additional $1.0 million if themovie “A Reason to Believe,” which was to be produced under the prioragreement, is not ultimately produced.  The 2005 amount includes adeferred payment of $1.8 million; the 2006 amount is payable semi-annually in2006; and the 2007 amount is payable in January 2007.  The HallmarkChannel will have a right of first negotiation to acquire broadcast rights tothe movies resulting from this development and, if it elects not to acquirethese rights, may still recover a portion of its funding if the movies areproduced for others.  In addition, NICC will receive $45,000 in consultingfees from a series which RHI Entertainment has produced, payable no later thanJuly 2006, and a deferred payment of $750,000 as the last payment for certainterminated obligations.

The deferredpayments mentioned above are payable to NICC on December 31, 2007 or upona change in control, whichever comes first.  Added to the deferred amountswill be (1) interest at the rate charged by NICC’s prime lender or(2) if NICC sells Crown Media Holdings common stock to finance anydeficit, the increase in the sale price of the common stock between the timeNICC sells the stock to fund a deferred amount and a market price of the CrownMedia Holdings common stock on the date the deferred amounts are paid by CrownMedia Holdings.

In the event thereis a change of control of Crown Media Holdings prior to the expiration of theagreement (i.e., December 31, 2007), NICC will immediately receive a $15.0million “termination payment,” any remaining portions of the payments for thenon-dramatic specials and the “made for television” movie development describedabove and the deferred payments described above.  The Hallmark Channelwill be obligated to continue to broadcast and pay for the Sunday “New Morningwith Naomi Judd” and weekday “New Morning” series and the Sunday morningprogramming block for an additional six months following the change in control,after which all funding and broadcast obligations to NICC will cease. Also, under existing obligations, Crown Media Holdings would be required toredeem the $25.0 million preferred interest of NICC in Crown Media UnitedStates, LLC, for that amount plus accrued interest at LIBOR fromNovember 27, 2005.

If there has notbeen a change of control of the Company by June 30, 2007, Crown MediaHoldings is required to negotiate with NICC for a period of 60 days regardingcontinuation of the programming commitments.  If at the end of thenegotiating period the parties have not reached agreement and Crown MediaHoldings is not willing to continue the programming commitments at the samelevels, NICC may compel Crown Media Holdings to buy all NICC’s outstandingshares of Crown Media Holdings common stock at the then current market value bya written notice given no later than November 1, 2007.  If NICC sellsmore than 50% of the shares of Crown Media Holdings common stock which it ownedas of February 22, 2001, except as part of a sale of Crown Media Holdings,most of the commitments and obligations related to programming as describedabove cease (at the option of Crown Media United States) at the end of the thencurrent broadcast season (approximately August 31).

During the three monthsended September 30, 2005 and 2006, Crown Media United States paid NICC $4.5million and $3.8 million, respectively, pursuant to the company agreement, asamended. During the nine months ended September 30, 2005 and 2006, Crown MediaUnited States paid NICC $9.7 million and $15.1 million, respectively, pursuantto the company agreement, as amended.

**11.  RHI Entertainment**

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

Since inception of Crown Media Holdings, RHIEntertainment has at times paid certain costs on behalf of Crown MediaHoldings. Non-interest bearing unreimbursed costs of $567,000 and $0 areincluded in payable to RHI Entertainment in the accompanying condensedconsolidated balance sheets as of December 31, 2005, and September 

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30, 2006, respectively.

***Film Asset Services Agreement with RHI Entertainment***

The Company has a film asset services agreement with RHIEntertainment, under which RHI Entertainment provides Crown Media Holdings withservices related to the administration, distribution and other exploitation ofthe Company’s film assets. In consideration for the services provided by RHIEntertainment, Crown Media Holdings was, prior to the sale of the Company’sinternational operations, obligated to pay a service fee of $1.5 million peryear, payable in quarterly installments of $375,000. At December 31, 2005, andSeptember 30, 2006, non-interest bearing unpaid accrued service fees of$188,000 and $0 were included in payable to RHI Entertainment in theaccompanying condensed consolidated balance sheets. Following the sale of theCompany’s international operations, the annual fee for these services wasreduced to $750,000 per year. This agreement will be terminated if the sale ofthe Company’s film library is completed.

***Program License Agreements with RHI Entertainment Distribution***

Crown Media United States has licensed programming fordistribution in the United States from Hallmark Entertainment Distribution, nowRHI Entertainment Distribution, since 1998. It currently licenses this programming under a Second Amended andRestated Program License Agreement dated as of January 1, 2005 (“SecondRestated Agreement”).  This SecondRestated Agreement expires on December 31, 2008.

Underthe Second Restated Agreement, RHI Entertainment Distribution is required toproduce and deliver to Crown Media United States, and Crown Media United Statesis required to order and license from RHI Entertainment Distribution, 13original movies and 3 original mini-series in 2005, 31 original movies and 6original mini-series in 2006 and 18 original movies and 3 original mini-seriesin 2007.   Crown Media United States may,however, completely cancel the 2007 commitment to order 18 original movies and3 original mini-series or it may reduce the number of original movies it isrequired to license in each of 2006 and 2007 by up to six movies per year.  Crown Media United States has exercised thisoption to reduce by six the number of original movies produced in 2006 and hasadvised RHI Entertainment Distribution that it will not exercise its right tocancel the 2007 original productions. Crown Media United States has exclusiverights to these original movies and mini-series during a three year exhibitionwindow (the window is five years for certain holiday-themed movies and moviesproduced in 2005).  Crown Media UnitedStates may exhibit the original movies and mini-series in any television mediain the United States, its territories and possessions (together with PuertoRico), including pay per view and high definition television. Crown MediaUnited States may also sublicense its exhibition rights in any television mediaregarding the original and other movies and mini-series covered by theagreement to third parties, subject to the reasonable consent of RHIEntertainment Distribution.  The licensefee payable for the original movies produced in 2005 is $1,600,000 per movie;in 2006 is $1,680,000 per movie and in 2007 is $1,764,000 per movie.  If the movies are produced for the HallmarkChannel’s “Mystery Movie” series, the license fees are increased by $200,000and if they are holiday-themed movies, the license fees are increased by$100,000.  The license fees formini-series produced in 2005 are $800,000 per hour; in 2006 are $840,000 perhour; and in 2007 are $882,000 per hour.  Crown Media United States must also share any revenues from video ondemand or pay per view exploitation with RHI Entertainment Distribution.

Inaddition to the original movies and mini-Series, Crown Media United States hasagreed to license from RHI Entertainment Distribution 22 “off-network” movies andmini-series in 2005 and a maximum of 15 such movies and mini-series in 2006through 2013.  These programs generallywill not have been seen on cable television in the United States prior to theirexhibition on the Hallmark Channel.  Thelicense fees payable for the off-network movies are $268,029 per movie in 2005;$281,420 per movie in 2006; $295,491 per movie in 2007 and $310,266 per moviein 2008 and subsequent years.  Thelicense fees payable for the off-network mini-series are $335,024 per hour in 2005;$351,775 per hour in 2006; $369,364 per hour in 2007 and $387,832 per hour in2008 and subsequent years.  Crown MediaUnited States’ initial exhibition period for these off-network movies andmini-series is three years and Crown Media United States’ exhibition rights areexclusive in all television media in the United States, including PuertoRico.  Crown Media United States’exhibition rights to these off-network movies and mini-series do not, however,include pay per view or video on demand. RHI Entertainment Distribution has an option to require Crown MediaUnited States to license these off-network movies and mini-series for anadditional, consecutive three year period at a cost of 50% of the initiallicense fee.

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CrownMedia United States has also agreed to license up to 143 older movies andmini-series from the RHI Entertainment Distribution Library for a three yearexclusive exhibition window, at an approximate total cost of $57.5million.  Most of these movies andmini-series have previously been exhibited on the Hallmark Channel or HallmarkMovie Channel.

Underboth the current and previous agreements with RHI Entertainment Distribution,Crown Media United States is obligated to share equally with RHI EntertainmentDistribution the amount by which third party sub-licensing fees exceed theinitial program license fee paid to RHI Entertainment Distribution.  Crown Media United States did not sub-licenseany RHI licensed program to a third party that resulted in revenue sharingduring the three months ended September 30, 2005 and 2006. Crown Media UnitedStates did not sub-license any RHI licensed program to a third party thatresulted in revenue sharing during the nine months ended September 30, 2005 and2006.

Programming costs related to the RHI EntertainmentDistribution program agreements were $7.6 million and $11.9 million for thethree months ended September 30, 2005 and 2006, respectively. Programming costsrelated to the RHI Entertainment Distribution program agreements were $21.5million and $32.4 million for the nine months ended September 30, 2005 and2006, respectively. As of December 31, 2005, and September 30, 2006, $22.7million and $16.2 million, respectively, are included in license fees payableto non-affiliates in the accompanying consolidated balance sheets. Crown MediaHoldings paid RHI Entertainment Distribution $6.0 million and $16.6 million forlicense fees during the three months ended September 30, 2005 and 2006,respectively. Crown Media Holdings paid RHI Entertainment Distribution $47.5million and $36.7 million for license fees during the nine months endedSeptember 30, 2005 and 2006, respectively.

**12. Employee Incentives**

Crown Media Holdings has one stock plan, the Amended andRestated Crown Media Holdings, Inc. 2000 Long Term Incentive Plan. The Plancovers two types of share-based compensation, stock options and restrictedstock units (RSU) that are subject to FAS 123R commencing on January 1, 2006.

***Stock Option Plan***

Crown Media Holdings may grant options for up to 10.0 millionshares under the Plan. The stock options expire 10 years from the date of grantand generally vest over service periods that range from date of grant to fouryears.  Certain option and share awardsprovide for accelerated vesting if there is a change in control (as defined inthe Plan).

***Stock Compensation***

Beginningwith our first quarter of fiscal 2006, we adopted SFAS 123R. We currently usethe Black-Scholes option pricing model to determine the fair value of stockoptions. The determination of the fair value of stock-based payment awards onthe date of grant using an option-pricing model is affected by our stock priceas well as assumptions regarding a number of complex and subjective variables.These variables include our expected stock price volatility over the term ofthe awards, actual and projected employee stock option exercise behaviors,risk-free interest rate and expected dividends.

Weestimate the expected term of options granted by taking the average of thevesting term and the contractual term of the option. We estimate the expectedvolatility of our common stock by using historical volatility. We base therisk-free interest rate that we use in the option valuation model on U.S.Treasury zero-coupon issues with remaining terms similar to the expected termon the options. We do not anticipate paying any cash dividends in theforeseeable future and therefore use an expected dividend yield of zero in theoption valuation model. We are required to estimate forfeitures at the time ofgrant and revise those estimates in subsequent periods if actual forfeituresdiffer from those estimates. We use historical data to estimate pre-vestingoption forfeitures and record stock-based compensation expense only for thoseawards that are expected to vest. The fair value of all stock-based paymentawards is amortized on a straight-line basis over the requisite service periodsof the awards, which are generally the vesting periods.

 

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TheCompany recorded $503,000 of compensation expense related to restricted stockunits for the three months ended September 30, 2006, on our consolidatedstatement of operations as a component of selling, general and administrativeexpense. The Company recorded a $3.3 million compensation benefit related torestricted stock units and $10,000 compensation expense related to stockoptions for the nine months ended September 30, 2006, on our consolidatedstatement of operations as a component of selling, general and administrativeexpense.

The Companyrecorded $3.0 million of compensation expense associated with the Employmentand Performance RSUs during the three months ended September 30, 2005, whichhas been recorded as a liability for RSUs in the accompanying consolidatedbalance sheets and is included in selling, general and administrative expensein the accompanying consolidated statements of operations. The Company recorded$8.3 million of compensation expense associated with the Employment and PerformanceRSUs during the nine months ended September 30, 2005, which has been recordedas a liability for RSUs in the accompanying consolidated balance sheets and isincluded in selling, general and administrative expense in the accompanyingconsolidated statements of operations.

As ofSeptember 30, 2006, there was no unrecognized compensation cost, adjusted forestimated forfeitures, related to non-vested stock options granted to ouremployees. Total unrecognized compensation cost will be adjusted for future changesin estimated forfeitures.

***General Stock Option Information***

Thefollowing table sets forth the summary of option activity under our stockoption program for the nine months ended September 30, 2006:
| ** **                   | ** ** | **Shares  (in thousands)** | ** ** | **Exercise  Price  Per Option** | ** ** | **Weighted-   Average  Exercise  Price  Per Option** | ** ** | **Aggregate  Intrinsic  Value** | ** ** | **Weighted-  Average  Fair Value** | ** ** | **Weighted-  Average  Remaining  Contractual  Term** | ** ** |
|------------------------------|------------|---------------------------------|------------|--------------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------|------------|-----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                   | ** ** | ** **                      | ** ** | ** **                           | ** ** | ** **                                                     | ** ** | ** **                      | ** ** | ** **                              | ** ** | ** **                                           | ** ** |
| Balance, December 31,  2005  |       | 867                             |       |                                 |       | $                                                              | 10.42      |                            |       |                                    |       |                                                 |       |   |
| Options  cancelled           |       | (22                             | )          | $                                    | 8.94-16.38 |                                                           | $          | 12.13                           |       |                                    |       |                                                 |       |   |   |
| Balance, September 30,  2006 |       | 845                             |       |                                 |       | $                                                              | 10.37      |                            | $          | 0.00                                    |       | $                                                    | 3.56       |   | 2.32 |   |
| Exercisable                  |       | 845                             |       |                                 |       | $                                                              | 10.37      |                            | $          | 0.00                                    |       | $                                                    | 3.56       |   | 2.32 |   |
|                              |            |                                 |            |                                      |            |                                                                |            |                                 |            |                                         |            |                                                      |            |  |  |  |  |

 

Informationregarding stock options at September 30, 2006, is summarized below: 
| **Options Outstanding and Exercisable**   | ** ** |
|----------------------------------------------------------|------------|
| **Range of  Exercise Prices  Per Option** | ** ** | **Shares  Outstanding** | ** ** | **Weighted Average  Remaining  Contractual Life** | ** ** | **Weighted Average  Exercise Price  Per Option** | ** ** |
| ** **                                               | ** ** | **(In thousands)** | ** ** | **(In years)** | ** ** | ** ** | ** ** |
| $6.30-10.50                                              |       | 527 |   | 0.83 |   | $ | 9.11 |   |
| $10.51-12.60                                             |       | 236 |   | 5.25 |   | $ | 11.48 |   |
| $12.61-14.70                                             |       | 42 |   | 2.73 |   | $ | 14.00 |   |
| $14.71-21.00                                             |       | 40 |   | 4.11 |   | $ | 16.62 |   |
|                                                     |       | 845 |   | 2.32 |   | $ | 10.37 |   |

 

***General Restricted Stock Unit Information***

TheCompany’s restricted stock units (“RSUs”) vest based on either employment orperformance conditions. Certain RSUs vest either in one-third increments on theanniversary of the grant date in each of the three years following the grant orall at one time on the third year anniversary of the grant date, in both casesbased on continuing employment (“Employment RSUs”). Other RSUs vest on thethird anniversary date of the grant date, provided that the price of theCompany’s Class A common stock is at least $14 or higher on that date (“PerformanceRSUs”). See Note 17, Subsequent Events, below for information regarding RSUsgranted in October 2006.

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TheCompany’s RSUs are settled in either common stock or cash as determined by theCompany’s Board of Directors. The Company has historically settled the RSUs incash, and considering such past practices, has classified its RSUs as liabilityawards for accounting purposes.

Prior tothe adoption of SFAS 123R, we recognized the estimated compensation cost ofemployment restricted stock units over the vesting term, including changes infair value at each reporting period. The estimated compensation cost was andcontinues to be based on the fair value of our stock price at the end of eachreporting period. We will continue to recognize the compensation cost, net ofestimated forfeitures, over the vesting term and include changes in fair valueat each reporting period.

TheCompany made an offer in May 2003 to senior management and vice presidents toexchange their options for Employment RSUs, resulting in a total of 5,126,732options exchanged for 2,050,693 Employment RSUs. The Employment RSUs vestedover three years in one-third increments on the anniversary of the grant dateeach year and the Company accrued expense related to the Employment RSUsratably over each increment’s vesting period using the price of our Class Acommon stock on the last day of the reporting period.

InMay 2004, the Company’s Board of Directors approved an additional grant toemployees of 1,065,000 RSUs. The Employment RSUs, which constitute 70% of theaward granted in 2004, vest in equal one-third installments over the next threeyears on the anniversary of the grant date each year. The Performance RSUs,constituting 30% of the award granted in 2004, vest on the 3rd anniversary of the grant date, provided thatthe price of the Company’s common stock is $14 or higher on that date.

The Company settled certain Employment RSUs during the three months endedMarch 31, 2005, for approximately $4.2 million in cash. Additionally, inconjunction with the close of the international transaction, the Companyimmediately vested and settled Employment RSUs held by individuals employed bythe international business in May 2005 for approximately $4.0 million incash.  In June 2005, the Company settledvested Employment RSUs for approximately $3.8 million in cash. In August 2005,the Company immediately vested and settled RSUs held by one employee of theCompany for approximately $139,000 in cash. In January 2006, the Companysettled vested Employment RSUs to one executive for approximately $4.4 million.In June 2006, the Company settledvested Employment RSUs for approximately $1.5 million in cash.

In June 2005, the Company’s Board of Directors approved agrant to those Directors who were not employees of the Company or of HallmarkCards or its affiliated companies, of 70,884 RSUs.  The RSUs vest in equal one-third installmentsover three years on the anniversary of the grant dates each year. In July 2005,the shareholders approved an amendment to our Plan, which ratified an amendmentadopted by the Board of Directors in June 2005 to allow the grant of RSUs toour Directors. Since the vesting dates were determined as if these grants werein May 2003 and May 2004 and some portions of the grants had, therefore,vested, in August 2005, the Company settled the vested RSUs held by theseDirectors for approximately $353,000 in cash. In June 2006, the Company settled vested RSUs for approximately$80,000 in cash.

In August 2005, the Company’s Board of Directorsapproved an additional grant of 828,000 Employment and Performance RSUs toemployees. 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 Performance RSUs, constituting 50%of the award granted in 2005, vest on the 3rd anniversary of the grant date, provided thatthe price of the Crown common stock is $14 or higher on that date. In August2006, the Company settled vested RSUs for approximately $442,000 in cash.

In August 2005,the Company’s Board of Directors approved an additional grant to one executiveof 115,000 RSUs (“CEO Grant”). The Employment RSUs, which constitute 50% of theaward granted in 2005, vested in equal one-third installments on dates whichwere three months, six months and nine months, respectively, after the grantdate and the Company has settled these RSUs for $203,000 in November 2005,$165,000 in February 2006 and $76,000 in May 2006. The Performance RSUs,constituting the remaining 50% of the award granted in 2005, have lapsedwithout vesting.

In August 2005, theCompany’s Board of Directors approved a grant to those Directors who were notemployees of the Company or of Hallmark Cards or its affiliated companies, atotal of 31,570 RSUs. The RSUs vest in equal

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one-thirdinstallments over three years on the anniversary of the grant dates each year.In August 2006, the Company settled vested RSUs for approximately $34,000 incash.

In August 2006, theCompany’s Board of Directors approved a grant to those Directors who were notemployees of the Company or of Hallmark Cards or its affiliated companies, atotal of 71,979 RSUs. The RSUs vest in equal one-third installments over threeyears on the anniversary of the grant dates each year.

Additionally, in August 2006, one executive retired and theCompany settled vested RSUs for approximately $16,000 in cash.

In August 2006,the Company’s Board of Directors approved an additional grant of 1,298,000Employment and Performance RSUs to the executive officers and other employees.The Employment RSUs constitute 35% of the grant and the Performance RSUs65%.  The Employment RSUs will vest andbe settled in stock or cash on August 17, 2009, the third anniversary of thegrant date, provided the individual holding the RSUs is employed by the Companyon that date. Performance RSUs become eligible to vest (“Achieved PerformanceRSUs”), in the range of 150% (which results in an award of additionalPerformance RSUs) to 0% of the Performance RSUs, depending upon the successfulrenewal of specific distributor agreements within certain time periods.  Sixty-five percent of the AchievedPerformance RSUs will fully vest upon the signing of the renewal agreements,which the Company intends to complete by November 2007.  In a second vesting, 65% to 135% (“theModifier”) of the Achieved Performance RSUs (less the Achieved Performance RSUspreviously vested) will vest on December 31, 2008, based upon a formula usingsubscriber revenue achieved for a specified time period.

 The Compensation Committee of the Board of theCompany has the discretion to increase or decrease the Modifier by 20% and alsomay extend the deadlines for satisfaction of the vesting conditions in theevent that a renewal of the distribution agreements is delayed for factorsbeyond the control of Crown.  In order tobe eligible for vesting and settlement of the Achieved Performance RSUs, theindividual holding them must either be employed at the time of the firstvesting or have been terminated without cause within 90 days of a vesting date.  The vesting of Employment RSUs acceleratesupon death or disability of an executive officer. Employment RSUs andPerformance RSUs have accelerated vesting if the executive is involuntarilyterminated without cause within 90 days before or after a change in control.

Under FAS 123R,the fair value of the 2003, 2004 and 2005 Employment RSU grants are estimatedusing a Black-Scholes Merton option pricing model.  The fair value of the 2004 and 2005Performance RSU grants are estimated at each reporting date using a Monte CarloLattice option pricing model. Beginning in 2006, the Company is applying aforfeiture rate to the RSUs as required by SFAS No. 123R.

*** ***

|                                          | ** ** | **Units**               | ** ** | **Weighted-Average Remaining** | ** ** |
|------------------------------------------|------------|-------------------------|------------|-------------------------------------|------------|
| **Employment RSUs**                 | ** ** | **(in thousands)** | ** ** | **Contractual Term**           | ** ** |
|                                     |       |                    |       |                                |       |
| Outstanding  Balance, December 31, 2005  |       | 1,477,343               |       |                                |       |
| Units issued                             |       | 454,300                 |       |                                |       |
| Units settled in cash                    |       | (1,009,453              | )          |                                |       |
| Units cancelled                          |       | (152,223                | )          |                                |       |
| Outstanding Balance,  September 30, 2006 |       | 769,967                 |       | 2.28                                |       |

 

The closing price of a share of our common stock on December31, 2005, was $9.17, $6.34 on March 31, 2006 and $4.12 on June 30, 2006, andwas $4.49 on September 30, 2006.

 

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|                                          | ** ** | **Units**               | ** ** | **Weighted-Average Remaining** | ** ** |
|------------------------------------------|------------|-------------------------|------------|-------------------------------------|------------|
| **Performance RSUs**                | ** ** | **(in thousands)** | ** ** | **Contractual Term**           | ** ** |
|                                     |       |                    |       |                                |       |
| Outstanding  Balance, December 31, 2005  |       | 688,500                 |       |                                |       |
| Units issued                             |       | 843,700                 |       |                                |       |
| Units cancelled                          |       | (240,500                | )          |                                |       |
| Outstanding Balance,  September 30, 2006 |       | 1,291,700               |       | 2.39                                |       |

 

At December 31, 2005, the 2004 Performance RSUs werevalued at $1.61 per unit, the 2005 Performance RSUs were valued at $4.36 perunit, and the CEO Performance RSUs were valued at $1.23 per unit. At September30, 2006, the 2004 Performance RSUs were valued at $0.05 per unit, the 2005Performance RSUs were valued at $0.49 per unit. The CEO Performance grantexpired in May 2006. Valuation of these Performance RSU grants is based uponmarket conditions.

The following table includes assumptions used to valuethe Employment and Performance RSUs at September 30, 2006.

** **

|                           | ** ** | **2004 Grant** | ** ** | **2005 Grant** | ** ** |
|---------------------------|------------|---------------------|------------|---------------------|------------|
| Expected  volatility      |       | 60.97               | %          | 46.94               | %          |
| Expected  dividends       |       | 0                   |       | 0                   |       |
| Expected Term  (in years) |       | 0.67                |       | 1.88                |       |
| Risk-free rate            |       | 4.91                | %          | 4.71                | %          |

 

The following table includes assumptions used to valuethe Performance RSUs at January 1, 2006.

 

|                           | ** ** | **2004 Grant** | ** ** | **2005 Grant** | ** ** | **CEO Grant** | ** ** |
|---------------------------|------------|----------------|------------|----------------|------------|---------------|------------|
| Expected volatility       |       | 39.34          | %          | 48.87          | %          | 40.04         | %          |
| Expected dividends        |       | 0              |       | 0              |       | 0             |       |
| Expected Term (in  years) |       | 1.42           |       | 2.67           |       | 0.46          |       |
| Risk-free rate            |       | 4.38           | %          | 4.37           | %          | 4.37          | %          |

 

UnderFAS 123R, the fair value of each 2006 Employment and Performance RSU grant isestimated using the fair value of $4.49 based upon the closing price of a share of our common stock as of the September 30,2006, reporting date.  Valuation of the2006 Employment RSUs is based solely on a service condition.  Valuation of the 2006 Performance RSUs isbased upon a service condition and a performance condition.

Inconnection with the adoption of SFAS 123R, we recorded total compensation costs related to RSUs granted under the Plan of $2.1million as a cumulative catch-up adjustment during the nine months endedSeptember 30, 2006. Prior to January 1, 2006, the Performance RSUs were notrecorded on the Company’s financial statements as a liability, as it was notdeemed probable that these units would be settled based on the performance ofthe Company’s common stock.

 
| ** **                              | ** ** | **Units**          | ** ** | **Weighted-Average Remaining** | ** ** |
|-----------------------------------------|------------|--------------------|------------|--------------------------------|------------|
| **Board of Directors RSUs**             | ** ** | **(in thousands)** | ** ** | **Contractual Term**           | ** ** |
| ** **                              | ** ** | ** **         | ** ** | ** **                     | ** ** |
| Outstanding Balance, December 31, 2005  |       | 32,468             |       |                           |       |
| Units issued                            |       | 103,549            |       |                           |       |
| Units settled in cash                   |       | (28,710            | )          |                           |       |
| Units cancelled                         |       | (26,157            | )          |                           |       |
| Outstanding Balance, September 30, 2006 |       | 81,150             |       | 2.57                           |       |

 

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**13. Employee Benefits**

***Deferred Compensation Plans***

The Company sponsors a deferred compensation plan for its management.Participants in this plan earn interest on their deferred compensation. Relatedliabilities of $3.2 million at both December 31, 2005, and September 30,2006, are included in the accompanying balance sheets among short and long-termaccrued liabilities. The Company has suspended this plan for 2006 and therewill be no deferrals of employee compensation earned in 2006.  The Company will, however, continue to payinterest on amounts deferred in previous years and pay out these amounts in accordancewith the terms of the plan. The Company intends to reactivate the plan in 2007.

The Company also sponsors a deferred compensation plan for its Board ofDirectors.  Participants in this planearn interest on their deferred compensation. Related liabilities of $538,000and $575,000 at December 31, 2005, and September 30, 2006, respectively,are included in the accompanying balance sheets among short and long-termaccrued liabilities. The Company has suspended this plan for 2006 and therewill be no deferrals of director compensation earned in 2006.  The Company will, however, continue to payinterest on amounts deferred in previous years and pay out these amounts inaccordance with the terms of the plan. The Company also intends to reactivatethis plan in 2007.

***Severance***

In April 2006, the Company terminated approximately 20employees in conjunction with its cost savings efforts. The Company’s severancecosts related to these employees were approximately $2.3 million.

**14. Segment Reporting**

The Company’scontinuing operations are currently organized into two principal divisionsrepresenting operating segments: domestic channels and film distribution. TheCompany evaluates performance and allocates resources based on the results ofthese segments. The key operating performance criteria used in this evaluationinclude revenue, operating 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.

 

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The following tables present theCompany’s key performance measures (in thousands):

*ThreeMonths Ended September 30, 2005*

* *
| ** **                                               | ** ** | ** **   | ** ** | **Film**         | ** ** | ** **      | ** ** | ** **       | ** ** |
|----------------------------------------------------------|------------|--------------|------------|------------------|------------|-----------------|------------|------------------|------------|
| ** **                                               | ** ** | **Domestic** | ** ** | **Distribution** | ** ** | **Adjustments** | ** ** | **Consolidated** | ** ** |
|                                                     |       |         |       |             |       |            |       |             |       |
| Total revenues                                           |       | $            | 48,266     |             | $          | (15,373         | )          | $                | 17,777     | (1) | $ | 50,670 |   |
| Programming costs                                        |       | (37,284      | )          | (105             | )          | 8,193           | (1)        | (29,196          | )          |
| Amortization of film  assets                             |       | —       |       | 2,565            |       | (16,395         | )(1)       | (13,830          | )          |
| Impairment of film  assets                               |       | —       |       | (22,939          | )          | —          | (1)        | (22,939          | )          |
| Subscriber acquisition  fee amortization expense         |       | (9,534       | )          | —           |       | 846             | (1)        | (8,688           | )          |
| Operating costs                                          |       | (3,368       | )          | 156              |       | —          | (1)        | (3,212           | )          |
| Selling, marketing,  general and administrative expenses |       | (8,160       | )          | (10,502          | )          | —          |       | (18,662          | )          |
| Loss from  continuing operations                         |       | (10,080      | )          | (46,198          | )          | 10,421          |       | (45,857          | )          |
| Interest expense                                         |       | (1,228       | )          | (18,118          | )          | —          |       | (19,346          | )          |
| Loss from discontinued  operations                       |       | —       |       | (4               | )          | —          | (2)        | (4               | )          |
| Loss on sale of  discontinued operations                 |       | —       |       | (615             | )          | —          |       | (615             | )          |
| Net loss                                                 |       | $            | (11,308    | )                | $          | (64,935         | )          | $                | 10,421     |   | $ | (65,822 | ) |
| Total assets                                             |       | $            | 781,394    |             | $          | 468,577         |       | $                | —     | (2) | $ | 1,249,971 |   |

 

*Nine MonthsEnded September 30, 2005*

* *
| ** **                                               | ** ** | ** **   | ** ** | **Film**         | ** ** | ** **      | ** ** | ** **       | ** ** |
|----------------------------------------------------------|------------|--------------|------------|------------------|------------|-----------------|------------|------------------|------------|
| ** **                                               | ** ** | **Domestic** | ** ** | **Distribution** | ** ** | **Adjustments** | ** ** | **Consolidated** | ** ** |
|                                                     |       |         |       |             |       |            |       |             |       |
| Total revenues                                           |       | $            | 129,062    |             | $          | 71,643          |       | $                | (63,774    | )(1) | $ | 136,931 |   |
| Programming costs                                        |       | (108,870     | )          | (312             | )          | 23,551          | (1)        | (85,631          | )          |
| Amortization of film  assets                             |       | —       |       | (69,658          | )          | 36,483          | (1)        | (33,175          | )          |
| Impairment of film  assets                               |       | —       |       | (22,939          | )          | —          | (1)        | (22,939          | )          |
| Subscriber acquisition  fee amortization expense         |       | (29,430      | )          | —           |       | 2,539           | (1)        | (26,891          | )          |
| Operating costs                                          |       | (7,979       | )          | (1,968           | )          | 209             | (1)        | (9,738           | )          |
| Selling, marketing, general  and administrative expenses |       | (40,929      | )          | (24,499          | )          | 213             |       | (65,215          | )          |
| Loss from  continuing operations                         |       | (58,146      | )          | (47,733          | )          | (779            | )          | (106,658         | )          |
| Interest expense                                         |       | (3,421       | )          | (51,844          | )          | 1,579           |       | (53,686          | )          |
| Loss from discontinued  operations                       |       | —       |       | (10,676          | )          | —          |       | (10,676          | )          |
| Loss from sale of  discontinued operations               |       | —       |       | (1,964           | )          | —          | (2)        | (1,964           | )          |
| Net loss                                                 |       | $            | (61,567    | )                | $          | (112,217        | )          | $                | 800        |   | $ | (172,984 | ) |
| Total assets                                             |       | $            | 781,394    |             | $          | 468,577         |       | $                | —     | (2) | $ | 1,249,971 |   |

 

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*ThreeMonths Ended September 30, 2006*

* *
| ** **                                               | ** ** | ** **   | ** ** | **Film**         | ** ** | ** **      | ** ** | ** **       | ** ** |
|----------------------------------------------------------|------------|--------------|------------|------------------|------------|-----------------|------------|------------------|------------|
| ** **                                               | ** ** | **Domestic** | ** ** | **Distribution** | ** ** | **Adjustments** | ** ** | **Consolidated** | ** ** |
|                                                     |       |         |       |             |       |            |       |             |       |
| Total revenues                                           |       | $            | 46,326     |             | $          | 762             |       | $                | 230        | (1) | $ | 47,318 |   |
| Programming  costs                                       |       | (42,324      | )          | (46              | )          | 7,314           | (1)        | (35,056          | )          |
| Amortization of  film assets                             |       | —       |       | (441             | )          | (4,119          | )(1)       | (4,560           | )          |
| Impairment of  film assets                               |       | —       |       | (38,308          | )          | (2,638          | )(1)       | (40,946          | )          |
| Subscriber  acquisition fee amortization expense         |       | (8,593       | )          | —           |       | 846             | (1)        | (7,747           | )          |
| Operating costs                                          |       | (2,494       | )          | 419              |       | —          | (1)        | (2,075           | )          |
| Selling,  marketing, general and administrative expenses |       | (10,222      | )          | (4,578           | )          | —          |       | (14,800          | )          |
| Loss from continuing operations                          |       | (17,307      | )          | (42,192          | )          | 1,633           |       | (57,866          | )          |
| Interest expense                                         |       | (3,607       | )          | (22,854          | )          | —          |       | (26,461          | )          |
| Loss from  discontinued operations                       |       | —       |       | —           |       | —          |       | —           |       |
| Gain on sale of  discontinued operations                 |       | —       |       | (1               | )          | —          | (2)        | (1               | )          |
| Cumulative  effect of change in accounting principle     |       | —       |       | —           |       | —          |       | —           |       |
| Net loss                                                 |       | $            | (20,914    | )                | $          | (65,047         | )          | $                | 1,633      |   | $ | (84,328 | ) |
|                                                     |       |         |       |             |       |            |       |             |       |
| Total assets                                             |       | $            | 758,776    |             | $          | 159,082         | (3)        | $                | —     |   | $ | 917,858 |   |

 

*Nine MonthsEnded September 30, 2006*

* *
| ** **                                               | ** ** | ** **   | ** ** | **Film**         | ** ** | ** **      | ** ** | ** **       | ** ** |
|----------------------------------------------------------|------------|--------------|------------|------------------|------------|-----------------|------------|------------------|------------|
| ** **                                               | ** ** | **Domestic** | ** ** | **Distribution** | ** ** | **Adjustments** | ** ** | **Consolidated** | ** ** |
|                                                     |       |         |       |             |       |            |       |             |       |
| Total revenues                                           |       | $            | 141,033    |             | $          | 10,322          |       | $                | (8,542     | )(1) | $ | 142,813 |   |
| Programming  costs                                       |       | (123,446     | )          | (1,890           | )          | 22,720          | (1)        | (102,616         | )          |
| Amortization of  film assets                             |       | —       |       | (8,251           | )          | (13,452         | )(1)       | (21,703          | )          |
| Impairment of  film assets                               |       | —       |       | (206,216         | )          | (19,616         | )(1)       | (225,832         | )          |
| Subscriber  acquisition fee amortization expense         |       | (25,799      | )          | —           |       | 2,539           | (1)        | (23,260          | )          |
| Operating costs                                          |       | (8,369       | )          | (1,337           | )          | —          |       | (9,706           | )          |
| Selling,  marketing, general and administrative expenses |       | (30,307      | )          | (13,350          | )          | —          |       | (43,657          | )          |
| Loss from continuing operations                          |       | (46,888      | )          | (220,722         | )          | (16,351         | )          | (283,961         | )          |
| Interest expense                                         |       | (10,026      | )          | (63,051          | )          | —          |       | (73,077          | )          |
| Loss from  discontinued operations                       |       | —       |       | —           |       | —          |       | —           |       |
| Gain on sale of  discontinued operations                 |       | —       |       | 153              |       | —          | (2)        | 153              |       |
| Cumulative  effect of change in accounting principle     |       | —       |       | (2,099           | )          | —          |       | (2,099           | )          |
| Net loss                                                 |       | $            | (56,914    | )                | $          | (285,719        | )          | $                | (16,351    | ) | $ | (358,984 | ) |
|                                                     |       |         |       |             |       |            |       |             |       |
| Total assets                                             |       | $            | 758,776    |             | $          | 159,082         | (3)        | $                | —     |   | $ | 917,858 |   |

----

(1)             Representselimination of intersegment transactions.

(2)             Represents gains and lossesfrom the sale of discontinued operations. See Note 15.

(3)             Includesassets held for sale of $144.9 million. See “Basis of Presentation” in Note 2.

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Fiveof our distributors each accounted for more than 10% of our consolidatedsubscriber revenue for both the three months ended September 30, 2005 and 2006,and together accounted for a total of 86% and 93% of consolidated subscriberrevenue for those periods, respectively. Three of our distributors each accounted for more than 15% of ourconsolidated subscribers for both the three months ended September 30, 2005 and2006, and together accounted for 58% and 65% of our subscribers on that date,respectively.

Fiveof our distributors each accounted for more than 10% of our consolidatedsubscriber revenue for both the nine months ended September 30, 2005 and 2006,and together accounted for a total of 86% and 91% of consolidated subscriberrevenue for those periods, respectively. Three of our distributors each accounted for more than 15% of ourconsolidated subscribers for both the nine months ended September 30, 2005 and2006, and together accounted for 58% and 65% of our subscribers on that date,respectively.

**15.  Assets Held for Sale andDiscontinued Operations**

OnFebruary 23, 2005, the Company signed an agreement for the sale of theassets associated with its international operations.  The sale closed on April 26, 2005. Theaccompanying condensed consolidated statements of operations and cash flows forthe three and nine months ended September 30, 2005, present the associatedresults of operations and cash flows of the international assets as “discontinuedoperations.”

Thenet loss from discontinued operations during the three and nine months endedSeptember 30, 2005, consisted of the following:

 

|                                    | ** ** | **Three Months Ended  September 30, 2005** | ** ** | **Nine Months Ended  September 30, 2005** | ** ** |
|------------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                         | ** ** | **(In thousands)**                                        | ** ** |
|                               |       |                                                           |       |                                                          |       |
| Revenue                            |       | $                                                              | —     |                                                          | $          | 34,575 |   |
| Costs and  expenses                |       | —                                                         |       | (42,358                                                       | )          |
| Interest expense                   |       | —                                                         |       | (2,081                                                        | )          |
| Income tax  provision              |       | (4                                                             | )          | (812                                                          | )          |
| Loss from discontinued  operations |       | $                                                              | (4         | )                                                             | $          | (10,676 | ) |

 

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 lossfrom discontinued operations for the nine months ended September 30, 2005 wouldhave included an additional $1.8 million of depreciation and amortizationexpense and an additional $3.8 million of amortization of film assets.

Interest expenseincludes 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, *Allocation of Interest toDiscontinued Operations*.  Suchinterest expense amounted to $1.6 million for the nine months ended September30, 2005. Upon receipt of cash from the sale, the Company was required to repayand retire $100.0 million of the Company’s bank credit facility.

The companyentered into a definitive agreement in October 2006 for the sale of thedomestic rights to its film library to RHI. The sale includes all rights in theUnited States to the over ­­­­­600 television movies, mini-series and series inthe Crown Media Distribution library. The Company will have the right to continue to broadcast selected titlesfrom the library on the Hallmark Channel and the Hallmark Movie Channel forperiods up to two years, subject to third-party exclusivity previously licensedby the Company.

The accompanyingbalance sheet as of September 30, 2006, presents the domestic rights to thefilm assets, along with related assets and liabilities, as “held for sale”pursuant to SFAS No. 144*Accounting for theImpairment or*

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* *

*Disposalof Long-Lived Assets*. The carrying amounts of the major classes of assets and liabilitiesincluded in the disposal group are comprised of the following:

 

|                                           | ** ** | **As of September 30, 2006** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                | ** ** | **(In thousands)**                          | ** ** |
|                                      |       |                                             |       |
| Accounts  receivable, net                 |       | $                                                | 7,065      |   |
| Receivable from  RHI Entertainment        |       | 16                                               |       |
| Prepaid and  other assets                 |       | 325                                              |       |
| Non-current  accounts receivable          |       | 3,588                                            |       |
| Film assets, net                          |       | 133,896                                          |       |
| Accounts payable  and accrued liabilities |       | (316                                             | )          |
| Deferred revenue                          |       | (895                                             | )          |
| Net assets of disposal  group             |       | $                                                | 143,679    |   |

 

Assetsheld for sale as of September 30, 2006, of $144.9 million were comprised ofassets included in our film distribution segment. Liabilities held for sale asof September 30, 2006, of $1.2 million were comprised of liabilities includedin our film distribution segment. See “Basis of Presentation” in Note 2.

The Company estimates that it will record a gain fromthe sale of its membership interests in Crown Media Distribution in 2006 ofapproximately $3.0 to $6.0 million.

**16. Commitments and Contingencies**

In the normal course of business, the Company hasentered into agreements that commit it to make cash payments in future periodswith respect to non-cancelable leases and programming contracts.

On May 22, 2006, the Company entered into an agreementwith a major cable programming distributor to license to this distributorexclusive domestic television distribution rights to certain televisionmini-series from the Company’s film library. The term of distributor’s rightsto each mini-series is 54 months and during that period the distributor maysublicense its rights to third parties. The distributor made an advance payment of $6.0 million to the Companyfor these rights.  The Company also hasrights to share in certain net proceeds of sublicensing by the distributor. TheCompany has the right to cancel this agreement at any time prior to January 1,2007 and the distributor cannot enter into any sublicenses before that datewithout the approval of the Company.  Ifthe Company cancels the agreement, it must refund the $6.0 million advancepayment to the distributor.  Thedistributor also has the right to terminate the agreement during the periodJune 1, 2008 through July 30, 2008.  Ifthe distributor terminates the agreement, the Company is obligated to refund tothe distributor the difference between the $6.0 million advance payment and therevenues the distributor has received from sublicensing the mini-series. TheCompany has included the $6.0 million in accounts payable and accruedliabilities on the accompanying condensed consolidated balance sheet. Thisagreement will be terminated and the advance will be returned upon the closingof the proposed sale of the membership interests in Crown Media Distribution.

**17. Subsequent Events**

***Sale of Membership Interests inCrown Media Distribution***

The company announced on October 5, 2006, that it hasentered into a definitive agreement for the sale of the domestic rights to itsfilm library to RHI. See Note 1 for further information.

***CEO Restricted Stock UnitsAgreement***

Under the 2006 RestrictedStock Units Agreement dated October 3, 2006, the Company granted 200,000restricted stock units to the Company’s CEO. The Employment RSUs constitute 50%of the grant and the Performance RSUs 50%. Each RSU corresponds to a right toreceive (at the Company’s discretion) one share of

34

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Class A common stock orcash in an amount equivalent to the value of one share of Class A common stockat the time of vesting. The Employment RSUs will vest and be settled on thefourth anniversary of the grant date, provided the CEO is employed by theCompany on that date, or upon death or disability. Performance RSUs becomeeligible to vest (“Achieved Performance RSUs”), in the range of 150% (whichresults in an award of additional Performance RSUs) to 0% of the PerformanceRSUs, depending upon the successful renewal of specific distributor agreementswithin certain time periods. Once the final renewal which determines the amountof the Achieved Performance RSUs has occurred, 65% of the Achieved PerformanceRSUs will vest and be settled. In a second vesting, 65% to 135% (the “Modifier”)of the Achieved Performance RSUs (less the Achieved Performance RSUs previouslyvested) will vest and be settled on December 31, 2008, based upon a formulausing subscriber revenue achieved for a specified time period.

The Company’sCompensation Committee has the discretion to increase or decrease the Modifierby 20% and also may extend the deadlines for satisfaction of the vestingconditions in the event that a renewal of the distribution agreements isdelayed for factors beyond the control of the Company. If the Companyterminates employment without cause or the CEO terminates for good reasonwithin 90 days prior to a vesting date for Performance RSUs, the PerformanceRSUs will vest as though the CEO were still employed by the Company on thatvesting date.   All RSUs vest immediately upon involuntarytermination without cause or termination for good reason if a change in controloccurs 90 days prior to or 90 days after such termination.

***CEO Share Appreciation RightsAgreement***

Under ShareAppreciation Rights Agreement dated October 3, 2006, the Company has agreed togrant stock appreciation rights (“SARs”) to the CEO upon occurrence of certainevents. The value of each SAR corresponds to the value of one share of Class Acommon stock and will be settled at the Company’s discretion in Class A commonstock or cash. SARs will be granted during the term of employment the day afterthe fair market value of the Company’s stock reaches the “threshold price” andstays at the threshold price or higher for 60 consecutive calendar days. SARswill then be granted each time that the fair market value of the Company’sstock increases another incremental five dollars over the previous price atwhich an SAR grant was triggered and stays at such price or higher for 60consecutive calendar days. Upon the occurrence of each event which triggers anSAR grant, the CEO will be granted that number of SARs with a value equal to0.8% of the Enterprise Growth as of the grant date divided by the triggeringCompany stock price. “Enterprise Growth” equals the increase in marketcapitalization (compared to the market capitalization based on the Start Priceor the last price triggering a grant of an SAR), adjusted upward or downward bythe amount of debt incurred or paid down since the Start Date or last triggerdate, as applicable. “Threshold price” shall mean the average of the fairmarket value for the 5 business days prior to the date of announcement of theCEO’s employment (i.e., October 4, 2006) (“Start Price”) plus five dollars.

In the event of achange in control of the Company, then as of the change in control, (i) ifthere has been no prior SAR trigger and the change in control price (price ofthe Company’s stock less transaction costs and certain other amounts) exceedsthe Start Price, then the CEO shall be granted that number of SARs equal to0.8% of the Enterprise Growth divided by the change in control price; or (ii)if there has been a previous SAR trigger and the change in control priceexceeds the previous SAR trigger, then the CEO shall be granted that number ofSARs equal to 0.8% of the Enterprise Growth divided by the change in controlprice. If the CEO’s employment is terminated without cause by the Company or byhim for good reason or because of his death or disability, and if a change incontrol occurs within 90 days after the termination of employment or anagreement that will result in a change of control is executed prior to thetermination and the change of control occurs within 180 days after thetermination, the CEO will receive a grant of SARs on the basis described above.

SARs will vestupon the earlier of (i) 3 years of employment after the grant date, (ii)termination of employment without cause by the Company, (iii) termination bythe CEO for good reason or (iv) upon a change in control of the Company. TheCompany at its discretion may settle SARs in cash or in stock.

***Employment Contracts with BrianStewart***

On November 8,2006, the Company and Brian Stewart executed a letter agreement which amendedMr. Stewart’s Employment Agreement dated July 24, 2006.  Such letter amended Mr. Stewart’s (1) titlefrom Senior

35

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Vice President, Financeand interim Chief Financial Officer to Executive Vice President, Finance, andChief Financial Officer; and (2) annual salary from $340,000 to $350,000.  The Company and Mr. Stewart also executed aRestricted Stock Units Agreement dated November 8, 2006, which provides for thegrant of 25,200 Employment RSUs and 46,800 Performance RSUs to Mr. Stewart. TheEmployment RSUs will vest and be settled in stock or cash on August 17, 2009,provided that Mr. Stewart is employed by the Company on that date and subjectto accelerated vesting in the event of a change of control of the Company. ThePerformance RSUs have the same terms as the Performance RSUs granted in August2006 and described in Note 12 above.

 

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**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” of the Company’s Annual Report on Form 10-K for the yearended December 31, 2005.

**Description of Business and Overview**

*Current Business*

Crown Media Holdings, Inc. (“Crown Media Holdings,” “CrownMedia” or the “Company”), through its subsidiaries, owns and operates paytelevision channels (collectively the “Hallmark Channel,” the “Hallmark MovieChannel,” the “channel” or collectively the “channels”) dedicated to highquality, entertainment programming for adults and families, in the UnitedStates. In addition, the Company owns a film library with approximately 600titles.  The library product is used onthe Hallmark Channel, the Hallmark Movie Channel and sold to third parties.

With 74.7 millionsubscribers (as provided by Nielsen Research) in the United States at September30, 2006, an increase of 1.4 million subscribers from June 30, 2006, CrownMedia Holdings is the 39th most widely distributed advertising-supported cablechannel in the United States. For the third quarter of 2006, we finished thequarter as the ninth highest rated advertising-supported cable channel fortotal day ratings and theseventh highest rated advertising-supported cable channelin prime time as measured by Nielsen Research.

We launched oursecond 24-hour linear channel, the Hallmark Movie Channel, during the firstquarter of 2005.  The Hallmark MovieChannel focuses on movies and mini-series and utilizes content from our filmlibrary for programming.  At September 30,2006, we had approximately 663,000 subscribers (up from 450,000 subscribers atJune 30, 2006) to the Hallmark Movie Channel. We are developing the HallmarkMovie Channel as an additional revenue source. While it can play a critical role in terms of contract renewals with thevarious distributors and can justify itself on that basis, it can also stand onits own in terms of its business model. It will generate advertising revenue in 2006 and as distribution continuesto expand, the financial contribution of the Hallmark Movie Channel willcontinue to grow. The Hallmark Movie Channel is operated through Crown MediaHoldings existing infrastructure at a small incremental cost, which mayincrease if we complete the sale of our membership interests in Crown MediaDistribution.

As mentionedabove, the Company owns a film library comprised of approximately 600titles.  Through our subsidiary, CrownMedia Distribution, we 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.

For informationregarding a proposed sale of the Company’s film library, see Note 1 and Note 3of Notes to the Unaudited Condensed Consolidated Financial Statements in thisReport.

*Current Challenges*

The HallmarkChannel faces challenges on the distribution front.  The distribution agreements are importantbecause they affect our number of subscribers, which in turn has a major impacton our subscriber fees, the number of persons viewing our programming, and thusrates charged for advertising. We have an ongoing focus on growing oursubscriber base. The current and long-term distribution challenges will berenewing our distribution arrangements with the multiple system operators asthey expire. Major distribution agreements expire from December 2006 throughDecember 2010; of these distribution agreements, agreements accounting forapproximately 80% of our subscriber base at December 31, 2005 will terminateand be the subject of renewal negotiations prior to or on December 31, 2007.While the economics of the renewals and potential cash incentive payments areunknown and could have a significant impact on our business, we believe that theratings success of the Hallmark Channel and the positive family-friendlyenvironment we have created with our programming schedule will enhance ourrenewal 

37

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discussions. We alsobelieve that our ability to offer to multiple systems operators a second channel,the Hallmark Movie Channel is a value added component of the renewalequation.  Any renewals of thesedistribution agreements may also be significant as to whether we are able tomaintain or increase our subscriber fees. In October 2005, we entered into a renewal of our distributionagreements with one of the major distributors in the United States for a periodof 3.3 years.

Domestic telephonecompanies are entering into the business of distributing television channels tohouseholds through their wire-lines. We have reached agreement with severaltelephone companies, which permit the carriage of the Hallmark Channel andMovie Channel, and are negotiating with others. We expect that subscribers to these telephone services will in largepart be customers previously served by existing cable television companies andsatellite television companies.  To date,subscribers and revenues through telephone companies have been insignificant.

Three factors havecontributed to the ratings improvements of the Hallmark Channel: acquiredseries and movies, original productions and marketing.  Acquired series such as *Little Houseon the Prairie*, *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 isprovided by RHI Entertainment.  TheCompany typically incurs additional marketing expenses surrounding originalproductions and certain acquired movies.

We have extendedour program license for M*A*S*H, however, commencing January 1, 2007, ourrights will be non-exclusive in cable television and we may only broadcast theseries from 8 a.m. to 8 p.m.  Previously,M*A*S*H has been aired on the Hallmark Channel during primetime on an exclusivebasis.  This change was made for costsavings and may affect our ratings in late primetime, at leasttemporarily.  Our replacement programmingfor M*A*S*H in primetime is yet to be determined.

To continue theratings growth and enhance the demographics of our viewers, includingattracting a younger audience, the Hallmark Channel must continue to invest inprogramming and marketing.

Delivering strongratings growth to larger audiences has made it possible for our advertisingsales to grow rapidly over the last few years. To advertisers, the Hallmark Channel offers a strong brand, positiveenvironment and family friendly programming with a successful growthpattern.  These characteristics haveenabled the channel to sell to a broader range of advertisers, including thosein the packaged goods and pharmaceutical industries.

We sold approximately 48% of our inventory foradvertising on our Channels in the upfront market (generally sales in June,July and August for the last quarter of 2006 and the first three quarters of2007), compared to 50% to 55% sold in the 2005 upfront market.  We were able to achieve significant increasesin our CPM’s in the upfront market for next year compared to the upfront marketfor this year. The balance of advertising inventory will be made available inthe scatter market, which in the past has yielded higher advertising rates thanthe upfront market.

**InternationalBusiness**

Please see Note 1 in Item 1 — Sale of theInternational Business of Notes to Unaudited Condensed Consolidated FinancialStatements in this Report.

**Film Assets**

Please see Note 1 in Item 1 — Sale of MembershipInterests in Crown Media Distribution of Notes to Unaudited CondensedConsolidated Financial Statements in this Report.

**Revenue from Continuing Operations**

*Our revenue consists primarily of subscriber fees, advertising and filmasset license fees.*

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* *

*Subscriber Fees*

Subscriber fees are generallypayable to us on a per subscriber basis by pay television distributors for theright to carry our channels. In the past, we have paid certain televisiondistributors up-front subscriber acquisition fees to carry our channel.Subscriber acquisition fees that we pay are capitalized and amortized over thecontractual term of the applicable distribution agreement as a reduction insubscriber fee revenue. If the amortization expense exceeds the revenuerecognized on a per distributor basis, the excess amortization is included as acomponent of cost of services. At the time we sign a distribution agreement, weevaluate the recoverability of the costs we incur against the incrementalrevenue directly and indirectly associated with each agreement.

Rates we receive per subscribervary according to:

·              thelevel of sophistication 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 are in continuous negotiationswith our existing distributors to increase our subscriber base in order toenhance our advertising results. We have been subject to requests by majordistributors to pay subscriber acquisition fees for additional subscribers orto waive or accept lower subscriber fees if certain numbers of additionalsubscribers are provided. We also may help fund the distributors’ efforts tomarket our channels or we may permit distributors to offer limited promotionalperiods without payment of subscriber fees. As we continue our efforts to addsubscribers, our domestic subscriber revenue may continue to be negativelyaffected by subscriber acquisition fee amortization, waiver of subscriber feesand bulk discounts resulting from the attainment of certain subscriber levels;however, we believe these measures, if necessary, will help us increase oursubscriber base more quickly, which in turn will allow us to attract additionaladvertisers and command higher advertising rates.

Our channel is usually offered asone of a number of channels on either a basic tier or part of other programpackages and is not generally offered on a stand-alone basis. Thus, whilea cable or satellite customer may subscribe and unsubscribe to the tiers andprogram packages in which our channel is placed, these customers do notsubscribe and unsubscribe to our channel alone. We are not provided with information from the distributors on theiroverall subscriber churn and in what manner their churn rates affect oursubscriber counts; instead, we are provided information on the total number ofsubscribers who receive the Hallmark Channel.

Our subscriber count depends onthe number of distributors carrying the Hallmark Channel and the size of suchdistributors as well as the program tiers on which our channel is carried bythese distributors. From time to time, we experience decreases in the number ofsubscribers as promotional periods end, or as a distributor arrangement isamended or terminated by us or the distributor. Changes to distributionarrangements during the nine months ended September 30, 2006, have not beensignificant. Management analyzes the estimated effect each new or amendeddistribution agreement will have on revenues and costs. Based upon theseanalyses, management endeavors to achieve a fair combination of subscribercommitments and subscriber acquisition fees with each of our domesticdistributors.

#### A*dvertising*

Our advertising rates aregenerally calculated on the basis of an agreed upon price per unit of audiencemeasurement in return for a guaranteed commitment by the advertiser. We committo provide advertisers certain rating levels in connection with their advertising.Revenue is recorded net of estimated delivery shortfalls, which are usuallysettled by providing the advertiser additional advertising time. Advertisingrates also vary by time of year due to seasonal changes in televisionviewership.

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*Film AssetLicense Fees*

Crown Media Distribution generates revenue from the film assets bygranting licenses to third parties to exhibit the films 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, home video distributors and brokers who resell rights toour film assets. License fees for our film assets are generally negotiatedbased, among other things, upon the size of the potential audience who will beviewing the programming and the term of the license. The market for our film library is typically seasonal, with over halfof the annual sales occurring in the fourth quarter in past years.  This seasonality is generally due to thetiming of our customers’ program scheduling activities. In 2006, film licensingactivities and revenues have been affected by the pending sale of the Company’sfilm library. If the pending sale of the Company’s film libraryis not ultimately completed, then the Company expects future film library salesvolumes to build to levels commensurate with periods prior to when the filmlibrary was offered for sale.

**Cost of Services**

Our cost of services consistsprimarily of program license fees; amortization of our film assets; subscriberacquisition fee expense; the cost of signal distribution; administration,distribution and other exploitation of our film assets; and the cost ofpromotional segments that are aired between programs. We expect cost ofservices to continue to increase in the future as we expand our existingmarkets and third party programming to support our advertising strategy.

**Critical Accounting Policies, Judgmentsand Estimates**

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States requiresCrown Media Holdings to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period. Actual results could differfrom those estimates.

For further information regarding our critical accounting policies,judgments and estimates, please see the Notes to Unaudited ConsolidatedFinancial Statements contained in this Report and “Critical AccountingPolicies, Judgments and Estimates” of the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2005, filed with the SEC. Thesepolicies, judgments and estimates concern, among other things, the film assets,allowance for doubtful accounts, program license fees, subscriber acquisitionfees, long-lived assets, revenue recognition and stock-based compensation.

**Effects of Transactions with Related andCertain Other Parties**

In 2006 and in prior years, we entered into a number of significanttransactions with Hallmark Cards and its subsidiaries. These transactionsinclude, among other things, programming, trademark licenses, administrativeservices, a line of credit, a tax sharing agreement, the issuance of fourpromissory notes and a waiver agreement. For information regarding such transactions and transactions with otherrelated parties, please see “Effects of Transactions with Related and CertainOther Parties” of the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2005, filed with the SEC and Notes 8 and 9 of Notes toUnaudited Condensed Consolidated Financial Statements in Item 1 of this Report.

## **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, 2005 and 2006, are derived fromthe unaudited financial statements of Crown Media Holdings and itssubsidiaries. This data should be read together with the consolidated financialstatements and related notes included elsewhere in this Form 10-Q.

 

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| ** **                                               | ** ** | **Three Months Ended** | ** ** | **Percent  Change** | ** ** | **Nine Months Ended** | ** ** | **Percent  Change** | ** ** |
|----------------------------------------------------------|------------|----------------------------------|------------|---------------------|------------|---------------------------------|------------|---------------------|------------|
| ** **                                               | ** ** | **September 30,**           | ** ** | **2006 vs.**   | ** ** | **September 30,**          | ** ** | **2006 vs.**   | ** ** |
| ** **                                               | ** ** | **2005**                         | ** ** | **2006**            | ** ** | **2005**                        | ** ** | **2005**            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                                |       |                             |       |                |       |                            |       |                |       |   |   |   |   |
| Subscriber fees                                          |       | $                                | 4,554      |                | $          | 6,022                           |       | 32                  | %          | $ | 13,357 |   | $ | 18,633 |   | 39 | % |
| Advertising                                              |       | 33,560                           |       | 40,231              |       | 20                              | %          | 105,553             |       | 122,173 |   | 16 | % |
| Film asset  license fees                                 |       | 2,102                            |       | 989                 |       | -53                             | %          | 7,354               |       | 1,777 |   | -76 | % |
| Sublicense fees  and other revenue                       |       | 10,454                           |       | 76                  |       | -99                             | %          | 10,667              |       | 230 |   | -98 | % |
| Total revenues                                           |       | 50,670                           |       | 47,318              |       | -7                              | %          | 136,931             |       | 142,813 |   | 4 | % |
| Cost of Services:                                        |       |                             |       |                |       |                            |       |                |       |   |   |   |   |
| Programming  costs                                       |       | 29,196                           |       | 35,056              |       | 20                              | %          | 85,631              |       | 102,616 |   | 20 | % |
| Amortization of  film assets                             |       | 13,830                           |       | 4,560               |       | -67                             | %          | 33,175              |       | 21,703 |   | -35 | % |
| Impairment of  film assets                               |       | 22,939                           |       | 40,946              |       | 78                              | %          | 22,939              |       | 225,832 |   | 884 | % |
| Subscriber acquisition  fee amortization                 |       | 8,688                            |       | 7,747               |       | -11                             | %          | 26,891              |       | 23,260 |   | -14 | % |
| Operating costs                                          |       | 3,212                            |       | 2,075               |       | -35                             | %          | 9,738               |       | 9,706 |   | 0 | % |
| Total cost of services                                   |       | 77,865                           |       | 90,384              |       | 16                              | %          | 178,374             |       | 383,117 |   | 115 | % |
| Selling, general and  administrative expense             |       | 16,830                           |       | 11,317              |       | -33                             | %          | 46,133              |       | 34,806 |   | -25 | % |
| Marketing expense                                        |       | 1,832                            |       | 3,483               |       | 90                              | %          | 19,082              |       | 8,851 |   | -54 | % |
| Loss from continuing  operations before interest expense |       | (45,857                          | )          | (57,866             | )          | 26                              | %          | (106,658            | )          | (283,961 | ) | 166 | % |
| Interest expense                                         |       | (19,346                          | )          | (26,461             | )          | 37                              | %          | (53,686             | )          | (73,077 | ) | 36 | % |
| Loss from continuing  operations                         |       | (65,203                          | )          | (84,327             | )          | 29                              | %          | (160,344            | )          | (357,038 | ) | 123 | % |
| Loss from discontinued  operations                       |       | (4                               | )          | —              |       | -100                            | %          | (10,676             | )          | — |   | -100 | % |
| Loss on sale from  discontinued operations               |       | (615                             | )          | (1                  | )          | -100                            | %          | (1,964              | )          | 153 |   | -108 | % |
| Cumulative effect of  change in accounting principle     |       | —                           |       | —              |       | 0                               | %          | —              |       | (2,099 | ) | 100 | % |
| Net loss                                                 |       | $                                | (65,822    | )                   | $          | (84,328                         | )          | 28                  | %          | $ | (172,984 | ) | $ | (358,984 | ) | 108 | % |
|                                                     |       |                             |       |                |       |                            |       |                |       |   |   |   |   |
| **Other Data:**                                          |       |                             |       |                |       |                            |       |                |       |   |   |   |   |
| Net cash used in  operating activities                   |       | $                                | (13,842    | )                   | $          | (3,029                          | )          | -78                 | %          | $ | (98,788 | ) | $ | (21,419 | ) | -78 | % |
| Capital expenditures                                     |       | $                                | (538       | )                   | $          | (373                            | )          | -31                 | %          | $ | (848 | ) | $ | (400 | ) | -53 | % |
| Proceeds from  disposition of international business     |       | $                                | —     |                | $          | —                          |       | 0                   | %          | $ | 221,979 |   | $ | — |   | -100 | % |
| Net cash provided by  (used in) financing activities     |       | $                                | 27,852     |                | $          | 3,327                           |       | -88                 | %          | $ | (102,643 | ) | $ | 23,142 |   | -123 | % |
| Net cash used in  discontinued operations                |       | $                                | (5,496     | )                   | $          | —                          |       | -100                | %          | $ | (15,057 | ) | $ | — |   | -100 | % |
| Total domestic day  household ratings (1)(3)             |       | 0.720                            |       | 0.785               |       | 9                               | %          | 0.695               |       | 0.750 |   | 8 | % |
| Total domestic primetime  household ratings (2)(3)       |       | 1.093                            |       | 1.295               |       | 18                              | %          | 0.988               |       | 1.191 |   | 21 | % |
| Subscribers at period end                                |       | 69,243                           |       | 74,721              |       | 8                               | %          | 69,243              |       | 74,721 |   | 8 | % |

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(1)             Totalday is the time period measured from the time each day the broadcast ofcommercially sponsored programming commences to the time such commerciallysponsored programming ends.                                       

(2)             Primetimeis defined as 8:00 - 11:00 P.M. in the United States.

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

 

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### *Results of Operations*

#### *Three Months EndedSeptember 30, 2005 Compared to Three Months Ended September 30, 2006*

*Revenue.*

 Our revenue from continuing operations, whichis comprised of subscriber fees, advertising and film asset license fees,decreased 7% to $47.3 million for the three months ended September 30, 2006. Our 32% increase to $6.0 million in subscriberfee revenue for the three months ended September 30, 2006, was a result of theexpiration of free carriage periods during 2006 for certain of our domesticdistributors. Many of our distribution deals require us to provide a period offree carriage to the cable operator. Subscriber acquisition fee expenserecorded as a reduction of revenue was $2.2 million for the three months endedSeptember 30, 2006, and $3.5 million for the comparable period in 2005.Subscribers have increased as a result of previously amended distributionagreements in the United States, which provided for incentives for growth indistribution.

The increase in advertising revenue to $40.2 million forthe three months ended September 30, 2006, compared to $33.6 million for thethree months ended September 30, 2005, reflects the growth in domesticsubscribers, an increase in household primetime ratings, and an increase inadvertising rates. Generally, as we have expanded our domestic subscribers andprovided higher rated programming, our advertising revenues have increased. Thenumber of advertisers was 435 at September 30, 2006, 427 at both March 31 andJune 30, 2006, as compared to 402 at September 30, 2005.

Amongthe 65 ad-supported cable channels in the United States market, the HallmarkChannel ranked 10th in total day with a 0.785 household rating forthe nine months ending September 30, 2006 and 9th forprimetime with a 1.295 household rating for the same period based on Nielsenratings. This ratings performance is significant, particularly because theHallmark Channel is not a fully distributed network. Most of the channels thatrate above the Hallmark Channel have higher levels of distribution.

Revenue from thesale of our film assets totaled $989,000 for the three months ended September 30, 2006, comparedwith $2.1 million for the comparable period in 2005.  We had a smallamount of library sales in the third quarter of 2006 due to the Company’sproposed sale of the membership interests in Crown Media Distribution.Generally, our library sales are condensed in the second half of the year asthis coincides with our customers scheduling of the upcoming programmingschedules.

Sublicensefees and other revenue for the three months ended September 30, 2005, was $10.5million primarily due to the sub-licensing of *Little Houseon the Prairie* to a third party.

*Cost of services. *Cost of services as apercent of revenue increased to 191% in 2006, as compared to 154% in 2005. Thisincrease was primarily due to changes in our cost of services explained below.

The Companyrecorded a $40.9 million impairment of its film assets during the three monthsended September 30, 2006, based in part upon a bid received from RHIEnterprises. Total programming costs for the three months ended September 30,2006, increased 20% due to our focus onretaining and acquiring higher quality series programming and the relatedamortization. The $9.3 million decrease in amortization of film assetswas primarily due to the reduction in third party licenses of library assetsfor the three months ended September 30, 2006.

Asnoted above, the Company amended distribution agreements with multiple systemoperators in prior periods. In the past, some of our distribution agreementshave required the Company to pay subscriber acquisition fees, which the Companyamortizes over the remaining life of the distribution agreement, todistributors for additional subscribers. As we fully amortized certainof our agreements with our domestic distributors, our subscriber acquisition fee amortization expense for the periodended September 30, 2006, as compared to the prior year period, decreased 11%.

The Company’s bad debt recovery was $115,000 for thethree months ended September 30, 2005, as compared to the Company’s bad debtrecovery of $1.0 million for the three months ended September 30, 2006. TheCompany increased collection efforts as compared to the prior year period.

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*Selling, general andadministrative expense.* Our selling, general and administrativeexpense decreased 33% due to a $2.5 million decrease in compensation expenserelated to the obligation to purchase restricted stock units, a $358,000decrease in depreciation and amortization expense related to assets becomingfully depreciated or amortized, a $274,000 decrease in accounting fees expense,and a $345,000 decrease in property tax expense.

*Marketing expense. *Our marketing expense increased 90% primarily due tothe costs of two fourth quarter marketing campaigns for the Hallmark Channel.We also anticipate an increase in marketing expense in the fourth quarterbecause of these planned promotions that coincide with Thanksgiving andChristmas and promotions surrounding the premier of “March of the Penguins” andValentine’s Day 2007.

*Interest expense. *Interestexpense increased for the three months ended September 30, 2006, compared toSeptember 30, 2005, by $7.1 million. This increase was due to the $2.9 million interest on our $132.8 millionnote payable to Hallmark Cards affiliates commencing October 1, 2005, the $1.4million interest on our $70.4 million note payable to Hallmark Cards affiliatescommencing March 21, 2006, the $519,000 increase in interest on our $86.3 millionnote payable to Hallmark Cards affiliates, and the $1.4 million increase ininterest on our bank credit facility. The increases in interest on the lattertwo notes was because of higher interest rates.

*Lossfrom Continuing Operations. *Lossfrom operations for the three months ended September 30, 2006, was $84.3million. Loss from continuing operations for the three months ended September30, 2005, was $65.2 million. Our loss from continuing operations increasedprimarily due higher programming, interest expenses and impairment of the valueof our film assets.

#### *Nine Months EndedSeptember 30, 2005 Compared to Nine Months Ended September 30, 2006*

*Revenue.*

 Our revenue from continuing operations, whichis comprised of subscriber fees, advertising and film asset license fees,increased 4% to $142.8 million for the nine months ended September 30, 2006. Our 39% increase to $18.6 million in subscriberfee revenue for the nine months ended September 30, 2006, was a result of theexpiration of free carriage periods for certain of our domestic distributors.Subscriber acquisition fee expense recorded as a reduction of revenue was $6.5million for the nine months ended September 30, 2006, and $10.1 million for thecomparable period in 2005.

The increase in advertising revenue to $122.2 millionfor the nine months ended September 30, 2006, compared to $105.6 million forthe nine months ended September 30, 2005, reflects the growth in domesticsubscribers, an increase in household primetime ratings, and an increase inadvertising rates.

Amongthe 65 ad-supported cable channels in the United States market, the HallmarkChannel ranked 10th in total day with a 0.750 household rating forthe nine months ending September 30, 2006 and 10th forprimetime with a 1.191 household rating for the same period based on Nielsenratings. This ratings performance is significant, particularly because theHallmark Channel is not a fully distributed network. Most of the channels thatrate above the Hallmark Channel have higher levels of distribution.

Revenuefrom the sale of our film assets totaled $1.8 million for the nine months endedSeptember 30, 2006, compared with $7.4 million for the comparable periodin 2005.  We had a small amount of library sales in the second and thirdquarters of 2006 and minimal library sales in the first quarter of 2006 due tothe Company’s proposed sale of the membership interests in Crown MediaDistribution. Generally, our library sales are condensed in the second half ofthe year as this coincides with our customers scheduling of the upcomingprogramming schedules.

Sublicensefees and other revenue for the nine months ended September 30, 2005, was $10.7million primarily due to the same sub-licensing of *Little Houseon the Prairie*.

*Cost of services. *Cost of services as apercent of revenue increased to 268% in 2006, as compared to 130% in 2005. Thisincrease was primarily due to the impairment of our film assets explainedbelow.

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The Companyrecorded a $225.8 million impairment of its film assets during the nine monthsended September 30, 2006, based in part upon bids received, and the terms ofthe proposed sale for, our membership interests in Crown Media Distribution.Total programming costs for the nine months ended September 30, 2006, increased20% due to our focus on retaining andacquiring higher quality series programming and the related amortization. The$11.5 million decrease in amortization of film assets was primarily due to thereduction in third party licenses of library assets for the nine months endedSeptember 30, 2006.

As we fully amortizedcertain of our agreements with our domestic distributors, our subscriber acquisition fee amortizationexpense for the period ended September 30, 2006, as compared to the prior yearperiod, decreased 14%.

The Company’s bad debt expense was $1.0 million for thenine months ended September 30, 2005, as compared to the Company’s bad debtexpense of $254,000 for the nine months ended September 30, 2006.

*Selling, general andadministrative expense.* Our selling, general and administrativeexpense decreased 25% primarily due to a $11.6 million decrease in compensationexpense related to the obligation to purchase restricted stock units and a $1.2million decrease in depreciation and amortization expense.

*Marketing expense. *Our marketing expense decreased 54% primarily due tothe elimination of the Mystery Movie marketing campaign for the HallmarkChannel.

*Interest expense. *Interestexpense increased for the nine months ended September 30, 2006, compared toSeptember 30, 2005, by $19.4 million. This increase was due to the $8.1 million interest on our $132.8 millionnote payable to Hallmark Cards affiliates commencing October 1, 2005, the $3.0million interest on our $70.4 million note payable to Hallmark Cards affiliatescommencing March 21, 2006, the $3.2 million increase in interest on our bankcredit facility, and the $1.5 million increase in interest on our $86.3 millionnote payable to Hallmark Cards affiliates. The increases in interest on thelatter two notes was because of higher interest rates. The increase was alsodue to the $3.8 million increase in interest payable to HC Crown on our $400.0million senior unsecured note payable, because of accrued interest added to theprincipal.

*Lossfrom Continuing Operations. *Lossfrom operations for the nine months ended September 30, 2006, was $357.0million. Loss from continuing operations for the nine months ended September30, 2005, was $160.3 million. Our loss from continuing operations increasedprimarily due to the impairment in the value of our film assets described aboveas well as increased programming and interest expenses.

*Lossfrom Discontinued Operations. *Lossfrom discontinued operations for the nine months ended September 30, 2005, was$10.7 million. The Company sold the international business on April 26, 2005.

*Cumulative effect of change in accounting principle.  *On January 1, 2006, weadopted SFAS 123R. The total compensationcost related to performance RSUs granted under the Plan net of estimated forfeitureswas $2.1 million, which was recorded as a cumulative catch-up adjustment duringthe nine months ended September 30, 2006. Under prior accounting treatment, theperformance RSUs were not classified as a liability as it was deemed improbablethat these RSUs would settle based upon the performance of our Class A commonstock.

## **Liquidityand Capital Resources**

Cash used in operating activities from continuingoperations was $98.8 million and $21.4 million for the nine months endedSeptember 30, 2005 and 2006.**Lossfrom operations for the nine months ended September 30, 2005 and 2006, was$160.3 million and $357.0 million, respectively. During the nine months ending September 30, 2006, the Company madepayments of $10.3 million for subscriber acquisition fees and $36.7 million forlicense fees payable to RHI Entertainment as compared to payments of $31.1million and $47.5 million for the same items during of the same period of2005.  Additionally, accounts receivablebalances decreased due to decreased library sales associated with the proposedsale of our membership interests in Crown Media Distribution and increased collections due in part to improvedcollection efforts.

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Cashprovided by investing activities was $213.8 million for the nine months ended September30, 2005.  Cash used in investingactivities was $7.9 million for the nine months ended September 30, 2006.  This decrease is due to payments to the buyerof the international business during 2006. The Company sold theinternational business on April 26, 2005, and will continue to make payments tothe buyer of the international business in accordance with the sale agreement.

Cash used in financing activities was $102.6 million forthe nine months ended September 30, 2005. Cash provided by financing activitieswas $23.1 million for the nine months ended September 30, 2006. During the ninemonths ending September 30, 2005 and 2006, we received proceeds of $26.1million and $12.0 million, respectively, from our tax sharing agreement withHallmark Cards. We borrowed $65.0 million under our credit facility to repaycertain programming obligations to Hallmark Cards affiliates, pay severance andRSU settlements for certain employees of the international business and to meetour operating demands during the nine months ended September 30, 2005. Weborrowed $15.0 million under our credit facility to cover the cash we used inoperating and investing activities during the nine months ended September 30,2006. During the nine months ended September 30, 2005, we repaid $195.0 millionunder our bank credit facility following the sale of our internationalbusiness.

Cashused in discontinued operations was $15.1 million and $0 for the nine monthsended September 30, 2005 and 2006, respectively.  Cash was used primarily to fund operatingexpenditures related to losses from discontinued operations of $10.7 millionfor the nine months ended September 30, 2005. The significant decrease in cashused by discontinued operations is because the Company sold theinternational business on April 26, 2005.

The following table aggregates all of our contractualcommitments as of September 30, 2006.
| ** **                                                                                     | ** ** | **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                                                          |       | $                                               | 221.6      |   | $ | — |   | $ | 221.6 |   | $ | — |   | $ | — |   |
| Company  obligated mandatorily redeemable preferred interest, including accretion              |       | 25.0                                            |       | — |   | 5.0 |   | 20.0 |   | — |   |
| HC Crown note  and interest payable                                                            |       | 91.5                                            |       | — |   | 91.5 |   | — |   | — |   |
| Senior unsecured  note to HC Crown, including accretion                                        |       | 596.6                                           |       | — |   | — |   | — |   | 596.6 |   |
| Note payable to  Hallmark Cards affiliate                                                      |       | 143.3                                           |       | — |   | 143.3 |   | — |   | — |   |
| Note payable to  Hallmark Cards affiliate                                                      |       | 52.3                                            |       | — |   | 52.3 |   | — |   | — |   |
| Capital lease  obligations                                                                     |       | 16.3                                            |       | 0.7 |   | 1.5 |   | 1.8 |   | 12.3 |   |
| Operating leases  (off-balance sheet commitments)                                              |       | 10.8                                            |       | 3.7 |   | 5.1 |   | 1.8 |   | 0.2 |   |
| Other  obligations                                                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Program license fees payable to non-affiliates                                                 |       | 186.7                                           |       | 89.6 |   | 53.7 |   | 41.2 |   | 2.2 |   |
| Program license fees payable to affiliates                                                     |       | 5.5                                             |       | 3.4 |   | 2.1 |   | — |   | — |   |
| Program license fees payable for non-affiliate future  windows (off-balance sheet commitments) |       | 208.4                                           |       | 99.9 |   | 63.3 |   | 30.6 |   | 14.6 |   |
| Program license fees payable for affiliate future  windows (off-balance sheet commitments)     |       | 22.3                                            |       | 16.5 |   | 5.8 |   | — |   | — |   |
| Subscriber acquisition fees                                                                    |       | 2.2                                             |       | 2.2 |   | — |   | — |   | — |   |
| Deferred compensation and interest                                                             |       | 3.8                                             |       | 1.2 |   | 2.6 |   | — |   | — |   |
| Payable to buyer of international business                                                     |       | 10.7                                            |       | 5.0 |   | 5.7 |   | — |   | — |   |
| Other payables to buyer of international business                                              |       | 6.4                                             |       | 1.1 |   | 1.9 |   | 1.5 |   | 1.9 |   |
| Total Contractual Cash  Obligations                                                            |       | $                                               | 1,603.4    |   | $ | 223.3 |   | $ | 655.4 |   | $ | 96.9 |   | $ | 627.8 |   |

 

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*Cash Flows*

As of September30, 2006, the Company had $9.8 million in cash and cash equivalents on hand. Asof September 30, 2006, the Company had borrowed $221.5 million from a $240.0 millionrevolving bank credit, which matures May 31, 2007.

The Company’s principal sources of funds are cash onhand, cash generated by operations, tax sharing payments from Hallmark Cardsand amounts available under the Company’s revolving bank credit facility.Payments under the tax sharing agreement are affected by Hallmark Cards’ taxposition and its ability to utilize the Company’s tax losses.  The Company has received $12.0 million in taxsharing payments in 2006 and does not currently expect to receive anyadditional cash payments during the remainder of 2006 or 2007. The Companycurrently has $18.5 million of unused revolving credit commitments, subject toapproval from our Board of Directors.

The ability of the existing sources of liquidity to besufficient to fund the Company’s operations depends upon the Company’s abilityto achieve its forecasts, however, management has not always been able toaccurately forecast future operations. In particular, continued growth in subscriber revenue and advertisingrevenue, as well as completion of the sale of the Crown Media Distribution filmlibrary or in the alternative, increasing the cash flow from library sales willbe required to maintain liquidity.  Anydecline in the popularity of the Hallmark Channel, any significant futuremodifications to the Company’s distribution agreements, an economic decline inthe advertising market, an increase in program acquisition costs (the extent ofsuch increase subject to the sale discussed above), an increase in competitionor other adverse operating conditions would impact the Company’s liquidity andits ability to fund the current level of operations.  To the extent that the Company requiresadditional capital and additional drawings on the bank credit facility are eithernot available or are insufficient, the Company would be forced to seekadditional funding from the issuance of debt or equity securities, a sale ofcertain assets or strategic transactions which provide capital. There can be noassurance that the Company would be able to secure additional financing orcomplete any such transactions.

The Company expects tocontinue making investments in programming, marketing and distribution duringthe next twelve months ending September 30, 2007. However, the Company’sliquidity position has demanded that all areas of expenses, includingprogramming, marketing and distribution be closely monitored andcontrolled.  The Company has and willcontinue to seek to sublicense certain of its programming rights but expectsthat programming expenses and cost of services will increase when compared tothese items for the prior twelve month period.

The Companyanticipates that its principal uses of funds for the remainder of 2006 willcontinue to include the payment of operating expenses, accounts payable andaccrued expenses, license fees for programming (including the prepayment ofcertain license fees for 2007), and interest under its bank credit facility.

As part of theseefforts to improve the capital structure, the Company has entered into anagreement to sell its membership interests in Crown Media Distribution asdescribed in this Report.

The Company currentlybelieves that cash on hand, cash generated by operations and the sale of itsmembership interests in Crown Media Distribution, and availability on its bankcredit facility, will be sufficient to fund the Company’s operations and meetits liquidity needs through September 30, 2007. However, if the Company does not consummate the sale of its membershipinterests in Crown Media Distribution (as discussed further in Note 1), itsability to continue as a going concern would be dependent upon the continuedfinancial support of Hallmark Cards. However, at this point in time, HallmarkCards has no obligation to provide any further funding to the Company.

The Company’s bank creditfacility will expire on May 31, 2007.   The Company plans tosignificantly reduce the amounts outstanding under the credit facility with theproceeds of the sale of the membership interests in Crown

 

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Media Distribution. Atthe same time as making these repayments on the credit facility, the Companyintends to reduce the size of the credit facility and, with the lenders’concurrence, extend the term of the credit facility.  Even if the sale of the film library were notconsummated, the Company would intend to extend or refinance the Bank creditfacility prior to or upon its maturity. Any such extension or refinancing might require a continuation of aletter of credit from Hallmark Cards or other steps by the Company and is notassured.

If the Company is notable to arrange for the extension, refinancing or replacement of the bankcredit facility prior to its maturity and the bank draws down on theirrevocable letter of credit provided by Hallmark Cards in support of the bankcredit facility, or alternatively Hallmark Cards purchases the interests of thelending banks, Hallmark Cards would have all obligations and the rights of thelending banks under the bank credit facility.  In that event, Hallmark Cardscould demand payment of outstanding amounts at any time after November 15,2007, under the terms of the waiver and standby purchase agreement (“WaiverAgreement”) described in Note 8 of Notes to the Unaudited CondensedConsolidated Financial Statements in this Report .

Upon maturity of the creditfacility on May 31, 2007, 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, but instead can elect toinitiate a process to foreclose on the Company’s assets. Suchforeclosure proceedings, which we view as a remote possibility, would affectour ability to continue our operations. Prior to any such possible foreclosureproceedings, however, the Company, if it has not secured an extension of thecredit facility or alternative financing, would cause Hallmark Cards pursuantto the terms of the Waiver Agreement to exercise its option to purchase all ofthe outstanding indebtedness under the credit facility and the credit facilitywould then be subject to terms of the Waiver Agreement not to demand paymentprior to November 15, 2007.

Due to the Company’sliquidity issues and its possible inability to meet its obligations when theycome due in November 2007, the Company anticipates that prior to November 15,2007, it will be necessary to either extend or refinance (i) the bank creditfacility and (ii) the promissory notes payable to affiliates of Hallmark Cardsdescribed in the Notes below. As part of a combination of actions and in orderto obtain additional funding, the Company may consider various alternatives,including refinancing the bank credit facility, raising additional capitalthrough the issuance of equity or debt securities, a sale of certain assets orother strategic alternatives.

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

For information regarding our Bank CreditFacility, HC Crown Loans and Tax Sharing Agreement, please see “Bank CreditFacility, HC Crown Loans, and Tax Sharing Agreement” of the Company’s AnnualReport on Form 10-K for the year ended December 31, 2005, filed with the SECand Notes 7, 8 and 9 of Notes to Unaudited Condensed Consolidated FinancialStatements in this Report.

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

Thediscussion set forth in this Form 10-Q contains statements concerning potentialfuture events. Such forward-looking statements are based on assumptions by CrownMedia Holdings management, as of the date of this Form 10-Q includingassumptions about risks and uncertainties faced by Crown Media Holdings.Readers can identify these forward-looking statements by their use of suchverbs as “expects,” “anticipates,” “believes,” or similar verbs or conjugationsof such verbs. If any of management’s assumptions prove incorrect or shouldunanticipated circumstances arise, Crown Media Holdings’ actual results, levelsof activity, performance, or achievements could materially differ from thoseanticipated by such forward-looking statements.

Amongthe factors 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’sForm 10-K Report for the year ended December 31, 2005. Such Risk Factorsinclude, but are not limited to, the following: competition for distribution of channels, viewers, advertisers and theacquisition of programming; fluctuations in the availability of programming;fluctuations in demand for programming which we air on our channels; ourability to address our liquidity needs; our incurrence of losses; and oursubstantial indebtedness affecting our financial condition and results.

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Thereare stated below certain Risk Factors which contain significant changes fromthose stated in the Company’s Form 10-K Report for the year ended December 31,2005. Crown Media Holdings will not update any forward-looking statementscontained in that Form 10-K 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 A commonstock 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 would resultin the need for additional external funds in order to continue operations. Wehave no arrangements for any such additional external financings, whether debtor equity, and are not certain whether any such new external financing would beavailable on acceptable terms. Any new debt financing would require thecooperation and agreement of existing lenders.

Further, as discussed in this report under “Liquidityand Capital Resources” above, we need to (1) extend, refinance or replace ourbank line of credit on or prior to May 31, 2007, or to extend or replaceborrowings from Hallmark Cards by November 15, 2007, that would result from thebanks drawing upon the irrevocable letter of credit supporting the bank creditfacility, and (2) extend or refinance license fees and payables to HallmarkCards and its subsidiaries on or prior to November 15, 2007.

Upon maturity of the credit facility on May 31, 2007,the lending group led by JP Morgan Chase has the right to 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 can elect to initiate a process toforeclose on the Company’s assets. Such foreclosure proceedings, whichwe view as a remote possibility, could affect our ability to continue our operations. Priorto any such possible foreclosure proceedings, the Company would considervarious alternatives as indicated above. The Company could also cause Hallmark Cards, pursuant to the terms ofthe Waiver Agreement, to exercise its option to purchase all of the outstandingindebtedness under the credit agreement. The credit facility would then besubject to Hallmark Cards agreement not to demand payment prior to November 15,2007.

### **Available Information**

We will make available free of charge through our website,www.hallmarkchannel.com, the Annual Report, our quarterly reports on Form 10-Q,our current reports on Form 8-K, and amendments to such reports, as soon asreasonably practicable after we electronically file or furnish such materialwith the Securities and Exchange Commission.

Additionally, we will make available, free of chargeupon request, a copy of our Code of Business Conduct and Ethics, which isapplicable to all of our employees, including our senior financial officers.Requests for a copy of this code should be addressed to the General Counsel at12700 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, 2006, the decline of the fairvalue of the fixed 

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income portfolio would not be material.

As of September 30, 2006, our cash, cash equivalents andshort-term investments had a fair value of $9.8 million, which were invested incash and short-term commercial paper. The primary purpose of these investingactivities has been to preserve principal until the cash is required to fundoperations. Consequently, the size of this portfolio fluctuates significantlyas 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, 2006, all of our investmentsin this category were in fixed rate instruments or money market type accounts.A decrease in interest rates has the effect of reducing our future annualinterest income from this portfolio, since funds would be reinvested at lowerrates as the instruments mature. Over time, any net percentage decrease in ourinterest rates could be reflected in a corresponding net percentage decrease inour interest income. For the three and nine months ended September 30, 2006,the impact of interest rate fluctuations, changed business prospects and allother factors did not have a material impact on the fair value of thisportfolio, or on our income derived from this portfolio.

We have not used derivative financial instruments forspeculative purposes. As of September 30, 2006, we are not hedged or otherwiseprotected against risks associated with any of our investing or financingactivities.

***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.

***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 $9.8 million, or 1% of total assets, as of September 30, 2006. Ourmaterial liabilities subject to interest rate risk consisted of capital leaseobligations, bank credit facility, notes payable to HC Crown, and note payablesto Hallmark Cards affiliate. The balance of those liabilities was $1.1 billion,or 80% of total liabilities, as of September 30, 2006. Net interest expense forthe three months ended September 30, 2006, was $26.5 million, 56%, of our totalrevenue. Net interest expense for the nine months ended September 30, 2006, was$73.1 million, 51%, of our total revenue. Our net interest expense of theseliabilities is sensitive to changes in the general level of interest rates,primarily U.S. and LIBOR interest rates. In this regard, changes in U.S. andLIBOR interest rates affect the fair value of interest bearing liabilities.

**Item 4.  *Controls andProcedures.***

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

Ourmanagement  evaluated, with theparticipation of our Chief Executive Officer and our Chief Financial Officer,the effectiveness of our disclosure controls and procedures as of the end ofthe period covered by this Quarterly Report on Form 10-Q. Based on thisevaluation, our Chief Executive Officer and our Chief Financial Officer haveconcluded that our disclosure controls and procedures were not effective as ofthe end of the period covered by this Quarterly Report on Form 10-Q because wehave not yet completed the remediation of the material weaknesses discussed inour Annual Report on Form 10-K for the year ended December 31, 2005 (“2005 Form10-K”).

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***b.  Changes in Internal Control over FinancialReporting***

There was nochange in the Company’s internal control over financial reporting that occurredduring the quarter ended September 30, 2006, that materially affected, or wasreasonably likely to materially affect, the Company’s internal control overfinancial reporting, except for the remediation measures implemented in thesecond quarter of 2006 as described below in this Item 4.

***c.  Remediation of Weakness in Internal Controlover Financial Reporting***

As discussed inmore detail in our 2005 Form 10-K, as of December 31, 2005, we did not maintaineffective controls over  (a) the reviewof the consolidated statement of cash flows; (b) the underlying informationsupporting the amounts included in the Company’s annual and interimconsolidated financial statements; and (c) the information available subsequentto the financial reporting close process for appropriate recognition and disclosurein the Company’s annual and interim consolidated financial statements. Inaddition, the Company’s controls over access to the general ledger and certainaccounting application systems were not designed effectively to provideadequate segregation of duties. Specifically, the following design deficiencies were identified: (a)certain members of accounting management had the ability to both initiate andapprove journal entries; (b) certain members of accounting management had theability to initiate and approve the payment of invoices and sign checks; and(c) a member of accounting management had access to an accounting applicationsystem and the ability to change information included therein without reviewand approval.

In order toidentify controls to address certain of the material weaknesses discussedabove, management is in the process of evaluating existing policies andcontrols related to (a) the review of the consolidated statement of cash flows;(b) the underlying information supporting the amounts included in the Company’sannual and interim consolidated financial statements; and (c) the informationavailable subsequent to the financial reporting close process for appropriaterecognition and disclosure in the Company’s annual and interim consolidatedfinancial statements.

Management hasimplemented, or plans to implement, the measures described below to remediatecertain of the material weaknesses described above:

·                  Management’sAbility to Both Initiate and Approve Journal Entries — We have designedcontrols which were implemented in the second quarter of 2006 to ensure that nopersonnel of the Company can both initiate and approve journal entries.

·                  Management’sAbility to Both Initiate, Approve the Payment of Invoices and Sign Checks — Wehave designed controls which were implemented in the second quarter of 2006 toensure that no personnel of the Company can both initiate and approve thepayment of invoices and sign checks.

·                  Management’sAbility to Change Accounting Applications without Review or Approval — We havedesigned controls which were implemented in the second quarter of 2006 toensure that no personnel of the Company can make changes to accountingapplications without appropriate review and approval.

The aforementionedmaterial weaknesses will not be considered remediated until new processes havebeen fully implemented, operated for a reasonable period of time, tested bymanagement, and evaluated as operating effectively.

We are fullycommitted to remediating our material weaknesses in internal control overfinancial reporting, and we believe we are taking the appropriate steps toproperly address these issues during 2006. However, the remediation of thedesign of the deficient controls and the associated testing efforts are notcomplete, and may require further remediation.

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**PART II.  OTHER INFORMATION**

**Item1A.  *Risk Factors***

See “RisksRelating to Our Business” in Part I, Item 2 above for information on changes torisk factors.

**Item 2.  *Unregistered Sales ofEquity Securities and Use of Proceeds***

The Company issued in October 2006 a stockappreciation right to its new CEO.  Thestock appreciation right is described in Note 17 of the Notes to the UnauditedCondensed Financial Statements in this Report and in the Company’s Form 8-KReport filed on October 6, 2006.  Weissued the SAR pursuant to an exemption from securities registration fornon-public offerings because the recipient is an executive officer of theCompany.

**Item 6.  *Exhibits***

**INDEX TO EXHIBITS**

| Exhibit Number | ** ** | **Exhibit Title**                                                                                                                                                                                                                             |
|----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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*          |       | Employment Agreement dated October 3, 2006 between  Crown Media Holdings, Inc. and Henry Schleiff.                                                                                                                                            |
| 10.2*          |       | Restricted Stock Unit Agreement dated October 3,  2006 between Crown Media Holdings, Inc. and Henry Schleiff.                                                                                                                                 |
| 10.3*          |       | Stock Appreciation Rights Agreement dated October 3,  2006 between Crown Media Holdings, Inc. and Henry Schleiff.                                                                                                                             |
| 10.4*          |       | Separation Agreement dated July 21, 2006  between Crown Media Holdings, Inc. and William Aliber (previously filed as Exhibit 99.1 to our  Current Report on Form 8-K filed on July 24, 2006 and incorporated herein by  reference). |
| 10.5*          |       | Letter Agreement dated November 8, 2006 between  Crown Media Holdings, Inc. and Brian Stewart.                                                                                                                                                |
| 10.6           |       | Amendment No. 2 to Waiver and Standby Purchase  Agreement dated November 6, 2006 by and between Hallmark Cards Incorporated  and Crown Media Holdings, Inc.                                                                                   |
| 31.1           |       | Rule 13a-14(a) Certification executed by the  Company’s Acting 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.                                                                                                                                                                                                                  |

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* Management contract or compensating plan or arrangement.

 

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**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/ HENRY S. SCHLEIFF |      | Principal Executive Officer |     | November 9, 2006 |
|      | Henry S. Schleiff     |      |                        |     |   |
|      |                  |      |                        |     |   |
| By:       | /s/ BRIAN C. STEWART  |      | Principal Financial and     |     | November 9, 2006 |
|      | Brian C. Stewart      |      | Accounting Officer          |     |   |

 

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