**UNITED STATES SECURITIES ANDEXCHANGE COMMISSION**

 

**Washington, D.C. 20549**

 

**Form 10-Q**

 

**(Mark One)**

| **ý**                                                                                                                                                                                                                 | ** ** | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|-----------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                       |       |       |
| **For the quarterly period ended June 30, 2004**                                                                                                                                                                      |
|                                                                                                                                                                                                                       |
| **or**                                                                                                                                                                                                                     |
|                                                                                                                                                                                                                       |       |       |
| **o**                                                                                                                                                                                                                      | ** ** | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                                                 | ** ** | ** ** |
| **For the transition period  from               to               .** |
|                                                                                                                                                                                                                       |
| **Commission File Number: 000-30700**                                                                                                                                                                                      |

 

**Crown Media Holdings, Inc.**

(Exact Name of Registrant as Specified in Its Charter)

 

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

 

**6430 S. Fiddlers Green Circle,**

**Suite 225,**

**Greenwood Village, Colorado 80111**

(Address of Principal Executive Offices and Zip Code)

 

**(303) 220-7990**

(Registrant’s Telephone Number, Including Area Code)

 

 

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

if Changed Since Last Report.)

 

Indicate by check markwhether the registrant:  (1) has filedall 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  ý     No  o

 

Indicate by check mark whether the registrant is an accelerated filer (asdefined in Exchange Act Rule 12b-2).  Yes  ý     No  o

 

As of August 2,2004, the number of shares of Class A Common Stock, $.01 par value outstandingwas 73,863,037, and the number of shares of Class B Common Stock, $.01 parvalue, outstanding was 30,670,422.

 

 

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**TABLE OF CONTENTS**

 
| **PART I**  | ** ** | **Financial Information**                                                                                                           |   |
|-------------|------------|-------------------------------------------------------------------------------------------------------------------------------------|--------|
|        |       |                                                                                                                                |   |
| Item 1      |       | Financial  Statements (Unaudited)                                                                                                   |   |
|        |       | CROWN MEDIA HOLDINGS, INC. AND SUBSIDIARIES                                                                                         |   |
|        |       | Consolidated Balance Sheets  – December 31, 2003 and June 30, 2004 (Unaudited)                                       |   |
|        |       | Consolidated  Statements of Operations and Comprehensive Loss (Unaudited)  - Three and Six Months Ended June 30, 2003 and 2004 |   |
|        |       | Consolidated Statements  of Cash Flows (Unaudited)  - Six Months Ended June 30, 2003 and 2004                                  |   |
|        |       | Notes  to Unaudited Consolidated Financial Statements                                                                               |   |
|        |       |                                                                                                                                |   |
| Item  2     |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                         |   |
|        |       |                                                                                                                                |   |
| Item  3     |       | Quantitative  and Qualitative Disclosures About Market Risk                                                                         |   |
|        |       |                                                                                                                                |   |
| Item 4      |       | Controls and Procedures                                                                                                             |   |
|        |       |                                                                                                                                |   |
| **PART II** | ** ** | **Other Information**                                                                                                               |   |
|        |       |                                                                                                                                |   |
| Item 2      |       | Changes  in Securities, Use of Proceeds and Issuer Purchases of Equity Securities                                                   |   |
|        |       |                                                                                                                                |   |
| Item  4     |       | Submission  of Matters to a Vote of Security Holders                                                                                |   |
|        |       |                                                                                                                                |   |
| Item 6      |       | Exhibits and Reports  on Form 8-K                                                                                                   |   |
|        |       |
| Signatures  |       |
|             |            |                                                                                                                                     |        |  |

 

2

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*In this Form10-Q the terms “Crown Media Holdings” or the “Company,” refer to Crown MediaHoldings, Inc.  and, unless the contextrequires otherwise, subsidiaries of Crown Media Holdings that operate or haveoperated our businesses, Crown Media International, LLC (“Crown MediaInternational”), Crown Media United States, LLC (“Crown Media United States”),Crown Media Distribution, LLC (“Crown Media Distribution”), Crown EntertainmentLimited (“Crown Entertainment”), and Crown Media Trust (“Crown Media Trust”).The term “common stock” refers to our Class A common stock and Class B commonstock, unless the context requires otherwise.*

 

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

 

**PART I. FINANCIAL INFORMATION**

** **

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

 

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

**CONSOLIDATEDBALANCE SHEETS**

**(In thousands, except share and per share amounts)**

 

| ** **                                                                                    | ** ** | **As of  December 31,  2003** | ** ** | **As of June 30,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                    | ** ** | ** **                         | ** ** | **(Unaudited)**               | ** ** |
| **ASSETS**                                                                                    |       |                               |       |                          |       |
|                                                                                          |       |                               |       |                          |       |
| Cash and cash equivalents                                                                     |       | $                                  | 4,306      |                          | $          | 9,510 |   |
| Accounts receivable, less  allowance for doubtful accounts of $6,703 and $5,985, Respectively |       | 57,839                             |       | 59,250                        |       |
| Program license fees —  affiliates, net of accumulated amortization                      |       | 27,127                             |       | 31,299                        |       |
| Program license fees —  non-affiliates, net of accumulated amortization                  |       | 65,571                             |       | 65,946                        |       |
| Subtitling and dubbing, net of  accumulated amortization                                      |       | 2,827                              |       | 2,723                         |       |
| Receivable from affiliate                                                                     |       | 12,083                             |       | 11,873                        |       |
| Prepaid and other assets                                                                      |       | 15,209                             |       | 15,885                        |       |
| Total current assets                                                                          |       | 184,962                            |       | 196,486                       |       |
| Accounts receivable, net of  current portion                                                  |       | 5,891                              |       | 8,809                         |       |
| Program license fees —  affiliates, net of current portion                               |       | 47,748                             |       | 42,633                        |       |
| Program license fees —  non-affiliates, net of current portion                           |       | 106,047                            |       | 88,667                        |       |
| Subtitling and dubbing, net of  current portion                                               |       | 2,020                              |       | 1,324                         |       |
| Film assets, net of  accumulated amortization                                                 |       | 750,737                            |       | 737,537                       |       |
| Subscriber acquisition fees,  net of accumulated amortization                                 |       | 113,196                            |       | 109,035                       |       |
| Property and equipment, net of  accumulated depreciation                                      |       | 29,235                             |       | 25,073                        |       |
| Goodwill                                                                                      |       | 314,033                            |       | 314,033                       |       |
| Debt issuance costs, net of  accumulated amortization                                         |       | 6,478                              |       | 5,671                         |       |
| Prepaid and other assets, net  of current portion                                             |       | 1,363                              |       | 1,340                         |       |
| Total assets                                                                                  |       | $                                  | 1,561,710  |                          | $          | 1,530,608 |   |

** **

**3**

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** **

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

**CONSOLIDATED BALANCE SHEETS**

**(In thousands, except share and per share amounts)**

 

| ** **                                                                                                                                                             | ** ** | **As of  December 31,  2003** | ** ** | **As of June 30,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                                                                                             | ** ** | ** **                         | ** ** | **(Unaudited)**               | ** ** |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                          |       |                               |       |                          |       |
|                                                                                                                                                                   |       |                               |       |                          |       |
| LIABILITIES:                                                                                                                                                           |       |                               |       |                          |       |
| Accounts payable and accrued  liabilities                                                                                                                              |       | $                                  | 34,417     |                          | $          | 30,577 |   |
| Subscriber acquisition fees  payable                                                                                                                                   |       | 9,119                              |       | 18,365                        |       |
| License fees payable to  affiliates                                                                                                                                    |       | 30,671                             |       | 44,931                        |       |
| License fees payable to  non-affiliates                                                                                                                                |       | 87,720                             |       | 70,185                        |       |
| Payables to affiliates                                                                                                                                                 |       | 7,827                              |       | 11,759                        |       |
| Interest payable to HC Crown                                                                                                                                           |       | 2,655                              |       | 4,222                         |       |
| Credit facility and interest  payable                                                                                                                                  |       | 510                                |       | 507                           |       |
| Capital lease obligation                                                                                                                                               |       | 1,559                              |       | 1,626                         |       |
| Deferred programming revenue                                                                                                                                           |       | 2,163                              |       | 3,174                         |       |
| Total current liabilities                                                                                                                                              |       | 176,641                            |       | 185,346                       |       |
| Accrued liabilities, net of  current portion                                                                                                                           |       | 18,906                             |       | 20,526                        |       |
| Subscriber acquisition fees  payable, net of current portion                                                                                                           |       | 1,500                              |       | 1,424                         |       |
| License fees payable to  affiliates, net of current portion                                                                                                            |       | 60,229                             |       | 60,229                        |       |
| License fees payable to  non-affiliates, net of current portion                                                                                                        |       | 82,090                             |       | 67,100                        |       |
| Line of credit payable to HC  Crown                                                                                                                                    |       | 75,000                             |       | 75,000                        |       |
| Payable to Hallmark  Entertainment Holdings, Inc.                                                                                                                      |       | 52,052                             |       | 52,052                        |       |
| Payable to Hallmark  Entertainment, Inc.                                                                                                                               |       | 47,948                             |       | 47,948                        |       |
| Senior unsecured note to HC  Crown, including accrued interest.                                                                                                        |       | 417,083                            |       | 438,459                       |       |
| Credit facility, net of  current portion                                                                                                                               |       | 300,000                            |       | 310,000                       |       |
| Capital lease obligation, net  of current portion                                                                                                                      |       | 7,731                              |       | 6,900                         |       |
| Company obligated mandatorily  redeemable preferred interest, including accretion                                                                                      |       | 9,079                              |       | 10,152                        |       |
| Total liabilities                                                                                                                                                      |       | 1,248,259                          |       | 1,275,136                     |       |
| Commitments  and contingencies                                                                                                                                         |       |                               |       |                          |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                             |       |                               |       |                          |       |
| Class A common stock, $.01 par  value; 200,000,000 shares authorized; issued and outstanding shares of  73,863,037 as of December 31, 2003 and June 30, 2004 |       | 739                                |       | 739                           |       |
| Class B common stock, $.01 par  value; 120,000,000 shares authorized; issued and outstanding shares of  30,670,422 as of December 31, 2003 and June 30, 2004 |       | 307                                |       | 307                           |       |
| Paid-in capital                                                                                                                                                        |       | 1,308,880                          |       | 1,332,483                     |       |
| Accumulated other  comprehensive income                                                                                                                                |       | 2,013                              |       | 2,494                         |       |
| Accumulated deficit                                                                                                                                                    |       | (998,488                           | )          | (1,080,551                    | )          |
| Total stockholders’ equity                                                                                                                                        |       | 313,451                            |       | 255,472                       |       |
| Total liabilities and  stockholders’ equity                                                                                                                       |       | $                                  | 1,561,710  |                          | $          | 1,530,608 |   |

 

See accompanying notes to unaudited consolidated financial statements.

 

4

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

**CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS**

**(In thousands, except per share amounts)**

 
| ** **                                                                            | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| ** **                                                                            | ** ** | **2003**                              | ** ** | **2004**                           | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                                            | ** ** | **(Unaudited)**                       | ** ** |
|                                                                                  |       |                                  |       |                               |       |   |   |   |   |
| Revenue:                                                                              |       |                                  |       |                               |       |   |   |   |   |
| Subscriber fees, net                                                                  |       | $                                     | 17,864     |                               | $          | 20,193 |   | $ | 33,890 |   | $ | 40,152 |   |
| Advertising                                                                           |       | 23,321                                |       | 31,053                             |       | 45,330 |   | 60,708 |   |
| Advertising by Hallmark Cards                                                         |       | 350                                   |       | 444                                |       | 700 |   | 794 |   |
| Film asset license fees                                                               |       | 3,865                                 |       | 4,087                              |       | 7,404 |   | 12,434 |   |
| Other revenue                                                                         |       | 23                                    |       | 63                                 |       | 57 |   | 85 |   |
| Total revenue, net                                                                    |       | 45,423                                |       | 55,840                             |       | 87,381 |   | 114,173 |   |
| Cost of services:                                                                     |       |                                  |       |                               |       |   |   |   |   |
| Programming costs:                                                                    |       |                                  |       |                               |       |   |   |   |   |
| Affiliates                                                                            |       | 9,987                                 |       | 11,234                             |       | 18,724 |   | 21,833 |   |
| Non-affiliates                                                                        |       | 14,087                                |       | 19,802                             |       | 28,793 |   | 39,030 |   |
| Amortization of film assets                                                           |       | 6,809                                 |       | 5,484                              |       | 13,586 |   | 15,466 |   |
| Subscriber acquisition fee  amortization                                              |       | 6,610                                 |       | 6,091                              |       | 12,606 |   | 12,032 |   |
| Depreciation and amortization  of technical facilities                                |       | 1,186                                 |       | 1,183                              |       | 2,371 |   | 2,366 |   |
| Operating costs                                                                       |       | 11,591                                |       | 8,253                              |       | 22,083 |   | 19,863 |   |
| Total cost of services                                                                |       | 50,270                                |       | 52,047                             |       | 98,163 |   | 110,590 |   |
| Selling, general and administrative  expense                                          |       | 12,285                                |       | 17,801                             |       | 26,450 |   | 34,609 |   |
| Marketing expense                                                                     |       | 8,732                                 |       | 8,177                              |       | 14,171 |   | 13,960 |   |
| Reorganization recovery                                                               |       | —                                |       | (279                               | )          | — |   | (279 | ) |
| Depreciation and amortization  expense                                                |       | 2,648                                 |       | 2,317                              |       | 5,071 |   | 4,730 |   |
| Loss from operations                                                                  |       | (28,512                               | )          | (24,223                            | )          | (56,474 | ) | (49,437 | ) |
| Guaranteed preferred  beneficial accretion                                            |       | (12,171                               | )          | —                             |       | (23,218 | ) | — |   |
| Interest expense, net                                                                 |       | (7,514                                | )          | (15,895                            | )          | (14,856 | ) | (31,682 | ) |
| Loss before income taxes                                                              |       | (48,197                               | )          | (40,118                            | )          | (94,548 | ) | (81,119 | ) |
| Income tax provision                                                                  |       | (1,200                                | )          | (469                               | )          | (1,539 | ) | (944 | ) |
| Net loss                                                                              |       | $                                     | (49,397    | )                                  | $          | (40,587 | ) | $ | (96,087 | ) | $ | (82,063 | ) |
| Other comprehensive income  (loss):                                                   |       |                                  |       |                               |       |   |   |   |   |
| Foreign currency translation  adjustment                                              |       | 635                                   |       | 30                                 |       | 410 |   | 481 |   |
| Comprehensive loss                                                                    |       | $                                     | (48,762    | )                                  | $          | (40,557 | ) | $ | (95,677 | ) | $ | (81,582 | ) |
| Weighted average number of  Class A and Class B shares outstanding, basic and diluted |       | 104,465                               |       | 104,533                            |       | 104,465 |   | 104,533 |   |
| Net loss per share, basic and  diluted                                                |       | $                                     | (0.47      | )                                  | $          | (0.39 | ) | $ | (0.92 | ) | $ | (0.79 | ) |

 

See accompanying notes to unaudited consolidated financial statements.

 

5

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

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

 
| ** **                                                                   | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                   | ** ** | **2003**                           | ** ** | **2004** | ** ** |
| ** **                                                                   | ** ** | **(Unaudited)**                    | ** ** |
| CASH  FLOWS FROM OPERATING ACTIVITIES:                                       |       |                               |       |   |   |
| Net  loss                                                                    |       | $                                  | (96,087    | ) | $ | (82,063 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                               |       |   |   |
| Depreciation  and amortization                                               |       | 84,795                             |       | 103,496 |   |
| Accretion  on guaranteed preferred beneficial interest                       |       | 22,018                             |       | — |   |
| Loss  on change in fair value of derivative liability                        |       | 1,200                              |       | — |   |
| Accretion  on convertible debt                                               |       | 5,191                              |       | — |   |
| Accretion  on company obligated mandatorily redeemable preferred interest    |       | —                             |       | 1,073 |   |
| Provision  for allowance for doubtful accounts                               |       | 1,566                              |       | (11 | ) |
| Gain  on sale of property and equipment                                      |       | (15                                | )          | (98 | ) |
| Stock-based  compensation                                                    |       | 323                                |       | 5,808 |   |
| Changes  in operating assets and liabilities:                                |       |                               |       |   |   |
| Increase  in accounts receivable                                             |       | (5,732                             | )          | (4,673 | ) |
| Additions  to program license fees                                           |       | (65,813                            | )          | (44,679 | ) |
| Additions  to subtitling and dubbing                                         |       | (1,767                             | )          | (1,198 | ) |
| Additions  to subscriber acquisition fees                                    |       | (1,224                             | )          | (13,319 | ) |
| Increase  in prepaid and other assets                                        |       | (474                               | )          | (1,870 | ) |
| Decrease  in accounts payable and accrued liabilities.                       |       | (11,710                            | )          | (38,527 | ) |
| Increase  (decrease) in interest payable                                     |       | (768                               | )          | 22,943 |   |
| Increase  (decrease) in subscriber acquisition fees payable                  |       | (23,024                            | )          | 9,796 |   |
| Increase  in license fees payable to affiliates                              |       | 17,264                             |       | 14,259 |   |
| Increase  in payables to affiliates                                          |       | 1,007                              |       | 1,378 |   |
| Increase  (decrease) in deferred revenue                                     |       | (197                               | )          | 1,011 |   |
| Net  cash used in operating activities                                       |       | (73,447                            | )          | (26,674 | ) |
| CASH  FLOWS FROM INVESTING ACTIVITIES:                                       |       |                               |       |   |   |
| Purchases  of property and equipment                                         |       | (1,781                             | )          | (1,206 | ) |
| Proceeds  from disposition of property and equipment                         |       | 38                                 |       | 140 |   |
| Net  cash used in investing activities                                       |       | (1,743                             | )          | (1,066 | ) |
| CASH FLOWS FROM FINANCING  ACTIVITIES:                                       |       |                               |       |   |   |
| Proceeds from tax sharing  agreement with Hallmark Cards                     |       | 21,300                             |       | 23,600 |   |
| Borrowings under the HC Crown  note payable                                  |       | 70,000                             |       | — |   |
| Borrowings under the credit  facility                                        |       | —                             |       | 10,000 |   |
| Distribution to holders of  guaranteed preferred beneficial interest         |       | (7,406                             | )          | — |   |
| Principal payments under  capital lease obligation                           |       | (702                               | )          | (760 | ) |
| Net cash provided by financing  activities                                   |       | 83,192                             |       | 32,840 |   |
| Effect of exchange rate  changes on cash                                     |       | (51                                | )          | 104 |   |
| Net increase in cash and cash  equivalents                                   |       | 7,951                              |       | 5,204 |   |
| Cash and cash equivalents,  beginning of period                              |       | 335                                |       | 4,306 |   |
| Cash and cash equivalents, end  of period                                    |       | $                                  | 8,286      |   | $ | 9,510 |   |
| Supplemental disclosure of  cash and non-cash activities:                    |       |                               |       |   |   |
| Interest paid                                                                |       | $                                  | 7,706      |   | $ | 6,743 |   |
| Interest paid on preferred  securities                                       |       | $                                  | 8,944      |   | $ | — |   |
| Income taxes paid                                                            |       | $                                  | 1,539      |   | $ | 944 |   |

 

See accompanying notes to unaudited consolidated financial statements.

 

6

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

**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**For the Three and Six Months Ended June 30, 2003 and 2004**

 

**1. Business and Organization**

 

***Organization***

 

Crown Media Holdings, Inc. (“Crown MediaHoldings” 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 and in various countries throughout the world. Theinternational operations of the Hallmark Channel are operated by Crown MediaInternational LLC (“Crown Media International”) and, in the United Kingdom, byCrown Entertainment Limited (“Crown Entertainment”). Crown Media Internationalcommenced its operations outside the United States in 1995. Domestically, theHallmark Channel is operated and distributed by Crown Media United States LLC (“CrownMedia United States”). Crown Media International acquired an interest in CrownMedia United States in 1998 and as a result of subsequent transactions CrownMedia Holdings owned 100% of the common interests of Crown Media United Statesby March 2001. Significant investors in Crown Media Holdings includeHallmark Entertainment Investments Co. (“Hallmark Entertainment Investments”),a subsidiary of Hallmark Cards, Incorporated (“Hallmark Cards”), the NationalInterfaith Cable Coalition, Inc. (“NICC”), and, indirectly through theirinvestments in Hallmark Entertainment Investments, Liberty Media Corporation(“Liberty Media”) and J.P. Morgan Partners (BHCA), L. P. (“J.P. Morgan”).

 

***Liquidity***

 

*Cash Flows*

 

As of June 30, 2004, the Company had $9.5 million in cash and cashequivalents on hand and $10.0 million available under its bank credit facility.The Company’s principal sources of funds are currently cash inflows fromoperations, cash on hand, periodic cash inflows expected under the tax sharingagreement with Hallmark Cards and amounts available for borrowing under itsbank credit facility.

 

The Company’s principal uses of funds during 2004 are expected to bethe payment of operating expenses, payments for licensing of programming andsubscriber acquisition fees, and interest payments under its bank creditfacility. As part of the Company’s growth strategy, the Company expects tocontinue making investments in programming and distribution during 2004.

 

As of June 30, 2004, the Company believes that cash inflows fromits operations, cash on hand, remaining availability under its bank creditfacility and payments anticipated under the tax sharing agreement with HallmarkCards, all of which are currently its principal sources of funds, will besufficient to meet its liquidity needs for at least the next twelve months. Inany event, in order to provide more liquidity, we may consider pursuingalternatives to raise additional cash, which could include the issuance ofadditional equity or debt securities or extension of our bank line of credit.There can be no assurance, however, that additional funding will be available,if at all, on terms acceptable to the Company. Any new debt financing wouldrequire the agreement of existing lenders, including HC Crown.

 

*Potential Sale of theInternational Business*

 

On April 13, 2004, the Company announced that it is exploring strategicalternatives for its international operations and the international rights toits film library, including, but not necessarily limited to, a sale or othercorporate transaction in an effort to maximize shareholder value.  Any sale would, and any other corporatetransaction might, require the consent of existing lenders, and be subject toother customary conditions. The Company contemplates using any proceeds fromany such transaction to pay down its debt and/or other obligations.  The Company can not provide assurance thatany such transaction will occur.

 

7

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**2. Summary of Significant Accounting Policies**

 

***Interim Financial Statements***

 

In the opinion ofmanagement, the accompanying consolidated balance sheets and related interimconsolidated statements of operationsand cash flows, include all adjustments, consisting of normal recurring itemsnecessary for their fair presentation in conformity with accounting principlesgenerally accepted in the United States. Interim results are not necessarilyindicative of results for a full year.The information included in this Form 10-Q should be read in conjunction withManagement’s Discussion and Analysis and consolidated financial statements andnotes thereto included in the Crown Media Holdings, Inc. 2003 Annual Report onForm 10-K.

 

***Principles of Consolidation***

 

The consolidated financial statements include the consolidated accountsof Crown Media Holdings, including those of its wholly owned subsidiaries. Allsignificant intercompany balances and transactions have been eliminated inconsolidation.

 

***Cash and Cash Equivalents***

 

Crown Media Holdings considers all highly liquidfinancial instruments purchased with an initial maturity of three months orless to be cash equivalents. The fair value of Crown Media Holdings’ cashequivalents approximates cost at each balance sheet date.

 

***Subscriber Acquisition Fees***

 

Crown Media United States has distribution agreements with every majorpay television distributor (based on the number of subscribers) in the UnitedStates. These distributors carry the Hallmark Channel on certain of theircable, satellite, terrestrial television, or satellite master antennatelevision systems. Under certain of these agreements, Crown Media UnitedStates is obligated to pay subscriber acquisition fees, if defined subscriberlevels are met, in order to obtain additional carriage of the Hallmark Channelby those distributors. Such costs are accrued when Crown Media UnitedStates receives notice from the distributors that they have met the penetrationpercentage or subscriber count defined in the underlying agreements.

 

Subscriber acquisition fees are amortized overthe contractual life of the distribution agreements (ranging from 4 to 9years) as a reduction of subscriber feerevenue. If the amortization expense exceeds the revenue recognized on a perdistributor basis, the excess amortization is included as a component of costof services. Crown Media Holdings assesses the recoverability of these costsperiodically. It also assesses the recoverability when events such as changesin distributor relationships occur or other indicators, which would suggestimpairment.

 

Subscriber acquisition fees are comprised of thefollowing:

 
| ** **                            | ** ** | **As of December 31,  2003** | ** ** | **As of June 30,  2004** | ** ** |
|---------------------------------------|------------|-----------------------------------|------------|-------------------------------|------------|
| ** **                            | ** ** | ** **                        | ** ** | **(unaudited)**               | ** ** |
| ** **                            | ** ** | **(In thousands)**                | ** ** |
| Subscriber acquisition fees,  at cost |       | $                                 | 191,377    |                          | $          | 204,696 |   |
| Accumulated amortization              |       | (78,181                           | )          | (95,661                       | )          |
| Subscriber acquisition fees,  net     |       | $                                 | 113,196    |                          | $          | 109,035 |   |

 

As of December 31, 2003, and June 30,2004, the consolidated balance sheets also reflect subscriber acquisition feespayable of $10.6 million and $19.8 million, respectively. For the three monthsended June 30, 2003 and 2004, Crown Media United States made cash paymentsof $12.8 million and $984,000, respectively, reducing subscriber acquisitionfees payable. For the six months ended June 30, 2003 and 2004, Crown MediaUnited States made cash payments of $24.2 million and $3.5 million,respectively, reducing subscriber acquisition fees payable.

 

8

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Under certain ofthe agreements with distributors mentioned above, additional subscriberacquisition fees will become payable by the Company if defined incrementalsubscriber levels are reached. Under certain of the agreements, the Company mayalso be required to pay substantial marketing support payments, if subscribersexceed proscribed benchmarks, as defined in the respective agreements. Thesemarketing support payments are expensed when it becomes probable thatsubscribers will exceed such benchmarks.

 

***Program License Fees***

 

Program license fees are payable in connectionwith the acquisition of the rights to air programs acquired from others. Inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 63, *Financial Reporting by Broadcasters,* program rights aregenerally deferred and then amortized on a straight-line basis over theirlicense periods or anticipated usage. At the inception of these contracts andperiodically thereafter, Crown Media Holdings evaluates the recoverability ofthese costs compared to the estimated future revenues directly associated withthe programming and related expenses. Where an evaluation indicates that aprogramming contract will ultimately result in a loss, additional amortizationis provided to currently recognize that loss. The Company broadcasts certain ofits film assets on the Hallmark Channel, primarily in its internationalmarkets.  The Company accounts for suchusage by first calculating the cost of the broadcast rights under theindividual-film-forecast-computation method and then amortizes the computedcost over the respective license period using the straight-line method.

 

***Subtitling and Dubbing***

 

Subtitling and dubbing represent costs incurredto prepare programming for airing in international markets. These costs arecapitalized as incurred and are amortized over the shorter of the program’sairing window for programming licensed from unaffiliated third-parties or theprogram’s estimated life for programming licensed from Hallmark EntertainmentDistribution and the Company’s film assets. Costs related to programminglicensed from Hallmark Entertainment Distribution are amortized over a maximumperiod of 3 years. Amortization expense forsubtitling and dubbing costs was $1.2 million and $1.1 million for the threemonths ended June 30, 2003 and 2004, respectively. Amortization expensefor subtitling and dubbing costs was $2.3 million and $2.0 million for the sixmonths ended June 30, 2003 and 2004, respectively.

 
| ** **                              | ** ** | **As of December 31,  2003** | ** ** | **As of June 30,  2004** | ** ** |
|-----------------------------------------|------------|-----------------------------------|------------|-------------------------------|------------|
| ** **                              | ** ** | ** **                        | ** ** | **(unaudited)**               | ** ** |
| ** **                              | ** ** | **(In thousands)**                | ** ** |
| Subtitling and dubbing assets,  at cost |       | $                                 | 7,863      |                          | $          | 7,340 |   |
| Accumulated amortization                |       | (3,016                            | )          | (3,293                        | )          |
| Subtitling and dubbing assets,  net     |       | $                                 | 4,847      |                          | $          | 4,047 |   |

 

***Property and Equipment***

 

Property and equipment are recorded at cost.Depreciation of property and equipment is provided using the straight-linemethod over the estimated useful lives of the respective assets, ranging fromthree to eight years. Leasehold improvements are amortized over the life of theunderlying lease. When a property is sold or otherwise disposed of, the costand related accumulated depreciation and amortization are removed from theaccounts and any resulting gain or loss is included in income. The costs ofnormal maintenance and repairs are charged to expense when incurred.

 

***Accounting for Trust Preferred Securities***

 

In December 2001, Crown Media Holdingsformed a special-purpose entity, Crown Media Trust. Crown Media Trust issuedtrust preferred securities in Crown Media Trust’s name to investors in aprivate placement and loaned the proceeds to Crown Media Holdings. This loanwas designed so that interest and principal payments matched the dividend andany redemption requirements on the trust preferred securities issued by CrownMedia Trust. Interest received by Crown Media Trust from Crown Media Holdingsfunded distributions to the holders of the preferred securities.

 

9

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Crown Media Holdings owned 100% of the commonequity in Crown Media Trust. The trust preferred securities included terms thatallowed the holder to earn a return above the stated dividend rate on thesecurities under certain conditions. Based on fair value calculations usingdiscounted cash flows and Black-Scholes models, a portion of the proceeds fromthe preferred securities was allocated and classified in Crown Media Holdings’balance sheet as guaranteed preferred beneficial interest in Crown MediaTrust’s debentures and a portion was classified as convertible debt. Issuancecosts related to the guaranteed preferred beneficial interest portion were nettedagainst the guaranteed preferred beneficial interest and accreted as additionalexpense in earnings. Issuance costs related to the convertible debt portionwere recorded as a deferred debt issuance costs asset and were amortized asadditional interest expense, using the effective interest method.

 

On December 17, 2001, Crown Media Holdingscompleted the $265.0 million private placement of the trust preferredsecurities to a group of institutional investors. Under the terms of theprivate placement, Crown Media Holdings issued units to the investors, eachunit consisted of one preferred security of Crown Media Trust, and onecontingent appreciation certificate, issued by Crown Media Holdings.

 

Crown Media Holdings calculated the initial valueof the contingent appreciation certificate portion of the trust preferredsecurities by using Black-Scholes models and by using a combination of put andcall options that would provide the same future payout as the convertible debtportion. Crown Media Holdings calculated the initial fair value of theguaranteed preferred beneficial interest portion of the trust preferredsecurities using a discounted cash flow model. The proceeds from the private placement of the trust preferredsecurities of $265.0 million were bifurcated between the convertible debt andguaranteed preferred beneficial interest portions based upon their relativefair values.

 

On August 5, 2003, Crown Media Holdings repurchased all of thepreferred securities of Crown Media Trust and related contingent appreciationcertificates issued by the Company. The securities were repurchased forapproximately $329.1 million, including approximately $2.4 million of scheduledcash distributions on the trust preferred securities during the quarter.

 

***Revenue Recognition***

 

Subscriber fees from pay television distributorsare recognized each month as revenue when an agreement is executed, programmingis provided, the price is determinable, and collectibility is reasonablyassured. Subscriber fees from pay television distributors are recorded net ofamortization of subscriber acquisition costs in accordance with Emerging IssuesTask Force (“EITF”) No. 01-9, *Accounting forConsideration Given by a Vendor to a Customer (Including a Reseller of theVendor’s Products)*. Subscriber acquisition fee expense is recordedto the extent that the amortization of subscriber acquisition costs exceeds therelated revenue earned from the pay television distributor.

 

Advertising revenues are recognized as earned in the period in which theadvertising is telecast and are generally billed monthly in arrears. If thecollectibility of this revenue is not reasonably assured with any individualcustomer, the revenue is not recognized until cash is received. 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.

 

Advertising revenue and expenses in bartertransactions are recorded at the fair value of the advertising to be provided.The fair value is determined based upon amounts paid in cash for similaradvertisements from buyers unrelated to the other party in the bartertransaction. When the revenue does not meet the requirements of EITF No. 99-17,*Accounting for Advertising Barter Transactions,*no revenue is recognized. For each of the three and six months endedJune 30, 2003, revenue from advertising barter transactions of $94,000 andthe corresponding barter expenses were included as a component of bothadvertising revenue and marketing expenses in the accompanying consolidatedstatements of operations. For each of the three and six months endedJune 30, 2004, the Company did not record any revenue from advertisingbarter transactions.

 

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Revenue from film asset licensing agreements isrecognized when an agreement is executed, the film is available for exhibitionby the licensee, the license fee is fixed or reasonably determinable,collectibility is reasonably assured and the cost of each film is known orreasonably determinable. Revenue from film asset licensing agreementscontaining multiple film titles is allocated among the various film titlesbased on their relative fair values. Payments received from licensees prior tothe availability of a film are recorded as deferred revenue.

 

Revenues from foreign sources for the threemonths ended June 30, 2003 and 2004, represented 47% and 40%,respectively, of total revenue. Revenues from foreign sources for the sixmonths ended June 30, 2003 and 2004, represented 46% and 40%,respectively, of total revenue. Such revenues, generally denominated in UnitedStates dollars, were primarily from sales to customers in Australia, India,Malaysia, Mexico, Philippines, Poland, Singapore, South Africa, South Korea, Taiwan,and the United Kingdom, during all periods presented. The Company recordsrevenue from certain foreign countries only when the cash is received due tothe uncertainty regarding collection. For the three months ended June 30,2003 and 2004, $1.2 million and $396,000, respectively, was invoiced, but notrecorded as revenue. For the six months ended June 30, 2003 and 2004, $2.9million and $597,000, respectively, was invoiced, but not recorded as revenue.

 

***Cost of Services***

 

Cost of services includes signal distributionexpenses, depreciation of the Company’s Network Operations Center andamortization of the capital lease for uplink and transponder space,amortization of program license fees, subtitling and dubbing amortization andcosts, subscriber acquisition amortization in excess of subscriber revenue andcosts, and amortization of film assets.

 

***Film Assets***

 

InSeptember 2001, the Company acquired certain film assets from HallmarkEntertainment Distribution. The Company amortizes its film assets using theindividual-film-forecast-computation method over a maximum period of 10 years.The individual-film-forecast-computation method amortizes such assets in thesame ratio that current period actual revenue bears to estimated unrecognizedultimate revenues. The Company’s projections of ultimate revenue regardingsales of certain rights related to its film assets to third parties andanticipated internal use of its film assets are based on the history of eachfilm and similar films, sales and marketing plans, and other factors, all ofwhich require significant judgment by management. The 10-year period used forsales to third parties and internal use commences on the date of acquisition.

 

TheCompany reviews the film assets for impairment at least annually or morefrequently if events or changes in circumstances indicate that the carryingamount of the film assets may not be recoverable. If the carrying value of theindividual film assets exceeds its fair value, the film assets are written-downto their fair values. On an annual basis, the Company is required by thecovenants in its credit agreement to have an outside expert perform a valuationof the film assets. This valuation supported the Company’s determination thatthe estimated fair value of the film assets exceeded the carrying value atDecember 31, 2003. A discounted cash flows model is used by the Companyand its valuation expert to estimate fair value. Future cash flows are based onthe terms of any existing contractual arrangements plus the projected cashinflows from future license sales. The Company and its valuation expertconsidered the following factors, among others, in estimating future cashinflows for a film:  (a) if previouslyreleased, the film’s performance in historical markets, (*b*) the public’s perception of the film’sstory, cast, director, or producer, (*c*)historical results of similar films, (*d*)historical results of the cast, director, or producer on prior films, and (*e*) running time of the film.  Inestimating a film’s fair value, the Company and its valuation expert considerthose cash outflows necessary to generate the film’s cash inflows. Therefore, future exploitation and participation costs are factored into theestimation of fair value. When estimating the fair value of a film under thediscounted cash flow methodology, the discount rate is determined using acombination of the estimated incremental borrowing rate of the Company’s filmlicense customers in the case of projected third party sales, and the Company’sincremental borrowing rate in the case of projected internal use.

 

Amortizationexpense for the film assets was $6.8 million and $5.5 million for the threemonths ended June 30,

 

11

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2003 and 2004,respectively. Amortization expense for the film assets was $13.6 million and$15.5 million for the six months ended June 30, 2003 and 2004,respectively. Based upon the carrying amount of the film assets atJune 30, 2004, the Company expects to amortize $55.0 million to $65.0 millionof film assets during the year ending December 31, 2004.

 
| ** **               | ** ** | **As of December 31,  2003** | ** ** | **As of June 30,  2004** | ** ** |
|--------------------------|------------|-----------------------------------|------------|-------------------------------|------------|
| ** **               | ** ** | ** **                        | ** ** | **(unaudited)**               | ** ** |
| ** **               | ** ** | **(In thousands)**                | ** ** |
| Film assets              |       | $                                 | 810,928    |                          | $          | 810,928 |   |
| Residual assets          |       | 9,129                             |       | 11,298                        |       |
| Accumulated amortization |       | (69,320                           | )          | (84,689                       | )          |
| Film assets, net         |       | $                                 | 750,737    |                          | $          | 737,537 |   |

 

***Goodwill***

 

The Company hasallocated all of its goodwill to its domestic reporting unit, Crown MediaUnited States, since the goodwill was recorded as a result of a series oftransactions whereby the Company became the owner of 100% of the membershipunits of Crown Media United States.  In accordance with SFAS No. 142, *Goodwill and Other Intangible Assets*, Crown Media Holdingsceased amortizing goodwill on January 1, 2002. Annually, the Companyemploys a valuation expert to evaluate the carrying value of the Company’sgoodwill for impairment, as required by SFAS No. 142.  The Company has selected November 30 asits annual goodwill impairment review date. The evaluation utilized adiscounted cash flow methodology to estimate the fair value of the domesticreporting unit. The estimated cash flow available for distribution over aten-year period was added to the estimated terminal value and discounted to thepresent using the domestic reporting unit’s estimated weighted average cost ofcapital.  The assumptions utilized in thediscounted cash flow model required significant judgment by management and itsvaluation expert. As this valuation exceeded the carrying value of the domesticreporting unit as of November 30, 2003, the step one test described bySFAS No. 142 was deemed to have been passed and the step two test was notperformed.

 

***Taxes on Income***

 

Pursuant to the Tax Sharing Agreement enteredinto with Hallmark Cards on March 11, 2003, the Company’s results ofoperations for tax purposes became a part of the Hallmark Cards consolidatedfederal tax return as of and subsequent to March 11, 2003.  However, the Company continues to account forincome taxes on a separate return basis. The Company accounts for income taxesusing an asset and liability method that requires the recognition of deferredtax assets and liabilities for the expected future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases and netoperating loss and tax credit carryforwards. Deferred tax assets andliabilities are measured using enacted tax rates expected to be applied totaxable income in the years in which those temporary differences are expectedto be recovered or settled. The Company reduces deferred tax assets by avaluation allowance if it is more likely than not that some portion or all ofthe deferred tax assets will not be realized. Any payments received fromHallmark Cards under the Tax Sharing Agreement are recorded as an increase inpaid-in capital and any future reversal of the valuation allowance will berecorded as a reduction in paid-in capital, to the extent payments werereceived for such benefits under the Tax Sharing Agreement.

 

***Translation of Foreign Currency***

 

The balance sheets and statements of operationsof certain Crown Media Holdings’ foreign subsidiaries are measured using localcurrency as the functional currency. Revenues, expenses and cash flows of suchsubsidiaries are translated into United States dollars at the average exchangerates prevailing during the period. Assets and liabilities are translated atthe rates of exchange at the balance sheet date. Translation gains and lossesare deferred as a component of accumulated other comprehensive income (loss).Foreign currency transaction gains and losses recorded upon the remeasurementof financial assets and liabilities denominated in currencies other than thefunctional currency of the subsidiary are included in determining net loss forthe period.

 

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***Net Loss Per Share***

 

Basic net loss per share is computed by dividingthe net loss for the period by the weighted average number of common sharesoutstanding during the period. Diluted net loss per share is computed based onthe weighted average number of common shares and potentially dilutive commonshares outstanding. The calculation of diluted net loss per share excludespotential common shares if the effect would be antidilutive. Potential commonshares consist of incremental common shares issuable upon the exercise of stockoptions and restricted stock units. Approximately 1.7 million and 1.4 millionstock options for the three and six months ended June 30, 2003 and 2004,respectively, have been excluded from the calculations of diluted earnings pershare because their effect would have been antidilutive. Approximately 2.1million restricted stock units for the three and six months ended June 30,2003, respectively, have been excluded from the calculations of dilutedearnings per share because their effect would have been antidilutive.Approximately 2.8 million restricted stock units for the three and six monthsended June 30, 2004, respectively, have been excluded from thecalculations of diluted earnings per share because their effect would have beenantidilutive. Additionally, 10.1 million contingent appreciation certificatesissued in conjunction with the private placement of the trust preferred securitieshave also been excluded from the calculations of diluted earnings per share forthe three and six months ended June 30, 2003, as their effect would havebeen antidilutive.

 

***Stock-Based Compensation, Employee Incentives and Retention***

 

The Company accounts for its stock-based employeecompensation plan using the intrinsic value method under the recognition andmeasurement principles of Accounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees,* and relatedInterpretations. Accordingly, compensation cost for stock options issued toemployees is measured as the excess, if any, of the quoted market price of theCompany’s stock at the date of the grant over the exercise price of theunderlying stock options. In December 2002, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 148, *Accountingfor Stock-Based Compensation – Transition and Disclosure – an amendment of SFASNo. 123.*SFAS No. 148 requires certain additional disclosures of theestimated fair value of stock-based compensation. Such estimated fair value isdetermined through the use of the Black-Scholes option pricing model. SFAS No.123, *Accounting for Stock-Based Compensation,*encourages, but does not require, companies to record compensation cost for stock-basedemployee compensation plans at fair value.

 

In April 2003, theCompany’s Board of Directors approved actions to provide additional incentivesto encourage retention of its employees. Crown Media Holdings’ then outstandingstock options held by employees had exercise prices significantly above thecurrent market value of its Class A common stock.  The Company made an offer in May 2003 tosenior management and vice presidents, totaling approximately 55 persons, toexchange their options for restricted stock units (“RSUs”).  The exchange ratio was one RSU for every 2.5options for shares of the Company’s Class A common stock, resulting in a totalof 5,126,732 options exchanged for 2,050,693 RSUs. Each RSU, upon vesting,represents the right to receive one share of Class A common stock or the valueof the share in cash at the time of vesting. The RSUs vest over three years in one-third increments on theanniversary of the grant date each year. The Company’s Board may determine, atits discretion, whether the payment is made in common stock or cash for each ofthe one-third increments. As a result of the Board’s decision to settle thefirst one-third increment in cash, Crown Media Holdings is recordingcompensation expense based on the fair value of the common stock required tosettle the RSUs at each reporting period end during the vesting period of theRSUs. Such compensation expense is calculated using variable plan accounting.Options for 279,254 shares of common stock that were not exchanged are alsosubject to variable plan accounting in which compensation is remeasured at eachreporting date until the options are exercised, expire unexercised or areforfeited.

 

In May 2004, the Company’s Board of Directors approved an additionalgrant to employees of 1,065,000 RSUs. The Employment RSUs, which constitute 70%of the award, vest in equal one-third installments over the next three years onthe anniversary of the grant date each year. The Company is accruing expenserelated to the Employment RSUs ratably over each installment’s vesting period.The Performance RSUs, constituting 30% of the grant, vest on the 3rdanniversary of the grant date, provided that the price of the Crown commonstock is $14 or higher on that date. The Company will begin to accrue compensationexpense for the Performance RSUs when it becomes probable that the price of theCompany’s stock will be $14 or more on the 3rd anniversary of thegrant date. The Company’s Board determines, whether the RSUs are settled incash or common stock. Crown Media Holdings is

 

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adjustingcompensation expense at the end of each reporting period based on the fairvalue of the common stock required to settle the RSUs. Such compensationexpense is calculated using variable plan accounting.

 

In May 2004, the Company granted 115,000 RSUs to a Company executiveand changed the original vesting terms of this employee’s 2003 grant such thatone-half of the grant will vest in January 2004 and the other half will vestin January 2005. Compensation expense already recorded for this employee’s2003 grant will not be adjusted, rather, compensation expense for the remainingunvested portion of the grant will be accrued in one-half increments ratablyover the new vesting periods. Crown Media Holdings is adjusting compensationexpense at the end of each reporting period based on the fair value of thecommon stock required to settle the RSUs at each reporting period end duringthe vesting period of the RSUs. Such compensation expense is calculated usingvariable plan accounting.

 

The Company recorded $317,288 of compensation expense associated withthe RSUs during the three and six months ended June 30, 2003, which hasbeen recorded as an accrued liability in the accompanying consolidated balancesheet and is included in selling, general and administrative expense in theaccompanying consolidated statement of operations. The Company recorded $3.5million and $5.8 million of compensation expense associated with the RSUs duringthe three and six months ended June 30, 2004, respectively, which has beenrecorded as an accrued liability in the accompanying consolidated balance sheetand is included in selling, general and administrative expense in theaccompanying consolidated statement of operations. The Company settled the first one-third incrementof the 2003 RSUs in June 2004 for approximately $3.5 million in cash.

 

In addition, in May 2003, the Company’s Board immediately vested thestock options of all employees below the vice-president level who held optionsat that time and granted them a right to receive a future cash payment of $1.00for each outstanding option held by the employee. The immediate vesting of theemployees’ stock options created a new measurement date which required theCompany to record stock compensation expense, if any, for the excess of theCompany’s stock price on the measurement date over the underlying stockoptions’ exercise price.  Since the priceof the Company’s Class A common stock on the measurement date was less than theexercise price of all of the stock options owned by the employees, nocompensation expense was recorded under APB 25. However, the June 2004cash payments totaling $344,386 was contingent upon each respective employees’continuous employment through that date. As a result, the Company was recordingcompensation expense from June 2003 through May 2004 as the compensationwas earned. For the three and six months ended June 30, 2003, $29,000 ofcompensation expense was recorded related to this obligation, which has beenincluded in accrued liabilities in the accompanying consolidated balance sheet.For the three and six months ended June 30, 2004, $60,000 and $140,000 ofcompensation expense was recorded related to this obligation, which has beenincluded in accrued liabilities in the accompanying consolidated balance sheet.In June 2004, eligible employees received the $1.00 per option payment.

 

Had compensation expense for these plans beendetermined consistent with SFAS No. 123, Crown Media Holdings’ net loss andloss per share would have been increased to the following pro forma amounts forthe three and six months ended June 30, 2003 and 2004:

 

**Pro Forma Effects**

**(unaudited)**

**(In thousands, except per share amounts)**

 

| ** **                                                     | ** ** | **Three Months ended  June 30,** | ** ** | **Six Months ended June 30,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| ** **                                                     | ** ** | **2003**                              | ** ** | **2004**                           | ** ** | **2003** | ** ** | **2004** | ** ** |
|                                                           |       |                                  |       |                               |       |   |   |   |   |
| Net loss                                                       |       | $                                     | (49,397    | )                                  | $          | (40,587 | ) | $ | (96,087 | ) | $ | (82,063 | ) |
| Pro forma stock options  expense at  estimated fair value |       | (1,654                                | )          | (646                               | )          | (3,308 | ) | (1,323 | ) |
| Stock plan expense included in  net loss                       |       | 3                                     |       | —                             |       | 6 |   | — |   |
| Pro forma net loss                                             |       | $                                     | (51,048    | )                                  | $          | (41,233 | ) | $ | (99,389 | ) | $ | (83,386 | ) |
| Weighted average shares                                        |       | 104,465                               |       | 104,533                            |       | 104,465 |   | 104,533 |   |
| Pro forma net loss per share,  basic and diluted               |       | $                                     | (0.49      | )                                  | $          | (0.39 | ) | $ | (0.95 | ) | $ | (0.80 | ) |

 

There were no stock options granted during 2003 or during the three andsix months ended June 30, 2004.

 

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***Derivative Financial Instruments***

 

The Company follows the provisions of SFAS No.133, *Accounting for Derivative Instruments and HedgingActivities,* as amended. The standard requires the recognition of allderivative instruments on the balance sheet as either assets or liabilitiesmeasured at fair value. Changes in fair value are recognized immediately inearnings unless the derivatives qualify as hedges of future cash flows. TheCompany discontinues hedge accounting prospectively when it is determined thatthe derivative is no longer effective in offsetting the cash flows of thehedged item, the derivative expires or is sold, terminated or exercised, or thederivative is no longer designated as a hedging instrument. Changes in the fairvalue of the contingent appreciation certificates included in the trustpreferred securities were recognized immediately in earnings.  The trust preferred securities wererepurchased in August 2003 and the cost associated with the settlement ofthe contingent appreciation certificates has been included in the loss on earlyextinguishment of debt in the accompanying consolidated statements ofoperations.

 

***Use of Estimates***

 

The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesrequires Crown Media Holdings to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. Actual resultscould differ from those estimates. Significant estimates employed by theCompany are as follows.

 

The Company estimates and records the level of subscriber fees onemonth in advance based upon the actual prior month’s subscriber levels. TheCompany’s advertising revenue is heavily reliant upon third party ratingsestimates to determine the quantity of advertising delivered to viewers.

 

When multiple films are sold under a single arrangement, in order toproperly recognize revenue when each license fee commences, the Company must estimatethe relative fair value of each film and allocate the total contracted price tothe different films in the arrangement. The Company’s estimation of relativefair value uses similar information as is used in its annual third partyvaluation of its film assets.

 

The Company has established an allowance fordoubtful accounts based upon historical charge-off experience. Periodically,management analyzes the attributes of the accounts which management haswritten-off during the period and adjusts the allowance percentages managementapplies to its aged receivable balances.

 

The initial recoverability of subscriber acquisition fees is evaluatedby projecting the incremental subscriber fee and advertising revenueattributable to the incremental subscribers obtained through the distributionagreement.  This analysis includessignificant judgment and estimation by management in terms of the estimatedincremental advertising per subscriber.

 

The Company amortizes its film assets using the individual-film-forecast-computationmethod over a maximum period of 10 years from the date of acquisition,which amortizes such assets in the same ratio that current period actualrevenue bears to estimated unrecognized ultimate revenues. Estimatedunrecognized ultimate revenues are based on the history of each film andsimilar films, sales and marketing plans, and other factors, all of whichrequire significant judgment by management.

 

***Concentration of Credit Risk***

 

Financialinstruments, which potentially subject Crown Media Holdings to a concentrationof credit risk, consist primarily of cash, restricted cash, cash equivalentsand accounts receivable. Generally, Crown Media Holdings does not requirecollateral to secure receivables. Crown Media Holdings has no significant off-balancesheet financial instruments with risk of accounting losses.

 

***Fair Value***

 

Accounts payable and receivable, are reasonableestimates of their fair values because of their short-term nature.

 

15

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The interest rates on the bank credit facilityand the line of credit with HC Crown are variable and/or reset periodically,therefore, the fair value of this debt is not significantly affected byfluctuations in interest rates. The carrying amount of the senior unsecurednote to HC Crown at June 30, 2004, was $438.5 million, its fair value was$431.7 million and its unrealized gain was $6.8 million, assuming an interestrate of 10.50%. The company obligated mandatorily redeemable preferred interestwas revalued to its fair value as of July 1, 2003, upon adoption of SFASNo. 150 *Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity. *The Company estimates the fair value of the company obligatedmandatorily redeemable preferred interest on an annual basis in November as itis not practicable to perform the valuation more frequently.  The Company employs a discounted cash flowapproach to value the company obligated mandatorily redeemable preferredinterest that involves a significant amount of time to perform.  The valuation is dependent upon the futurepre-tax income of Crown Media United States since the Company is only obligatedto make payments on the instrument to the extent pre-tax income is generated byCrown Media United States.

 

***Recently Issued Accounting Pronouncements***

 

At a recent meeting, the FASB unanimously voted for proposed accountingstandards relating to equity-based compensation to be effective for fiscalperiods beginning after December 15, 2004 (January 1, 2005 for theCompany).  An exposure draft was released in the first quarter of 2004 andthe final standard is expected to be issued in 2004.  The accountingstandard is expected to require all companies to utilize the fair value methodof accounting for equity-based compensation in accordance with SFAS No. 123,“Accounting for Stock-Based Compensation.” Companies can currently voluntarilyadopt SFAS No. 123, using a variety of adoption methods.  The Company iscurrently evaluating the impact of the proposed accounting standards and theadoption alternatives provided under both the current standards and theproposed standards.  Crown Media Holdings discloses the pro forma impactof stock based compensation on its earnings in its notes to financial statements.

 

In December 2003, the FASB issued an exposure draft that wouldamend the computational guidance in SFAS No. 128, “Earnings per Share,” forcalculating the number of incremental shares included in diluted shares whenapplying the treasury stock method.  Also, this proposed Statement wouldeliminate the provisions of SFAS No. 128 that allow an entity to rebut thepresumption that contracts with the option of settling in either cash or stockwill be settled in stock.  In addition, this proposed Statement wouldrequire that shares that will be issued upon conversion of a mandatorilyconvertible security be included in the weighted-average number of ordinaryshares outstanding used in computing basic earnings per share from the datewhen conversion becomes mandatory.  This Statement will be effective forfiscal periods beginning after December 15, 2004 (January 1, 2005 forthe Company). After the effective date, all prior-period earnings per sharedata presented shall be adjusted retrospectively (including interim financialstatements, summaries of earnings and selected financial data) to conform withthe provisions of this Statement.  At this time, the Company does notbelieve any prior period earnings per share restatements will result from theexposure draft, since all of the Company’s convertible financial instrumentsare already included in the diluted earnings per share calculation.

 

**3. Reorganization**

 

InOctober 2002, the Company began reorganizing its operations in order toconcentrate its efforts on the Hallmark Channel in the U.S. and in its moresuccessful international markets.  TheCompany completed decentralizing many oversight and non-technical supportfunctions formerly located in the Company’s U.S.-based offices and transferredthose responsibilities to regional staff. In Latin America, the Company entered into an agreement with a localdistribution partner, Pramer S.C.A., who is now responsible for the day-to-dayoperations of the Hallmark Channel in this region.  At the completion of the reorganization inApril 2003, the Company’s workforce was reduced by approximately 30% or130 positions. Accordingly, the Company recorded a reorganization charge of$28.8 million during the fourth quarter of 2002. This charge was comprised of acharge of $5.5 million for severance costs and charges of $23.3 million relatedto exit costs for permanently abandoned satellite, transponder and facilityleases.

 

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The followingtable displays the activity and balances of the reorganization accrual accountfrom December 31, 2002, to June 30, 2004, which have been included inaccounts payable and accrued liabilities in the accompanying consolidatedbalance sheets.

 
| ** **                                 | ** ** | **Severance**      | ** ** | **Facilities** | ** ** | **Satellite and  Transponder** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|--------------------|------------|----------------|------------|--------------------------------|------------|-----------|------------|
| ** **                                 | ** ** | **(In thousands)** | ** ** |
|                                       |       |               |       |           |       |                           |       |      |       |
| Balance at December 31, 2003          |       | $                  | 4          |           | $          | 1,523                          |       | $         | 13,511     |   | $ | 15,038 |   |
| Additions due to accretion                 |       | —             |       | —         |       | 22                             |       | 22        |       |
| Deductions due to payments                 |       | —             |       | (67            | )          | (923                           | )          | (990      | )          |
| Balance at March 31, 2004             |       | 4                  |       | 1,456          |       | 12,610                         |       | 14,070    |       |
| Additions due to accretion                 |       | —             |       | —         |       | 16                             |       | 16        |       |
| Deductions due to adjustments to estimates |       | (4                 | )          | (126           | )          | (149                           | )          | (279      | )          |
| Deductions due to payments                 |       | —             |       | (142           | )          | (919                           | )          | (1,061    | )          |
| Balance at June 30, 2004              |       | $                  | —     |           | $          | 1,188                          |       | $         | 11,558     |   | $ | 12,746 |   |

 

**4. Program license fees**

 

Program license fees are comprised of thefollowing:

 

| ** **                           | ** ** | **As of December 31,  2003** | ** ** | **As of June 30,  2004** | ** ** |
|--------------------------------------|------------|-----------------------------------|------------|-------------------------------|------------|
| ** **                           | ** ** | ** **                        | ** ** | **(unaudited)**               | ** ** |
| ** **                           | ** ** | **(In thousands)**                | ** ** |
| Hallmark Entertainment  Distribution |       | $                                 | 112,069    |                          | $          | 113,003 |   |
| NICC                                 |       | 1,885                             |       | 8,326                         |       |
| Other affiliates                     |       | 5,906                             |       | 5,906                         |       |
| Non-affiliates                       |       | 242,329                           |       | 248,898                       |       |
| Program license fees, at cost        |       | 362,189                           |       | 376,133                       |       |
| Accumulated amortization             |       | (115,696                          | )          | (147,588                      | )          |
| Program license fees, net            |       | $                                 | 246,493    |                          | $          | 228,545 |   |

 

Programming costsfor the three months ended June 30, 2003 and 2004, were $24.1 million and$31.0 million, respectively. Programming costs for the six months endedJune 30, 2003 and 2004, were $47.5 million and $60.9 million,respectively. Amortization of program license fees, included as a component ofprogramming cost in the accompanying consolidated statements of operations, was$22.5 million and $31.3 million for the three months ended June 30, 2003and 2004. Amortization of program license fees, included as a component ofprogramming cost in the accompanying consolidated statements of operations, was$46.3 million and $60.9 million for the six months ended June 30, 2003 and2004.

 

AtDecember 31, 2003, and June 30, 2004, $4.8 million and $4.5 million,respectively, of program license fees were included in prepaid and other assetson the accompanying consolidated balance sheets since the airing windows hadnot begun but payment had been made.

 

License fees payable are comprised of thefollowing:

 

| ** **                           | ** ** | **As of December 31,  2003** | ** ** | **As of June 30,  2004** | ** ** |
|--------------------------------------|------------|-----------------------------------|------------|-------------------------------|------------|
| ** **                           | ** ** | ** **                        | ** ** | **(unaudited)**               | ** ** |
| ** **                           | ** ** | **(In thousands)**                | ** ** |
| Hallmark Entertainment  Distribution |       | $                                 | 90,609     |                          | $          | 102,353 |   |
| NICC                                 |       | 291                               |       | 2,807                         |       |
| Non-affiliates                       |       | 169,810                           |       | 137,285                       |       |
| Total license fees payable           |       | 260,710                           |       | 242,445                       |       |
| Less current maturities              |       | (118,391                          | )          | (115,116                      | )          |
| Long-term license fees payable       |       | $                                 | 142,319    |                          | $          | 127,329 |   |

 

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**5. Property and Equipment**

 

Property and equipment are comprised of thefollowing:

 

| ** **                                 | ** ** | **As of December 31,  2003** | ** ** | **As of June 30,  2004** | ** ** | **Life  (In years)** | ** ** |
|--------------------------------------------|------------|-----------------------------------|------------|-------------------------------|------------|----------------------|------------|
| ** **                                 | ** ** | ** **                        | ** ** | **(unaudited)**               | ** ** | ** **           | ** ** |
| ** **                                 | ** ** | **(In thousands)**                | ** ** | ** **                    | ** ** |
| Technical equipment and  computers         |       | $                                 | 40,927     |                          | $          | 41,454               |       | 3-5 |   |
| Leased asset                               |       | 13,252                            |       | 13,252                        |       | 8                    |       |
| Furniture, fixtures and  equipment         |       | 2,182                             |       | 2,106                         |       | 5                    |       |
| Leasehold improvements                     |       | 11,369                            |       | 11,111                        |       | 3-7                  |       |
| Construction-in-progress                   |       | 812                               |       | 762                           |       |                 |       |
| Property and equipment, at  cost           |       | 68,542                            |       | 68,685                        |       |                 |       |
| Accumulated depreciation and  amortization |       | (39,307                           | )          | (43,612                       | )          |                 |       |
| Property and equipment, net                |       | $                                 | 29,235     |                          | $          | 25,073               |       |   |   |

 

Depreciation and amortization expense related to property and equipmentwas $2.9 million and $2.6 million for the three months ended June 30, 2003and 2004, respectively. Depreciation and amortization expense related toproperty and equipment was $5.7 million and $5.3 million for the six months endedJune 30, 2003 and 2004, respectively. Software and other intangibleassets, net of accumulated amortization, of $4.6 million and $3.9 million as ofDecember 31, 2003, and June 30, 2004, respectively, have beenincluded in prepaid and other assets in the accompanying consolidated balancesheets.

 

**6. Credit Facility**

 

In connection with the completion of the purchase of the film assets,Crown Media Holdings entered into a credit agreement with a syndicate of banks,led by JP Morgan Chase Bank, under which the banks have extended to Crown MediaHoldings a five-year $320.0 million secured credit facility. The creditfacility includes a term loan of $100.0 million and a revolving line of creditof $220.0 million, up to $20.0 million of which can be letters of credit issuedat the request of Crown Media Holdings. At June 30, 2004, Crown MediaHoldings had outstanding borrowings of $310.0 million under the credit facilityand there were no letters of credit outstanding. The entire balance is due in2006 and, therefore, is classified as a non-current liability in theaccompanying consolidated balance sheets. This loan is guaranteed by CrownMedia Holdings’ subsidiaries and is secured by all tangible and intangibleproperty of Crown Media Holdings and its subsidiaries. The Company is obligatedto maintain certain financial debt covenants in conjunction with the creditfacility. As of March 31, 2004, the Company was not in compliance with thetwelve-month trailing EBITDA covenant (as defined) associated with its bankcredit facility. On May 4, 2004, the Company amended its bank credit facilityand obtained a waiver for this event of non-compliance.

 

Interest expense on borrowings under the creditfacility for the three months ended June 30, 2003 and 2004, was $3.5million and $3.3 million, respectively. Interest expense on borrowings underthe credit facility for the six months ended June 30, 2003 and 2004, was$7.0 million and $6.4 million, respectively.

 

**7. Related Party Transactions**

 

***Senior Unsecured Note***

 

In August 2003, the Company issued a senior unsecured note to HCCrown for $400.0 million. A portion of the proceeds was used to repurchase theCompany’s outstanding trust preferred securities, and the balance of theproceeds, after expenses, was used to reduce amounts outstanding under its bankcredit facility.

 

The senior unsecured note payable to HC Crown does not require cashinterest payments for four years. Instead, the principal amount of the seniorunsecured note accretes at 10.25% per annum, compounding semi-annually, to$596.6 million on August 5, 2007. From that date, interest at 10.25% per annum will be payablesemi-annually on the accreted value of the senior unsecured note to HC Crown.  The note matures on August 5, 2011, andmay be prepaid by Crown Media Holdings at any time after August 5, 2004,without penalty. At December 31, 2003, $400.0 million of principal and$17.1 million of accreted interest were included in the senior unsecured notepayable in the accompanying consolidated balance sheet. At June 30, 2004,$400.0 million of principal and $38.5 million of

 

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accrued interest wereincluded in the senior unsecured note payable in the accompanying consolidatedbalance sheet. The note purchase agreement for the senior unsecured notecontains certain covenants which restrict on the part of the Company, amongother matters, from the incurrence of any additional indebtedness, therepurchase or other acquisitions of the Company’s stock, investments in other partiesand 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 is being amortized as additionalinterest expense over the term of the note payable.

 

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

 

OnDecember 14, 2001, the Company executed a line of credit promissory notewith a maturity date of December 21, 2007, in the amount of $75.0 millionpayable to HC Crown. This note replaced the promissory note previously issuedto HC Crown dated September 28, 2001. This line of credit is subordinateto the bank credit facility. The rate of interest under this line of credit isequal to LIBOR plus three percent, payable quarterly. At both December 31,2003, and June 30, 2004, borrowings under the note were $75.0 million.Accrued interest on the note of $2.7 million and $4.2 million as ofDecember 31, 2003, and June 30, 2004, respectively, is included ininterest payable to HC Crown on the accompanying consolidated balance sheets.

 

***Tax Sharing Agreement***

 

On March 11, 2003, Crown Media Holdings became a member ofHallmark Cards consolidated federal tax group and entered into a federal taxsharing agreement with Hallmark Cards (the “Tax Sharing Agreement”). HallmarkCards includes Crown Media Holdings in its consolidated federal income taxreturn.  Accordingly, Hallmark Cards hasbenefited from past tax losses and will benefit from future federal tax losses,which may be generated by Crown Media Holdings. Based on the Tax Sharing Agreement, Hallmark Cards has agreed to payCrown Media Holdings all of the benefits realized or realizable by HallmarkCards as a result of including Crown Media Holdings in its consolidated incometax return, 75% in cash on a quarterly basis and the balance when Crown MediaHoldings becomes a federal taxpayer. Under the Tax Sharing Agreement, at Hallmark Cards’ option, the balanceof the 25% in federal tax benefits may also be applied as an offset against anyamounts owed by Crown Media Holdings to any member of the Hallmark Cardsconsolidation group under any loan, line of credit or other payable, subject tolimitations under any loan indentures or contracts restricting such offsets. Asof June 30, 2004, Hallmark Cards has not exercised this option.

 

The Company received $49.4 million under the Tax Sharing Agreementduring 2003. The Company received $21.3 million and $23.6 million under the TaxSharing Agreement during the six months ended June 30, 2003 and 2004,respectively. These receipts have been recorded as an addition to paid-incapital in the accompanying consolidated balance sheet.

 

***Hallmark Entertainment Investments***

 

On March 11, 2003, Hallmark EntertainmentHoldings, Inc. (“Hallmark Entertainment Holdings”,a wholly-owned subsidiary of Hallmark Cards) contributed 100% of the CrownMedia Holdings shares owned by it to Hallmark Entertainment Investments. Two ofCrown Media Holdings’ investors, Liberty Crown, Inc., a subsidiary of LibertyMedia, and JP Morgan, also contributed 100% of their Crown Media Holdingsshares to Hallmark Entertainment Investments, and VISN contributed 10% of itsCrown Media Holdings shares to Hallmark Entertainment Investments, all inreturn for shares in Hallmark Entertainment Investments. Hallmark EntertainmentHoldings, now an owner of more than 80% of Hallmark Entertainment Investments,has voting power over all of the Crown Media Holdings shares owned by HallmarkEntertainment Investments.

 

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

 

Since inception, Hallmark Entertainment has attimes paid certain costs on behalf of Crown Media Holdings. For the three andsix months ended June 30, 2003, the Company paid $845,000 to HallmarkEntertainment as a reimbursement of such costs. Hallmark Entertainment incurred$445,000 on Crown Media Holdings behalf for the three and six months endedJune 30, 2003. No amounts were reimbursed to Hallmark Entertainment duringthe three and six months ended June 30, 2004. Hallmark Entertainmentincurred $1.9 million and $2.4 million, respectively,

 

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on Crown Media Holdings behalf for the three and six months endedJune 30, 2004. Unreimbursed costs of $670,000 and $3.1 million areincluded in payable to affiliates in the accompanying consolidated balancesheets as of December 31, 2003, and June 30, 2004, respectively.

 

***Services Agreement with Hallmark Cards***

 

Crown Media Holdings entered into an Intercompany Services Agreementwith Hallmark Cards, which was effective January 1, 2003, under whichHallmark Cards agreed for a term of three years to provide Crown Media Holdingswith tax, risk management, health safety, environmental, insurance, legal,treasury and 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. At December 31, 2003 andJune 30, 2004, unpaid accrued service fees and unreimbursed expenses of $6.8million and $8.3 million, respectively, have been included in payable toaffiliates in the accompanying consolidated balance sheets.

 

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

 

The Company entered into a film asset servicesagreement with Hallmark Entertainment, under which Hallmark Entertainmentprovides Crown Media Holdings with services related to the administration,distribution and other exploitation of the Company’s film assets. The servicesagreement expires on December 31, 2006, subject to cancellation byeither party after the first or second year.In consideration for the services provided by Hallmark Entertainment, CrownMedia Holdings is obligated to pay a service fee of $1.5 million per year,payable in quarterly installments of $375,000. Crown Media Holdings paid$375,000 to Hallmark Entertainment during both of the three months endedJune 30, 2003 and 2004. Crown Media Holdings paid $750,000 to HallmarkEntertainment during both of the six months ended June 30, 2003 and 2004.At both December 31, 2003, and June 30, 2004, unpaid accrued servicefees of $375,000 were included in payable to affiliates in the accompanyingconsolidated balance sheet.

 

***Trademark Agreement with Hallmark Cards***

 

Crown Media United States, Crown Media International and CrownEntertainment have trademark license agreements with Hallmark Cards andHallmark Licensing, Inc. for use of the “Hallmark” mark for the versions of theHallmark Channel distributed both in the United States and internationally andfor the Hallmark Movie Channel.  Thesetrademark license agreements expire on September 1, 2004.

 

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

 

Crown Media International has a program licenseagreement with Hallmark Entertainment Distribution dated January 1, 2001.The agreement expires on December 31, 2005, subject to a renewal throughDecember 31, 2010. Under the terms of the agreement, Crown MediaInternational has the exclusive right to exhibit Hallmark EntertainmentDistribution produced programming in the territories in which Crown MediaInternational operates during three 18-month windows. Crown Media Internationalalso has the exclusive right to exhibit programming in markets where it doesnot currently operate, if it elects to distribute the Channel in those markets,subject to any agreement between Hallmark Entertainment Distribution and athird party existing at the time Crown Media International launches the Channelin those markets. In addition, under the agreement, Hallmark EntertainmentDistribution is generally obligated to sell to Crown Media International all ofthe programming it produces and Crown Media International is obligated topurchase up to 50 programs produced per year during the term of the agreement.

 

Crown Media United States also licensesprogramming for distribution in the United States from Hallmark EntertainmentDistribution under a separate program license agreement, dated January 1,2001. Under this program agreement, Crown Media United States licenses programsowned or controlled by Hallmark Entertainment Distribution, as well as allprogramming produced by or on behalf of Hallmark Entertainment Distribution forCrown Media United States. The program agreement has a term of five years andis automatically renewable for additional three-year periods, subject to rateadjustments, so long as Hallmark Entertainment Distribution or its

 

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affiliates, owns an interest of 35% or more of Crown Media Holdings.  If, at any time, Hallmark EntertainmentDistribution ceases to own a 35% interest in Crown Media Holdings, and if, atthat time, the remaining term of the program agreement is less than two years,then the remaining term of the program agreement will be extended to the datetwo years after the date on which Hallmark Entertainment Distribution ceased toown a 35% interest in Crown Media Holdings.

 

If either Crown Media United States or Crown Media Internationalsub-licenses any licensed program to a third party, they must equally sharewith Hallmark Entertainment Distribution the excess, if any, of thesublicensing fee over the initial program license fee paid by the Company.  The Company did not sub-license any licensedprograms to third parties during the three and six months ended June 30,2003 and 2004.  Amounts due to HallmarkEntertainment Distribution as a result of sub-licensing agreements entered intoin other periods have been included in license fees payable to affiliates inthe accompanying balance sheets as noted below.

 

Programming costsrelated to the Hallmark program agreements were $6.3 million and $8.1 million,respectively, for the three months ended June 30, 2003 and 2004.Programming costs related to the Hallmark program agreements were $12.1 millionand $15.9 million, respectively, for the six months ended June 30, 2003and 2004. As of December 31, 2003, and June 30, 2004, $90.6 millionand $102.4 million, respectively, are included in license fees payable toaffiliates in the accompanying consolidated balance sheets.

 

***Company Obligated Mandatorily Redeemable Preferred Interest and NICCLicense Agreements***

 

VISN owns a $25.0million company obligated mandatorily redeemable preferred interest in CrownMedia United States (the “preferred interest”) issued in connection with aninvestment by Crown Media International in Crown Media United States. OnNovember 13, 1998, HEN Domestic Holdings, Inc., a wholly-owned subsidiaryof Crown Media International, Vision Group, VISN and Henson Cable Networks, Inc.signed an amended and restated company agreement governing the operation ofCrown Media United States, which agreement was further amended onFebruary 22, 2001 and January 1, 2002 (the “company agreement”).

 

 Under thecompany agreement, 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.

 

Under the company agreement, Crown Media United States may be requiredto make certain payments in regards to programming provisions to the NationalInterfaith Cable Coalition (“NICC”). Specifically, Crown Media United States may be required to pay licensefees to NICC or fund production costs consisting of: (i) a total of $5.3million per year, with CPI escalations, for two recurring programming blocksproduced by NICC; (ii) up to $10 million per year for an additional recurring“signature” series program block co-produced by NICC and Crown Media UnitedStates; (iii) up to $600,000 per “non-dramatic” holiday special produced byNICC; and (iv) $1.0 million per “dramatic” holiday special co-produced by NICCand Hallmark Entertainment. In addition,six months prior to the expiration of the agreement, Crown Media United Statesmust negotiate in good faith with NICC regarding a continuation of thisprogramming and funding commitment. If agreement is not reached and Crown MediaUnited States does not continue the NICC programming and funding commitments atthe same levels, NICC is entitled to compel Crown Media Holdings to buy all ofNICC’s Crown Media Holdings shares at their then-current market value no laterthan 60 days following the expiration of the amendment. Crown Media UnitedStates, however, can nullify this put by electing to continue the NICCprogramming and funding commitments at the same levels.

 

Pursuant toadditional amendments effective January 1, 2002, and January 1, 2004,Crown Media United States agreed to advance NICC $3,000,000 in each of 2002,2003 and 2004 to help fund NICC’s cost of expanding its production operationsto produce the aforementioned programming. This advance will be recovered from the

 

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license fees payable forthis programming when such programming is produced and accepted by Crown MediaUnited States for distribution on the Channel. These expenses are included ascomponents of affiliate programming costs in the accompanying consolidatedstatements of operations.

 

During the threemonths ended June 30, 2003 and 2004, Crown Media United States paid NICCin the aggregate of $674,000 and $3.7 million, respectively, related to thecompany agreement. During the six months ended June 30, 2003 and 2004,Crown Media United States paid NICC in the aggregate of $5.0 million and $7.2million, respectively, related to the company agreement. As of December 31,2003, and June 30, 2004, $291,000 and $2.8 million, respectively, relatedto this arrangement are included in license fees payable to affiliates in theaccompanying consolidated balance sheets.

 

**8. Operations in Different Geographic Areas**

 

Information relating to Crown Media Holdings’operations in different geographic regions is set forth in the following table.

 

| ** **                                 | ** ** | **Revenue from  Unrelated****Entities** | ** ** | **Revenue from****Related  Entities** | ** ** | **Operating****Loss** | ** ** | **Identifiable****Assets** | ** ** |
|--------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|-----------------------|------------|----------------------------|------------|
| ** **                                 | ** ** | **(In millions)**                       | ** ** |
| Three months ended June 30,  2003:    |       |                                    |       |                                  |       |                  |       |                       |       |
| Domestic                                   |       | $                                       | 19.8       |                                  | $          | 0.4                   |       | $                          | (23.1      | ) | $ | 608.9 |   |
| International                              |       | 21.3                                    |       | —                                |       | (1.3                  | )          | 90.4                       |       |
| Film distribution                          |       | 3.9                                     |       | —                                |       | (4.1                  | )          | 791.1                      |       |
| Consolidated total                         |       | $                                       | 45.0       |                                  | $          | 0.4                   |       | $                          | (28.5      | ) | $ | 1,490.4 |   |
| Guaranteed preferred  beneficial accretion |       |                                    |       |                                  |       | (12.2                 | )          |                       |       |
| Interest expense                           |       |                                    |       |                                  |       | (7.5                  | )          |                       |       |
| Loss before income taxes                   |       |                                    |       |                                  |       | $                     | (48.2      | )                          |       |   |
|                                       |       |                                    |       |                                  |       |                  |       |                       |       |
| Three months ended  June 30, 2004:    |       |                                    |       |                                  |       |                  |       |                       |       |
| Domestic                                   |       | $                                       | 29.0       |                                  | $          | 0.4                   |       | $                          | (17.4      | ) | $ | 666.0 |   |
| International                              |       | 22.3                                    |       | —                                |       | (5.2                  | )          | 84.0                       |       |
| Film distribution                          |       | 4.1                                     |       | —                                |       | (1.6                  | )          | 780.6                      |       |
| Consolidated total                         |       | $                                       | 55.4       |                                  | $          | 0.4                   |       | $                          | (24.2      | ) | $ | 1,530.6 |   |
| Interest expense                           |       |                                    |       |                                  |       | (15.9                 | )          |                       |       |
| Loss before income taxes                   |       |                                    |       |                                  |       | $                     | (40.1      | )                          |       |   |
|                                       |       |                                    |       |                                  |       |                  |       |                       |       |
| Six months ended June 30,  2003:      |       |                                    |       |                                  |       |                  |       |                       |       |
| Domestic                                   |       | $                                       | 39.3       |                                  | $          | 0.7                   |       | $                          | (38.0      | ) | $ | 608.9 |   |
| International                              |       | 40.0                                    |       | —                                |       | (9.8                  | )          | 90.4                       |       |
| Film distribution                          |       | 7.4                                     |       | —                                |       | (8.7                  | )          | 791.1                      |       |
| Consolidated total                         |       | $                                       | 86.7       |                                  | $          | 0.7                   |       | $                          | (56.5      | ) | $ | 1,490.4 |   |
| Guaranteed preferred  beneficial accretion |       |                                    |       |                                  |       | (23.2                 | )          |                       |       |
| Interest expense                           |       |                                    |       |                                  |       | (14.9                 | )          |                       |       |
| Loss before income taxes                   |       |                                    |       |                                  |       | $                     | (94.6      | )                          |       |   |
|                                       |       |                                    |       |                                  |       |                  |       |                       |       |
| Six months ended June 30,  2004:      |       |                                    |       |                                  |       |                  |       |                       |       |
| Domestic                                   |       | $                                       | 54.8       |                                  | $          | 0.8                   |       | $                          | (37.2      | ) | $ | 666.0 |   |
| International                              |       | 46.2                                    |       | —                                |       | (7.7                  | )          | 84.0                       |       |
| Film distribution                          |       | 12.4                                    |       | —                                |       | (4.5                  | )          | 780.6                      |       |
| Consolidated total                         |       | $                                       | 113.4      |                                  | $          | 0.8                   |       | $                          | (49.4      | ) | $ | 1,530.6 |   |
| Interest expense                           |       |                                    |       |                                  |       | (31.7                 | )          |                       |       |
| Loss before income taxes                   |       |                                    |       |                                  |       | $                     | (81.1      | )                          |       |   |

 

British SkyBroadcasting, which is domiciled in the United Kingdom and revenues from whichare included in the Company’s international segment, accounted for 14% and 13%of the Company’s consolidated revenues for the three months ended June 30,2003 and 2004, respectively. British Sky Broadcasting, accounted for 14% of theCompany’s consolidated revenues for each of the six months ended June 30,2003 and 2004, respectively. No other individual country, other than the UnitedStates and the United Kingdom, accounted for more than 10% of the Company’sconsolidated revenues. No individual pay television distributor accounted formore than 10% of the Company’s consolidated subscribers for the three and sixmonths ended June 30, 2003 and 2004.

 

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**9. Subsequent Events**

 

The Company hasestablished a retention bonus program for approximately 175 employees who couldbe affected if Crown Media Holdings’ international business is sold. Underthe program, the Company will pay a total of at least $3.0 millionin retention bonuses.  If the Company's internationalbusiness is sold or negotiations for a sale continue past December 31,2004, the Company may be obligated to pay as much as $6.0 million in totalretention bonuses.  In addition, the Company  intends to create aseverance plan for affected employees who are not re-employed by the buyer.

 

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

 

**Overview**

 

*CurrentChallenges*

 

The Company facesmany challenges in the current domestic and international marketplaces. Thedomestic cable industry is saturated with channels striving to positionthemselves on lower analog tiers and on digital platforms of cable TVdistributors. The Company has less leverage in the marketplace in regard to tierpositioning and advertising sales than many of our competitors since theyoperate multiple channels while we operate only one channel. Among otherthings, owners of multiple channels are able to leverage demand for their morepopular channels to convince distributors and advertisers to distribute andadvertise on their less successful channels. Our ratings and subscribers mustcontinue to grow in future years in order to increase subscriber demand for ourChannel and our advertising revenues. The Company strives to obtain additionalsubscribers by renegotiating distribution agreements, and, as a result, mayface increased subscriber acquisition fee payments. The Company also attempts,and has succeeded, in improving its ratings by acquiring new programming andrevising its programming schedules to meet the demands of its viewers. A largeraudience share results in higher advertising rates, which, in turn, increasesrevenue. Domestically, we foresee in 2004 an increase in our advertisingrevenues due to an enhanced programming schedule and growing subscribercounts.

 

In the United Kingdom and our Europe Middle East and Africa (“EMEA”)market, we have acquired programming, much of which has not been previouslyaired on cable television in the aforementioned markets. We expect thisprogramming to attract additional viewers, resulting in increased ratings. Inour Latin American and Asian markets, our primary focus is to manage ourinvestment, minimize our programming expenditures through the use of our film assets,expand our subscriber base and thereby command increased subscriber fees andadvertising revenue. We face challenges to overcoming the political andeconomic problems in certain of our international markets. Managementcontinuously evaluates our position in these countries. The Company completedthe restructuring of its international segment during 2003 by decentralizingmany oversight and non-technical support functions formerly located in theCompany’s U.S.-based offices and transferring those responsibilities toregional staff. Certain operating expenses decreased because ofthis action, primarily the ongoing expense related to salaries and leasingtransponder space.

 

Utilization of our film assets, both through external sales andinternal use, is a significant focus of management. This business provides uswith a significant, additional source for revenue and cash flow. Externaldemand for our film library assets improved during 2003 and we have seen highersales with the improvement of the economy and an increase in incentives for oursales force.

 

The primary financial and non-financial measures analyzed by managementare Adjusted EBITDA (as defined below) and the metrics driving each of ourrevenue lines such as: subscriber counts, advertising rates, domestic ratingsand ratings for certain international markets, and demographics of our viewingaudiences.

 

*Cash Flow*

 

Our management isstriving to increase cash flows in 2004 and future years through the sale ofadvertising and ongoing cost management. The Company believes it will be cash flow positive in the fourth quarterof 2004 and Adjusted EBITDA positive for the fourth quarter of 2004, barringunforeseen circumstances.  We willcontinue to monitor expenses, and, potentially, reduce marketing and othergeneral and administrative expenses in 2004 to meet our cash flow goals.  If our cash flow improves, we will also focusin the future on repaying borrowings under our bank credit facility.  Our present plan includes the expansion ofour line of credit in 2004 and the refinancing of the bank credit facilityduring 2006 as well as the HC Crown line of credit.

 

Significant usesof cash during the six months ended June 30, 2004 were for programacquisitions in primarily our domestic and United Kingdom markets. The Companyalso paid subscriber acquisition fees resulting from

 

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distribution agreementsrenegotiated in 2003 and prior years. Attainment of certain subscriber levelswill also cause an increase in subscriber acquisition fee payments in futureyears, but, as many of our more significant distribution agreements expire in2007, we do not foresee significant subscriber acquisition fee payments untilafter 2007*.*

 

On April 13, 2004, the Company announced thatit is exploring strategic alternatives for its international operations and theinternational rights to its film library, including, but not necessarilylimited to, a sale or other corporate transaction in an effort to maximizeshareholder value.  Any sale would, andany other corporate transaction might, require the consent of existing lenders,and be subject to other customary conditions. The Company contemplates usingany proceeds from any such transaction to pay down its debt and/or other obligations.  The Company can not provide assurance thatany such transaction will occur.

** **

The Company has established a retention bonus program for approximately175 employees who could be affected if Crown Media Holdings’ internationalbusiness is sold. Under the program, the Company will pay a total ofat least $3.0 million in retention bonuses.  If the Company'sinternational business is sold or negotiations for a sale continue pastDecember 31, 2004, the Company may be obligated to pay as much as $6.0 millionin total retention bonuses.  In addition, the Company  intends tocreate a severance plan for affected employees who are not re-employed by thebuyer.

 

**Revenue**

 

Our revenue consists of subscriber fees, advertising and film licensefees.

 

*Subscriber Fees*

 

Subscriber fees are generally payable to us on a per subscriber basis bypay television distributors for the right to carry our Channels. In the UnitedStates, we pay certain television distributors up-front subscriber acquisitionfees to carry our Channel. However, such payments are not common in theinternational cable television markets. Subscriber acquisition fees that we payare capitalized and amortized over the contractual term of the applicabledistribution agreement as a reduction in subscriber fee revenue. If theamortization expense exceeds the revenue recognized on a per distributor basis,the excess amortization is included as a component of cost of services. At thetime we sign a distribution agreement, we evaluate the recoverability of the costswe incur against the incremental revenue directly and indirectly associatedwith each agreement.

* *

Rates we receive per subscriber vary according to:

 

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

 

•                                          the relativeposition in the market of the distributor and the popularity of the Channel;

 

•                                          the packagingarrangements for the Channel; and

 

•                                          othercommercial terms such as granting the distributor exclusivity to carry ourChannel (only in territories outside the U.S.) and length of the contract term.

 

In some circumstances, international distributors provide minimumrevenue guarantees.

 

We are in continuous negotiations with both our existing distributorsand new distributors to increase our subscriber base in order to enhance our advertisingresults. In the United States, we are often subject to requests by distributorsto pay subscriber acquisition fees for additional subscribers or to waive oraccept lower subscriber fees if certain numbers of additional subscribers areprovided. In both domestic and international markets we also may help fund the

 

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distributors’efforts to market our Channels or we may permit distributors to offer limitedpromotional periods without payment of subscriber fees. As we continue ourefforts to add subscribers, our subscriber revenue will continue to benegatively affected by subscriber acquisition fee amortization, waiver ofsubscriber fees and bulk discounts resulting from the attainment of certain subscriberlevels; however, we believe that as a result of these measures, our subscribercounts will increase which in turn will allow us to attract additionaladvertisers and command higher advertising rates.

 

We also expect international subscriber rates to decrease as we renewdistribution agreements. These international rates are affected by theincreasing competitive nature of the industry, the growth of digital cable, theshift in the industry in more developed countries from subscriber fee revenue toadvertising revenue, foreign currency devaluation associated with globaleconomies and the economic turbulence in certain of our markets. Although weanticipate international subscriber rates to decrease, we expect subscribercounts to increase and, thereby, offset the negative effect the decreased rateswill have on revenue.

 

Our distribution agreement with a primary pay television distributor inSpain was amended on October 1, 2003. Under the amendment, thedistribution of our Channel to that party will end on December 31, 2004,at which time a new distribution agreement will have to be negotiated. Prior tothat date, we will begin negotiations to renew a distribution agreement inSpain beyond 2004.

 

Our Channel is usually offered as one of a number of channels on eithera basic tier or part of other program packages. Our Channel is generally notoffered on a stand-alone basis. Thus, while a cable or satellite customer maysubscribe and unsubscribe to the tiers and program packages in which ourChannel is placed, these customers do not subscribe and unsubscribe to ourChannel alone. We are not provided with information from the distributors ontheir overall subscriber churn and in what manner their churn rates affect oursubscriber counts; we instead are provided information on the total number ofsubscribers who receive the Hallmark Channel.

 

Our subscriber count depends on the number of distributors carrying theHallmark Channel and the size of such distributors as well as the program tierson which our Channel is carried by these distributors. From time to time, weexperience decreases in the number of subscribers domestically andinternationally as promotional periods end or a distributor arrangement isamended or is terminated by us or the distributor. Changes to distributionarrangements in 2004 have not been significant. Management analyzes theestimated effect each new or amended distribution agreement will have onrevenues and costs. Based upon these analyses, management endeavors to achievea fair combination of subscriber commitments and subscriber acquisition feeswith each of our domestic distributors.

 

#### *Advertising*

####  

Advertising sales generally are made on the basis of a price peradvertising spot or per unit of audience measurement (for example, a ratingspoint). Thus, our advertising revenues are heavily dependent on third partiesratings of the persons viewing our Channel. Prices vary on a market-by-marketbasis. Rates differ among markets depending on audience demographics.

 

In markets where regular audience measurements are available, ouradvertising rates are generally calculated on the basis of an agreed upon priceper unit of audience measurement in return for a guaranteed investment level bythe advertiser. In these countries, we commit to provide advertisers certainrating levels in connection with their advertising. Revenue is recorded net ofestimated delivery shortfalls, which are usually settled by providing theadvertiser additional advertising time. In other less sophisticated markets,our advertising rates are calculated on the basis of cost per advertising spotor package of advertising spots, and the price varies by audience levelexpected (but not measured) during a particular time slot. This is thepredominant arrangement in the countries outside the United States in which wesell advertising time. Advertising rates also vary by time of year due toseasonal changes in television viewership.

 

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*Film Licensing*

 

Crown MediaDistribution generates revenue from the film assets by granting licenses toexhibit the films to third parties. We are also using the films as programmingfor our Channel. Customers for our film assets consist of other televisionchannels, home video distributors and brokers who resell rights to our filmassets in various international markets. License fees for our film assets aregenerally negotiated based upon the size of the potential audience who will beviewing the programming.

 

**Costof Services**

 

Our cost of servicesconsists primarily of program license fees, amortization of our film assets;subscriber acquisition fee expense; the cost of signal distribution; dubbingand subtitling programming for foreign audiences; administration, distributionand other exploitation of our film assets; and the cost of promotional segmentsthat are aired between programs. We expect cost of services to continue toincrease in the future as we expand our existing markets and third partyprogramming to support our advertising strategy. We expect the cost of servicesto increase in 2004 as compared to 2003 because of the following: weintend to acquire or use a greater amount and variety of quality programming asa part of our efforts to continue the increases in our ratings; the amortizationof film assets will increase when sales of those assets increase; and weanticipate higher levels of subscriber acquisition fee amortization as resultof incremental increases in the distribution of our Channel.

 

**CriticalAccounting Estimates**

 

The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesrequires Crown Media Holdings to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. Actual resultscould differ from those estimates.

 

For information regarding use of estimates,accounting treatment and accounting policies concerning revenue, subscriberacquisition fees, program license fees, subtitling and dubbing, film assets,property and equipment, goodwill and intangible assets, taxes on income,stock-based compensation, the 2002 reorganization and recently issuedaccounting pronouncements, please see the Notes to Unaudited ConsolidatedFinancial Statements.

 

The following discussion concerns certainaccounting estimates and assumptions that are considered to be material due tothe levels of subjectivity and judgment necessary to account for uncertainmatters and the susceptibility of such matters to changes.

 

***Revenue Recognition***

 

Subscriber fees from pay television distributors are recognized asrevenue when an agreement is executed, programming is provided, the price isdeterminable, and collectibility is reasonably assured. We estimate and recordthe level of subscriber fees one month in advance based upon the actual priormonth’s subscriber levels. Historical results support our method of estimatingsubscriber fee revenue as subscriber levels generally increase each month.

 

Advertising revenues are recognized as earned in the period in whichthe advertising is telecast and are generally billed monthly. If uncertainty asto the collectibility of this revenue exists, the revenue is recognized on acash basis. Advertising revenue and expenses in barter transactions arerecorded at the fair value of the advertising to be provided. In certainmarkets, delivery of advertising is determined based upon data received fromthird parties who measure the ratings of our Channels. The ratings informationdrives our calculations of impressions delivered which in turn drives theamount of revenue we recognize from each advertising spot. Our advertisingrevenue is therefore heavily reliant upon these third party ratings estimatesto determine the quantity of advertising delivered to viewers.

 

Revenue from film asset licensing agreements is recognized when anagreement is executed, the film is available for exhibition by the licensee,the license fee is fixed or reasonably determinable, collectibility isreasonably assured and the cost of each film is known or reasonablydeterminable. When multiple films are sold under a single arrangement, in orderto properly recognize revenue when each license period commences, we mustestimate the

 

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relative fairvalue of each film and allocate the total contracted price to the differentfilms in the arrangement. Our estimation of relative fair value uses similarinformation as is used in our annual third party valuation of our film assets.

 

The Company records revenue from customers incertain foreign countries only when the cash is received due to the uncertaintyregarding collection.

 

***Allowance for Doubtful Accounts***

 

The Company has established an allowance fordoubtful accounts based upon historical charge-off experience.  Periodically, we analyze the attributes ofthe accounts which we have written-off during the period and adjust theallowance percentages we apply to our aged receivable balances.  As noted previously, for revenue generated incertain countries in which economic factors lead us to believe thatcollectibility of these revenues is not reasonably assured, we recognize suchrevenue as it is received in cash.

 

***SubscriberAcquisition Fees***

 

Crown Media United States has distribution agreements with every majorcable distributor in the United States, some of which require the payment ofsubscriber acquisition fees. The initial recoverability of these subscriberacquisition fees is evaluated by projecting the incremental subscriber fee andadvertising revenue attributable to the incremental subscribers obtainedthrough the distribution agreement.  Thisanalysis includes significant judgment and estimation by management in terms ofthe estimated incremental advertising per subscriber.

 

***Film Assets***

 

The Company amortizes its film assets using theindividual-film-forecast-computation method over a maximum period of10 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 unrecognizedultimate revenues. Estimated unrecognized ultimate revenues are based on thehistorical performance of each film and similar films, sales and marketingplans, and other factors, all of which require significant judgment bymanagement.

 

The Company reviews the film assets for impairment at least annually ormore frequently if events or changes in circumstances indicate that thecarrying amount of the film assets may not be recoverable. If the carryingvalue of the individual film assets exceeds its fair value, the film assets arewritten-down to their fair values.  TheCompany estimates the fair value of individual film assets using a discountedcash flow approach.  This fair valuemethod requires significant judgment by management.

 

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

 

#### **Hallmark Transactions**

####  

In 2003 and inprior years, we entered into a number of significant transactions with HallmarkCards and its subsidiaries. These transactions concern, among other things,programming, trademark licenses, administrative services, a line of credit, aTax Sharing Agreement and the issuance of a $400.0 million seniorunsecured note.

 

*TaxSharing Agreement*

 

In March 2003, the Company became a member of Hallmark Cardsconsolidated federal tax group and entered into a Tax Sharing Agreement withHallmark Cards, which was amended at the time the Company issued the seniorunsecured note to HC Crown. We account for income taxes as if Crown MediaHoldings were a separate taxpayer. Accordingly, Hallmark Cards’ ability to useour tax losses does not impact our assessment of the need for a valuationallowance on deferred tax assets, including future tax losses. Any paymentsreceived from Hallmark Cards under the Tax Sharing Agreement are recorded as anincrease in paid-in capital. During 2003, the Company received

 

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$49.4 millionunder the Tax Sharing Agreement. During the six months ended June 30,2004, the Company received $23.6 million under the Tax Sharing Agreement. Forinformation regarding the Tax Sharing Agreement, please see Notes 2 and 7to the Notes to Unaudited Consolidated Financial Statements.

 

*SeniorUnsecured Note*

 

On August 5, 2003, Crown Media Holdings repurchased all of theoutstanding trust preferred securities of Crown Media Trust and related contingentappreciation certificates issued by the Company. The securities wererepurchased for approximately $329.1 million. Funds for this repurchase wereobtained from the proceeds from the issuance of a senior unsecured note issuedto HC Crown in the amount of $400.0 million. After repayment of certainexpenses for the issuance, including a fee of $3.0 million to HC Crown, theCompany used the balance of the proceeds of the note, approximating $67.3million, to pay principal, interest and prepayment penalties on its bankrevolving credit loans. For information regarding our senior unsecured note,please see Note 7 to the Notes to Unaudited Consolidated FinancialStatements.

 

*NICCLicense Agreement*

 

For information regarding our amendment to our license agreement withNICC, please see Note 7 to the Notes to Unaudited Consolidated FinancialStatements.

 

*PramerAgreement*

 

On January 30, 2003, Crown Media International entered into anagreement with Pramer S.C.A., a wholly-owned subsidiary of Liberty MediaCorporation, under which Pramer provides affiliate and advertising salesrepresentation services, as well as programming, production and technicalservices in connection with the distribution of the Hallmark Channel in Centraland South America. Pramer receives a 35% commission on advertising sales and a20% commission on affiliate sales and is reimbursed for its costs of providingproduction and technical services. The agreement with Pramer will terminate onDecember 31, 2005, unless certain early termination rights arise and areexercised. One of our Board members is an executive of Liberty MediaCorporation, one of our significant investors.

 

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

##  

In the table below, we provide selectedhistorical consolidated financial and other data of Crown Media Holdings andits subsidiaries. The following selected consolidated statement of operationsdata for three and six months ended June 30, 2003 and 2004, are derivedfrom the 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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| ** **                                        | ** ** | ** **                           | ** ** | **Percent  Change** | ** ** | ** **                         | ** ** | **Percent  Change** | ** ** |
|---------------------------------------------------|------------|--------------------------------------|------------|---------------------|------------|------------------------------------|------------|---------------------|------------|
| ** **                                        | ** ** | **Three Months Ended June 30,** | ** ** | **2004  vs.**       | ** ** | **Six Months Ended June 30,** | ** ** | **2004  vs.**       | ** ** |
| ** **                                        | ** ** | **2003**                             | ** ** | **2004**            | ** ** | **2003**                           | ** ** | **2003**            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                                         |       |                                 |       |                |       |                               |       |                |       |   |   |   |   |
| Subscriber fees                                   |       | $                                    | 17,864     |                | $          | 20,193                             |       | 13                  | %          | $ | 33,890 |   | $ | 40,152 |   | 18 | % |
| Advertising                                       |       | 23,671                               |       | 31,497              |       | 33                                 | %          | 46,030              |       | 61,502 |   | 34 | % |
| Film asset license fees                           |       | 3,865                                |       | 4,087               |       | 6                                  | %          | 7,404               |       | 12,434 |   | 68 | % |
| Other revenue                                     |       | 23                                   |       | 63                  |       | 174                                | %          | 57                  |       | 85 |   | 49 | % |
| Total revenues                                    |       | 45,423                               |       | 55,840              |       | 23                                 | %          | 87,381              |       | 114,173 |   | 31 | % |
| Cost of Services:                                 |       |                                 |       |                |       |                               |       |                |       |   |   |   |   |
| Programming costs                                 |       | 24,074                               |       | 31,036              |       | 29                                 | %          | 47,517              |       | 60,863 |   | 28 | % |
| Amortization of film assets                       |       | 6,809                                |       | 5,484               |       | -19                                | %          | 13,586              |       | 15,466 |   | 14 | % |
| Subscriber acquisition fee amortization expense   |       | 6,610                                |       | 6,091               |       | -8                                 | %          | 12,606              |       | 12,032 |   | -5 | % |
| Operating costs                                   |       | 12,777                               |       | 9,436               |       | -26                                | %          | 24,454              |       | 22,229 |   | -9 | % |
| Total cost of services                            |       | 50,270                               |       | 52,047              |       | 4                                  | %          | 98,163              |       | 110,590 |   | 13 | % |
| Selling, general and administrative expense       |       | 14,933                               |       | 19,839              |       | 33                                 | %          | 31,521              |       | 39,060 |   | 24 | % |
| Marketing expense                                 |       | 8,732                                |       | 8,177               |       | -6                                 | %          | 14,171              |       | 13,960 |   | -1 | % |
| Loss from operations                              |       | $                                    | (28,512    | )                   | $          | (24,223                            | )          | -15                 | %          | $ | (56,474 | ) | $ | (49,437 | ) | -12 | % |
|                                              |       |                                 |       |                |       |                               |       |                |       |   |   |   |   |
| **Other Data:**                                   |       |                                 |       |                |       |                               |       |                |       |   |   |   |   |
| Net cash used in operating activities             |       | $                                    | 25,104     |                | $          | 6,873                              |       | -73                 | %          | $ | 73,447 |   | $ | 26,674 |   | -64 | % |
| Capital expenditures                              |       | $                                    | 949        |                | $          | 1,085                              |       | 14                  | %          | $ | 1,781 |   | $ | 1,206 |   | -32 | % |
| Net cash provided by financing activities         |       | $                                    | 27,092     |                | $          | 8,918                              |       | -67                 | %          | $ | 83,192 |   | $ | 32,840 |   | -61 | % |
| Adjusted EBITDA (1)                               |       | $                                    | (9,801     | )                   | $          | (6,385                             | )          | -35                 | %          | $ | (19,938 | ) | $ | (9,394 | ) | -53 | % |
| Total domestic day household ratings (2)(4)       |       | 0.490                                |       | 0.564               |       | 15                                 | %          | 0.468               |       | 0.601 |   | 28 | % |
| Total domestic primetime household ratings (3)(4) |       | 0.736                                |       | 0.810               |       | 10                                 | %          | 0.708               |       | 0.846 |   | 19 | % |
| Total subscribers at year end:                    |       |                                 |       |                |       |                               |       |                |       |   |   |   |   |
| Hallmark Channel – International             |       | 56,827                               |       | 57,322              |       | 1                                  | %          | 56,827              |       | 57,322 |   | 1 | % |
| Hallmark Channel – U.S.                      |       | 51,808                               |       | 60,605              |       | 17                                 | %          | 51,808              |       | 60,605 |   | 17 | % |
| Total subscribers                                 |       | 108,635                              |       | 117,927             |       | 9                                  | %          | 108,635             |       | 117,927 |   | 9 | % |

 

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(1) See reconciliation of Adjusted EBITDA below.

(2)  Total day is the time period measured fromthe time each day the broadcast of commercially sponsored programming commencesto the time such commercially sponsored programming ends.

(3)  Primetime is defined as 8:00- 11:00 P.M. in the United States.

(4)  These Nielsen ratings are forthe time period January 1 through June 30.

 

Crown Media Holdings evaluates operating performance based on severalfactors, including Adjusted EBITDA. Our measure of Adjusted EBITDA differs fromthe normal definition of EBITDA (earnings before interest, taxes, depreciationand amortization) used by most companies. We define Adjusted EBITDA as earningsbefore interest, taxes, depreciation, amortization, subscriber acquisition feeamortization and amortization of film assets. We believe Adjusted EBITDA ismeaningful because it provides investors a means to evaluate the operatingperformance of our company on an ongoing basis using criteria that are used byother companies in our industry and investment bankers and analysts who trackour industry. We believe that Adjusted EBITDA is a meaningful measure becauseit represents a transparent view of our recurring operating performance andallows our management and investors to readily view operating trends, performanalytical comparisons and benchmark our company to similar companies in ourindustry. Adjusted EBITDA is used by our management to monitor segmentoperations and to determine the allocation of resources to segments. Our creditfacility also contains covenants that are based on an

 

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adjusted EBITDAmeasure. Consequently, management views Adjusted EBITDA as a critical measureof our operating performance to meet our debt covenants and monitors thismeasure closely. We disclose Adjusted EBITDA so that our investors can havesome of the same information available to our management to evaluate theirinvestment in our Company. We believe that Adjusted EBITDA provides anindication of the Company’s ability to generate cash flows from operatingactivities since the majority of our non-cash expenses are excluded from ourcalculation of Adjusted EBITDA. A significant portion of the Company’s coststructure relates to the amortization of film assets and subscriber acquisitioncosts, which are significant non-cash charges. The cash costs of acquiring filmassets and adding subscribers are essentially discretionary expenditures. Theadjusted EBITDA calculation allows the Company to assess how much is availableto pay debt service and gives a further indication of how much remains to funddiscretionary expenditures such as the acquisition of film assets or additionalsubscriber base. However, Adjusted EBITDA should be considered in addition to,not as a substitute for, historical operating income or loss, net loss, cashflow from operations and other measures of financial performance reported inaccordance with accounting principles generally accepted in the United States.

 

Adjusted EBITDA differs significantly from cash flows from operatingactivities reflected in the consolidated statement of cash flows. Cash flowfrom operating activities is net of interest and taxes paid and is a morecomprehensive determination of periodic income on a cash basis, exclusive ofnon-cash items of income and expenses such as depreciation and amortization. Incontrast, Adjusted EBITDA is derived from accrual basis income and is notreduced for cash invested in working capital. Consequently, Adjusted EBITDA isnot affected by the timing of receivable collections or when accrued expenses arepaid. We are not aware of any uniform standards for determining EBITDA or ourAdjusted EBITDA and believe presentations of EBITDA may not be calculatedconsistently by different entities in the same or similar businesses. In the table below, we provide a reconciliationof Adjusted EBITDA to net loss and to net cash used in operating activities ofCrown Media Holdings and its subsidiaries.

 
| ** **                                                                   | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                   | ** ** | **2003**                             | ** ** | **2004**                           | ** ** | **2003** | ** ** | **2004** | ** ** |
|                                                                         |       |                                 |       |                               |       |   |   |   |   |
| Net loss                                                                     |       | $                                    | (49,397    | )                                  | $          | (40,587 | ) | $ | (96,087 | ) | $ | (82,063 | ) |
| Amortization of film assets                                                  |       | 6,809                                |       | 5,484                              |       | 13,586 |   | 15,466 |   |
| Subscriber acquisition fee amortization expense                              |       | 8,068                                |       | 8,854                              |       | 15,508 |   | 17,481 |   |
| Depreciation and amortization                                                |       | 3,834                                |       | 3,500                              |       | 7,442 |   | 7,096 |   |
| Guaranteed preferred beneficial interest expense                             |       | 12,171                               |       | —                             |       | 23,218 |   | — |   |
| Interest expense and accretion                                               |       | 7,514                                |       | 15,895                             |       | 14,856 |   | 31,682 |   |
| Income tax provision                                                         |       | 1,200                                |       | 469                                |       | 1,539 |   | 944 |   |
| Adjusted earnings before interest, taxes,  depreciation and amortization     |       | $                                    | (9,801     | )                                  | $          | (6,385 | ) | $ | (19,938 | ) | $ | (9,394 | ) |
|                                                                         |       |                                 |       |                               |       |   |   |   |   |
| Restricted stock unit and stock-based compensation                           |       | 320                                  |       | 3,469                              |       | 323 |   | 5,808 |   |
| Programming, subtitling and dubbing amortization                             |       | 23,465                               |       | 32,607                             |       | 48,259 |   | 63,452 |   |
| Provision for allowance for doubtful account                                 |       | 238                                  |       | (1,328                             | )          | 1,566 |   | (11 | ) |
| Changes in operating assets and liabilities:                                 |       |                                 |       |                               |       |   |   |   |   |
| Additions to program license fees                                            |       | (20,698                              | )          | (18,537                            | )          | (65,813 | ) | (44,680 | ) |
| Additions to subscriber acquisition fees                                     |       | (364                                 | )          | (8,544                             | )          | (1,224 | ) | (13,319 | ) |
| Decrease in subscriber acquisition fees payable                              |       | (12,494                              | )          | 7,557                              |       | (23,024 | ) | 9,796 |   |
| Interest paid                                                                |       | (4,873                               | )          | (3,229                             | )          | (10,116 | ) | (6,743 | ) |
| Income taxes paid                                                            |       | (1,200                               | )          | (469                               | )          | (1,539 | ) | (944 | ) |
| Changes in other operating assets and liabilities,  net of adjustments above |       | 303                                  |       | (12,014                            | )          | (1,941 | ) | (30,639 | ) |
| Net cash used in operating activities                                        |       | $                                    | (25,104    | )                                  | $          | (6,873 | ) | $ | (73,447 | ) | $ | (26,674 | ) |

 

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***Results of Operations***

 

*Threeand Six Months Ended June 30, 2004 Compared to Three and Six Months EndedJune 30, 2003*

 

*Revenue.*

 

 Our revenue, which is comprised of subscriberfees, advertising and film asset license fees, increased 23% and 31% for thethree and six months ended June 30, 2004. Our 13% and 18% increases in subscriber fee revenue for the three and sixmonths ended June 30, 2004, were the result of the expiration of freecarriage periods for certain of our domestic distributors. Subscriberacquisition fee expense recorded as a reduction of revenue was $2.8 million and$5.4 million for the three and six months ended June 30, 2004, and $1.5million and $2.9 million for the comparable periods in 2003. Although thenumber of subscribers to the Hallmark Channel increased as of June 30, 2004,compared to June 30, 2003, subscriber revenue was also affected by anumber of other, offsetting factors, including discounts for new subscribers,and the waiver of subscriber fees and bulk discounts resulting from theattainment of certain subscriber levels. Eighty-five percent and 87% ofsubscriber fee revenue for the three and six months ended June 30, 2004,and 91% of subscriber fee revenue for both the three and six months endedJune 30, 2003, was earned internationally. Subscriber fee revenue was $3.0million and $5.3 million for the domestic Hallmark Channel for the three andsix months ended June 30, 2004, and $1.6 million and $3.0 million for thethree and six months ended June 30, 2003. Certain of our internationalsubscriber fee rates have and will continue to decrease as we renewdistribution agreements, which may provide for lower per subscriber rates thanunder previous agreements.

 

The increase in advertising revenue reflects thefollowing during 2004: the 9% growth in domestic and international subscribers;higher ratings in the United States; higher advertising rates resulting fromthe increase in distribution and viewership; and expanded sales of advertisingtime primarily in the United States. Our domestic advertising revenue increasedto $26.5 million and $50.2 million for the three and six months endedJune 30, 2004, compared to $18.6 million and $36.9 million for the threeand six months ended June 30, 2003. Additionally, the number ofadvertisers on our domestic Channel rose from 195 at June 30, 2003, to 302at June 30, 2004. Our international advertising revenue, primarily fromthe United Kingdom, increased to $11.3 million for the six months endedJune 30, 2004, compared to $9.1 million for the six months endedJune 30, 2003.

 

Among the 52 ad-supported cable channels in the United States market,the Hallmark Channel ranked 10th in total day with a 0.6 household rating for the second quarter of2004 and 18th for primetime with a 0.8 household rating for the same quarterbased on Nielsen ratings.

 

Film asset licensing fees earned during thesecond quarter of 2004 remained flat.  Wehave focused our selling effort on a small number of larger customers in theUnited States market, resulting in increased film asset licensing fees duringthe first six months of 2004 compared to the same period in 2003.

 

*Cost ofservices. *Cost ofservices as a percent of revenue decreased to 93% and 97% for the three and sixmonths ended June 30, 2004, as compared to 111% and 112% in the prioryear’s periods. These decreases were primarily due to our increases in totalrevenue discussed above and the changes in operating expenses explained below.

 

Total programming costs for the three and six months endedJune 30, 2004, increased 29% and 28% dueto the increased costs associated with the amortization of certain programmingsuch as *MASH*, *Matlock* and *Little House on the Prairie,* for our domestic Channel in2003. The decrease in amortization of film assets was primarily due to adecrease in the internal use of our film assets. The increase inamortization of film assets was primarily due to increased sales during the sixmonths ended June 30, 2004.

 

Operating costsfor the three and six months ended June 30, 2004, decreased $3.3 millionand $2.2 million primarily due to a $1.6 million decrease in bad debt expense.

 

*Selling,general and administrative expense.* The primary reason for the increases in thisexpense was compensation expense of $3.5 million and $5.8 million related toour RSUs for the three and six months ended June

 

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30, 2004. We commencedrecording compensation expense for our RSUs in June 2003. Our general andadministrative expense may increase in 2004 because of our retention bonusprogram described above, depending upon the results of exploring strategicalternatives for our international business.

 

*Lossfrom Operations. *Lossesfrom operations for the three and six months ended June 30, 2004, were$24.2 million and $49.4 million, which were comprised of a losses fromoperations of our domestic segment of $17.4 million and $37.2 million, lossesfrom operations of our international segment of $5.2 million and $7.7 million,and losses from operations of our film distribution segment of $1.6 million and$4.5 million. Losses from operations for the three and six months endedJune 30, 2003, were $28.5 million and $56.5 million, which were comprisedof a losses from operations of our domestic segment of $23.1 million and $38.0million, losses from operations of our international segment of $1.3 millionand $9.8 million, and losses from operations of our film distribution segmentof $4.1 million and $8.7 million.

 

*Guaranteedpreferred beneficial interest accretion. *This expense related to future obligations on our debenturesissued on December 17, 2001, in connection with the trust preferredsecurities of Crown Media Trust. The 2003 expense only included guaranteedpreferred beneficial interest accretion for a partial year due to therepurchase of our preferred securities on August 5, 2003.

 

*Interestexpense. *Interestexpense increased for the three and six months ended June 30, 2004,compared to June 30, 2003, by $8.4 million and $16.8 million.  This increase was primarily due to intereston our $400.0 million senior unsecured note payable commencing August 5,2003, which amounted to $10.6 million and $21.4 million for the three and sixmonths ended June 30, 2004.

 

## **Liquidityand Capital Resources**

##  

Cash used in operating activities was $26.7million and $73.4 million for the six months ended June 30, 2004 and 2003,respectively. Cash was used primarily to fund operating expenditures related tonet losses of $82.1 million and $96.1 million for the six months endedJune 30, 2004 and 2003, respectively. The decrease in cash flow used inoperations was primarily due to higher domestic advertising revenue andresulting cash receipts, as well as an increase in film asset sales anddecreases in programming expenditures and subscriber acquisition fee payments.

 

Cash used in investingactivities was $1.1 million and $1.7 million for the six months endedJune 30, 2004 and 2003, respectively. Cash used in investing activitiesdecreased primarily due to expenditures in our Network Operations Center toaccommodate the launch of our domestic Channel in the first quarter 2003 andour new domestic and international Channel websites being placed into serviceduring that period.

 

Cash provided by financing activities was $32.8million and $83.2 million for the six months ended June 30, 2004 and 2003,respectively. During the six months ended June 30, 2004 and 2003, wereceived proceeds of $23.6 million and $21.3 million, respectively, from ourTax Sharing Agreement with Hallmark Cards. We borrowed $70.0 million under ourline of credit with HC Crown to meet our operating demands during the sixmonths ended June 30, 2003.

 

The following table aggregates all of ourcontractual commitments as of June 30, 2004.

 

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| ** **                                                           | ** ** | **Scheduled Payments by Period** | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------|------------|
| **Contractual Obligations**                                          | ** ** | **Total**                        | ** ** | **Less than  1 Year** | ** ** | **2-3 Years** | ** ** | **4-5  Years** | ** ** | **After 5  Years** | ** ** |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Long-Term Debt                                                       |       | $                                | 310.3      |   | $ | 0.3 |   | $ | 310.0 |   | $ | — |   | $ | — |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Company Obligated Mandatorily Redeemable Preferred  Interest         |       | 25.0                             |       |   |   | 7.6 |   | 10.0 |   | 7.4 |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| HC Crown Line of Credit                                              |       | 75.0                             |       |   |   | — |   | 75.0 |   |   |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Senior Unsecured Note to HC Crown, including  accretion              |       | 596.6                            |       | — |   | — |   | — |   | 596.6 |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Capital Lease Obligations                                            |       | 31.3                             |       | 2.7 |   | 5.9 |   | 5.7 |   | 17.0 |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Operating Leases                                                     |       | 55.1                             |       | 14.7 |   | 21.1 |   | 13.4 |   | 5.9 |   |
| Other Obligations                                                    |       |                             |       |   |   |   |   |   |   |   |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Program license fees payable to non-affiliates and  NICC             |       | 137.3                            |       | 70.2 |   | 47.1 |   | 20.0 |   | — |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Program license fees payable to Hallmark Entertainment  Distribution |       | 102.3                            |       | 42.1 |   | 60.2 |   | — |   | — |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Program license fees payable for future windows                      |       | 189.5                            |       | 86.6 |   | 72.1 |   | 17.5 |   | 13.3 |   |
| Subscriber acquisition fees (a)                                      |       | 19.8                             |       | 18.4 |   | 1.4 |   | — |   | — |   |
| Deferred compensation and interest                                   |       | 2.0                              |       | — |   | 2.0 |   | — |   | — |   |
| Payable to Hallmark Entertainment Holdings (b)                       |       | 52.1                             |       | — |   | 52.1 |   | — |   | — |   |
| Payable to Hallmark Entertainment (b)                                |       | 47.9                             |       | — |   | 47.9 |   | — |   | — |   |
| Total Contractual Cash Obligations                                   |       | $                                | 1,644.2    |   | $ | 235.0 |   | $ | 627.4 |   | $ | 141.6 |   | $ | 640.2 |   |

 

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(a)                                  Current domestic distribution agreements couldsignificantly increase subscriber acquisition fees payable in the future by amaximum amount of $149.0 million, which would result if 42.0 million additionalsubscribers were provided with the Hallmark Channel.

 

(b)                                 Canonly be paid subsequent to repayment of the bank credit facility per agreement.

 

*Cash Flows*

 

As of June 30, 2004, the Company had $9.5 million in cash and cashequivalents on hand and $10.0 million available under its bank credit facility.The Company’s principal sources of funds are currently cash inflows fromoperations, cash on hand, periodic cash inflows expected under the tax sharingagreement with Hallmark Cards and amounts available for borrowing under itsbank credit facility. The Company projects that cash inflows from advertisingrevenue and film asset licensing fees will increase in 2004.  The Company anticipates cash inflows from itsfilm assets to be approximately $35.0 million to $40.0 million in 2004 and$35.0 million to $45.0 million in 2005. The Company also believes that since ithas a tax sharing agreement with its largest shareholder and since currentlyonly 75% of the tax benefit generated by the Company is being funded, there ispotential that future tax sharing payments could become available to theCompany at an earlier date than specified in the tax sharing agreement.

 

In connection with the Company’s growth strategy, the Company expectsto continue making investments in programming and distribution during 2004.Programming and distribution expenditures for 2004 are expected to be in therange of $150.0 million to $200.0 million. If necessary, the Company may reducesome of this anticipated spending in 2004. The Company’s principal uses offunds during 2004 are expected to be the payment of operating expenses,payments for licensing of programming and subscriber acquisition fees, andinterest payments under its bank credit facility.

 

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As of June 30, 2004, the Company believes that cash inflows from itsoperations, cash on hand, remaining availability under its bank credit facilityand payments anticipated under the tax sharing agreement with Hallmark Cards,all of which are currently its principal sources of funds, will be sufficientto meet its liquidity needs for at least the next twelve months. In any event,in order to provide more liquidity, we may consider pursuing alternatives toraise additional cash, which could include the issuance of additional equity ordebt securities or extension of our bank line of credit. There can be noassurance, however, that additional funding will be available, if at all, onterms acceptable to the Company. Any new debt financing would require theagreement of existing lenders, including HC Crown.

 

*Credit Facilities*

 

Through June 30, 2004, Crown Media Holdings had borrowed $310.0million under the line of credit in that amount with HC Crown. Because of thepartial repayment on the bank credit facility on August 5, 2003, theCompany has available funds under the bank credit facility of approximately$10.0 million at June 30, 2004.

 

*Potential Sale of theInternational Business*

 

On April 13, 2004, the Company announced thatit is exploring strategic alternatives for its international operations and theinternational rights to its film library, including, but not necessarilylimited to, a sale or other corporate transaction in an effort to maximizeshareholder value.  Any sale would, andany other corporate transaction might, require the consent of existing lenders,and be subject to other customary conditions. The Company contemplates usingany proceeds from any such transaction to pay down its debt and/or otherobligations.  The Company can not provideassurance that any such transaction will occur.

 

***Bank Credit Facility; Private Placement and HC Crown Line of Credit***

 

Our bank creditfacility, the HC Crown line of credit and the senior unsecured note to HC Crownare described in detail in Item 7 of Management’s Discussion and Analysis ofHistorical Financial Condition and Results of Operation in our Annual Report onForm 10-K for the year ended December 31, 2003, and earlier in thisReport.  As a result of these agreements,we are subject to a number of affirmative and negative covenants.

 

Under the Note Purchase Agreement for the senior unsecured note to HCCrown, the Company and its subsidiaries are restricted from, among others,incurring additional indebtedness, repurchasing or otherwise acquiring its ownstock and making investments in other parties and incurring additional liens.

 

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

##  

The discussion setforth in this Form 10-Q contains statements concerning potential future events.Such forward-looking statements are based on assumptions by Crown Media Holdingsmanagement, as of the date of this Form 10-Q including assumptions about risksand uncertainties faced by Crown Media Holdings. Readers can identify theseforward-looking statements by their use of such verbs as “expects,”“anticipates,” “believes,” or similar verbs or conjugations of such verbs. Ifany of management’s assumptions prove incorrect or should unanticipatedcircumstances arise, Crown Media Holdings’ actual results, levels of activity,performance, or achievements could materially differ from those anticipated bysuch forward-looking statements. Among the factors that could cause actualresults to differ materially are those discussed below in this Form 10-Q. CrownMedia Holdings will not update any forward-looking statements contained in thisForm 10-Q to reflect future events or developments.

 

If we do notsuccessfully address the risks described below, our business, prospects,financial condition, results of operations or cash flow could be materiallyadversely affected. The trading price of our Class A common stock could declinebecause of any of these risks.

 

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**Risks Relating to Our Business**

 

***Our business has incurred net losses since inception and may continueto incur losses.***

 

Both our international and domestic Channels havea history of net losses and we expect to continue to report net losses for theforeseeable future. As of June 30, 2004, we had an accumulated deficit ofapproximately $1.1 billion, total stockholders’ equity of approximately $255.5million, goodwill of approximately $314.0 million, and film assets of $737.5million.

 

We cannot assure you that we will achieve orsustain profitability. If we are not able to achieve or sustain profitability,the trading price of our Class A common stock may fall significantly. Todiminish our losses and become profitable, we will need to substantiallyincrease our revenue, particularly advertising and licensing revenue. This willrequire, among other things, increasing the distribution of our Channels,attracting more viewers to our Channels, attracting more advertisers, andincreasing our advertising rates. Risks associated with these areas of ourbusiness are described below.

 

In addition, in order to accomplish these goals,the management of Crown Media Holdings continues to believe that it isnecessary to increase subscribers and enhance our programming, which results inincreased subscriber acquisition fees and higher costs for programming. Overthe last three years, these actions have resulted in increased net losses forCrown Media Holdings.

 

***Our substantial indebtedness could adversely affect our financialhealth, and the restrictions imposed by the terms of our debt instruments mayseverely limit our ability to plan for or respond to changes in our business.***

 

We have a substantial amount of indebtedness. Asof June 30, 2004, our total debt was $846.9 million and we had $9.5million of cash and cash equivalents. In addition, we may borrow additionalamounts under our bank credit facility (to supplement the payments receivedunder the tax sharing agreement with Hallmark Cards) to cover the negative cashflow resulting from our current operations. Subject to restrictions under ourdebt agreements, we may also seek equity or debt financing from time to time tocover our operating losses, to finance acquisitions or capital expenditures orfor other purposes.

 

As a result of our level of debt and the terms ofour debt instruments:

 

• our vulnerability to adverse general economicconditions is heightened;

 

• we will be required to dedicate a portion of ourcash flow from operations to repayment of debt, limiting the availability ofcash for other purposes;

 

• we are and will continue to be limited byfinancial and other restrictive covenants in our ability to borrow additionalfunds, consummate asset sales, enter into transactions with affiliates orconduct mergers and acquisitions;

 

• our flexibility in planning for, or reacting to,changes in our business and industry will be limited;

 

• we are sensitive to fluctuations in interestrates; and

 

• our ability to obtain additional financing inthe future for working capital, capital expenditures, acquisitions, generalcorporate purposes or other purposes may be impaired.

 

Our ability to meet our debt and otherobligations and to reduce our total debt depends on our future operatingperformances and on economic, financial, competitive and other factors. Therecan be no assurance that our leverage and such restrictions will not materiallyand adversely affect our ability to finance our future operations or capitalneeds or to engage in other business activities.

 

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***We have increasing interest expense, which may impact our futureoperations.***

 

High levels of interest expense could have negative effects on ourfuture operations. Interest expense, which is net of interest income andincludes amortization of debt issuance costs and interest expense on borrowingsunder our senior and demand notes and bank credit facility, increasedsubstantially over the past year. The increase in interest expense in the pasttwelve months resulted from an increase in the average borrowings outstanding,due to cash generated from operations being insufficient to cover operatingexpenses and capital expenditures. A substantial portion of our cash flow fromoperations must be used to pay our interest expense and will not be availablefor other business purposes. In addition, we may need to incur additionalindebtedness in the future. We cannot assure you that our business willgenerate sufficient cash flow or that future financings will be available toprovide sufficient proceeds to meet our obligations or to service our totaldebt.

 

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

 

Because we currently operate at a loss and mayhave a negative cash flow, any unanticipated significant expense or anydevelopment that hampers our growth in revenue or decreases any of our revenue,would result in the need for additional external funds in order to continueoperations. We have no arrangements for any 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 the cooperationand agreement of existing lenders.

 

***Modification of any existing agreements with United States distributorscould decrease our subscriber fees revenue but, if our distribution isincreased, it could also result in higher advertising revenue.***

 

Several of the Crown Media United States’existing distribution agreements contain “most favored nations” clauses. Theseclauses typically provide that, in the event Crown Media United States entersinto an agreement with another distributor on more favorable terms, these termsmust be offered to the existing distributor, subject to certain exceptions andconditions. Distribution agreements which we may enter into in the future mayalso contain similar “most favored nation clauses.” In the past, CrownMedia United States was asked to comply with such clauses and modify itsdistribution agreements with certain distributors after entering into newdistribution agreements.  Any claimsunder these clauses in the future could result in the payment of cash or theissuance of stock by us to our distributors and would negatively affectsubscriber revenues; however, if our subscription base is increased as a resultof such modification, it could result in higher advertising revenue.

 

***If we are unable to obtain programming from third parties, we may beunable to increase our subscriber base.***

 

We compete with other pay television channelproviders to acquire programming. If we fail to continue to obtain programmingon reasonable terms for any reason, including as a result of competition, wecould be forced to incur additional costs to acquire such programming or lookfor alternative programming, which may hinder the growth of our subscriberbase.

 

***If our programming declines in popularity, our subscriber fees andadvertising revenue could fall and the additional revenue we expect as a resultof the acquisition of film assets from Hallmark Entertainment Distribution maybe lower than we anticipate.***

 

Our success depends partly upon unpredictable andvolatile factors beyond our control, such as viewer preferences, foreignexchange rates, competing programming and the availability of otherentertainment activities. We may not be able to anticipate and reacteffectively to shifts in tastes and interests in our markets. In particular, ourability to react effectively may be limited by our obligation to licenseprogramming from Hallmark Entertainment Distribution, which has standards thatlimit the types of programming that it will provide to us. Our competitors mayhave more flexible programming arrangements, as well as greater amounts ofproduction, better distribution, and greater capital resources, and may be ableto react more quickly to shifts in tastes and interests. As a result, we may beunable to maintain the commercial success of any of our current programming, orto generate sufficient demand and market acceptance for our new programming. Ashift in viewer preferences in programming or alternative entertainmentactivities could also reduce the amount of revenue we anticipate receiving fromlicensing of our film assets and cause a decline in both advertising andsubscriber fees revenue. The decline in revenue could hinder or prevent us fromachieving profitability and could adversely affect the market price of ourClass A common stock.

 

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***We are currently dependent on Hallmark Entertainment to distribute andmaximize licensing fees from the film assets.***

 

Currently, we are dependent on HallmarkEntertainment, a related party, to distribute and license our film assets tothird parties for us under a services agreement. This services agreementexpired on December 31, 2003, and the parties renewed this agreement. Thenew services agreement contains the same terms and conditions as the previousagreement and will expire on December 31, 2006. This arrangement reducesour control over the sales and distribution of the film assets and might delayour realization of the full revenue stream from the film assets. We andHallmark Entertainment each have the right to terminate the service agreementon a yearly basis. If Hallmark Entertainment elects to terminate the agreementbefore we have established our own distribution network, we may not be able toestablish our own or obtain alternative distribution services of equivalentquality or on terms as favorable to us. Termination of this services agreementcould hinder our ability, at least in the short-term, to achieve the amount ofadditional revenue anticipated from these activities and could adversely affectthe market price of our Class A common stock.

 

We anticipate that in due course we will developour own distribution/sales network and hire employees to perform the servicescurrently performed by Hallmark Entertainment under the service agreement. Ourability to do so is unproven and will require financial, operational andmanagement resources. We may not be able to hire the number of employees, oremployees who are sufficiently qualified, to perform these services, or do soin a cost efficient manner. If the cost to develop and maintain this employeebase is greater, or if this process takes longer than anticipated, it couldhave a negative impact on the revenue we anticipate generating from the filmassets.

 

***If we are unable to increase our advertising revenue, we may be unableto achieve profitability.***

 

Although it is expected over time that our advertising revenue willincrease, if we fail to increase significantly our advertising revenue, we maybe unable to achieve or sustain profitability or to expand our business.  A failure to increase advertising revenue maybe a result of any or all of the following: (i) we have a limited history of marketing and selling advertising time,particularly internationally; (ii) we may be unable to identify, attract andretain experienced sales and marketing personnel with relevant experience forour U.S. Channel; (iii) our sales and marketing organization may be unable tosuccessfully compete against the significantly more extensive and well-fundedsales and marketing operations of our current or potential competitors; (iv)the advancement of technologies such as Digital Video Recording may causeindustry-wide changes concerning the frequency in which individuals are exposedto advertising on television; and/or (v) we will not be able to increaseour advertising sales rate-card or may be required to run additionaladvertising spots which affect the availability of advertising inventory forfuture sales. Success in increasing ouradvertising revenue also depends upon the number and coverage of thedistributors who carry our Channels, our number of subscribers, and theviewership ratings for our programming.

 

The international cable advertising market ismuch less developed than in the United States, the United Kingdom and CentralEurope. We believe that only certain international markets have the potentialfor growth in advertising revenues and intend to emphasize those markets butcannot assure success.

 

***Hallmark Entertainment Investments controls us and this control couldcreate conflicts of interest or inhibit potential changes of control.***

 

Hallmark Entertainment Investments controls allof our outstanding shares of Class B common stock and owns shares of Class Acommon stock, representing approximately 96.1% of the outstanding voting poweron all matters submitted to our stockholders. Hallmark EntertainmentHoldings, a subsidiary of Hallmark Cards, controls the voting of all our sharesheld by Hallmark Entertainment Investments. HallmarkEntertainment Investments’ control could discourage others from initiatingpotential merger, takeover or other change of control transactions that mayotherwise be beneficial to our business or holders of Class A common stock. Asa result, the market price of our Class A common stock could suffer, and ourbusiness could suffer. Hallmark Entertainment Investments’ control relationshipwith us also could give rise to conflicts of interest in certain situations.

 

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***We could lose the right to use the name “Hallmark” because we havelimited-duration trademark license agreements, which could harm our business.***

 

We license the name “Hallmark” from HallmarkCards and Hallmark Licensing, Inc., for various uses, including in the name ofour international and domestic Channels, and this license expires onSeptember 1, 2004. If Hallmark Cards determines not to renew the trademarklicense agreements for any reason, including our failure to meet minimumprogramming thresholds dependent on programming provided by affiliates ofHallmark Cards or to comply with Hallmark Cards’ programming standards, wewould be forced to significantly revise our business plan and operations, andcould experience a significant erosion of our subscriber base and advertisingrevenue, particularly in the United States.

 

***If our third-party suppliers fail to provide us with networkinfrastructure services on a timely basis, our costs could increase and ourgrowth could be hindered.***

 

We currently rely on third parties to supply keynetwork infrastructure services, including uplink, playback, transmission andsatellite services to certain of our markets, which are available only fromlimited sources. We have occasionally experienced delays and other problems inreceiving communications equipment, services and facilities and may, in thefuture, be unable to obtain such services, equipment or facilities on the scaleand within the time frames required by us on terms we find acceptable, or atall. If we are unable to obtain, or if we experience a delay in the deliveryof, such services, we may be forced to incur significant unanticipated expensesto secure alternative third party suppliers or adjust our operations, whichcould hinder our growth and reduce our revenue and potential profitability.

 

***If our Network Operations Center fails or its operations are disrupted,our costs could increase and our growth could be hindered.***

 

We are currently using the Network OperationsCenter for the origination and playback of signals for the Hallmark Channelboth domestically and internationally. Like other single-point facilities, theNetwork Operations Center is subject to interruption from fire, tornadoes,lightning and other unexpected natural causes. Although we have redundantsystems in place, equipment failure, employee misconduct or outsideinterference could also disrupt the Network Operations Center’s services. Wecurrently do not have and are not planning a duplicate operations facility. Anysignificant interruption at the Network Operations Center affecting thedistribution of our Channels could have an adverse effect on our operatingresults and financial condition.

 

***If our local distribution partner for the Latin Americanregion fails to perform, our operations could be disrupted and our businessharmed.***

 

In the first quarter of 2003, we moved the majority of our operationsconcerning the distribution of the Hallmark Channel in Mexico, Central andSouth America to a local distribution partner in Argentina, Pramer, primarily to substantially reduce our expenses foroperations in this region. If Pramer is unable to adequately perform thefunctions of selling our Channel to local operators, to gain sufficientadvertising sales and to appropriately market the Channel, or, if Pramer’sservices are significantly interrupted for any reason, we may not improve ourperformance in Latin America.

 

***If we are unable to retain key executives and other personnel, ourgrowth could be inhibited and our business harmed.***

 

Our success depends on the expertise andcontinued service of our executive officers and key employees of oursubsidiaries. If we fail to attract, hire or retain the necessary personnel, orif we lose the services of our key executives, we may be unable to implementour business plan or keep pace with developing trends in our industry.

 

***We are subject to the risks of doing business outside the UnitedStates.***

 

Historically, a significant portion of ourrevenue has been generated from foreign operations. In order to maintain orexpand our presence in foreign markets, we have entered and may in the futureenter into strategic relationships with local operators in those markets.Certain foreign laws, regulations and judicial procedures may not be asprotective of programmer rights as those applicable in the United States. Inaddition, many foreign countries

 

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have currency and exchange laws regulating the international transfer ofcurrencies. To the extent that significant currency fluctuations result inmaterially higher costs to any of our foreign customers, those customers may beunable or unwilling to make the required payments. We may be subject to delaysin access to courts and to the remedies local laws impose in order to collectour payments and recover our assets. We also may experience problems withcollecting accounts due from foreign customers, which would adversely affectour revenue and income. Our growth and profitability may also suffer as aresult of, among other matters, competitive pressures on video delivery, laborstoppages, recessions and other political or economic events adverselyaffecting world or regional trading markets or affecting a particular customer.

 

***Our current and future operations in emerging markets may be harmed bythe increased political and economic risks associated with these markets.***

 

We currently broadcast in several foreign marketswhere market economies have only recently begun to develop, and we may expandthese operations in the future. If the governments in these markets adopt morerestrictive economic policies, we may not be able to continue operating, or toimplement our expansion plans, in those markets. More generally, we are exposedto certain risks, many of which are beyond our control, inherent in operatingin emerging market countries. These risks include changes in laws and policiesaffecting trade, investment and taxes (including laws and policies relating tothe repatriation of funds and to withholding taxes), differing degrees ofprotection for intellectual property and the instability of emerging marketeconomies, currencies, and governments.

 

***The amount of our goodwill, as well as our film costs, may hinder ourability to achieve profitability.***

 

As a result of our acquisitions of all the commoninterests in Crown Media United States, we have generated a significant amountof goodwill. We ceased the amortization of this acquired goodwill, and we arerequired to periodically review whether the value of our goodwill has beenimpaired. If we are required to write down our goodwill, our results ofoperations, stockholders’ equity or profitability could be materially adverselyaffected.

 

We also have a film cost relating to theamortization of the purchase price for the film assets that we use and licenseto others. This film cost is, and will continue to be, a significant componentof our cost of services each quarter.

 

***Our stock price may be volatile and could decline substantially.***

 

The stock market has, from time to time,experienced extreme price and volume fluctuations. Many factors may cause themarket price for our Class A common stock to decline, including:

 

• our operating results failing to meet theexpectations of securities analysts or investors in any quarter;

 

• material announcements by us or our competitors;

 

• governmental regulatory action;

 

• technological innovations by competitors orcompeting technologies;

 

• investor perceptions of our industry orprospects, or those of our customers; and

 

• changes in general market conditions or economictrends.

 

 Additionally, of theapproximately 73.9 million shares of the Company’s outstanding Class A commonstock, only 9.6 million shares (approximately 13%) are not held by affiliatesof the Company.  This stock ownershipstructure may also be a cause of volatility in the market price of theCompany’s Class A common stock.

 

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**Risks Relating to Our Industry**

 

***The proposed change in television ratings in the United States couldreduce our Channel revenue and our ability to achieve profitability.***

 

Our domesticadvertising revenues are partially dependent on television ratings provided byNielsen Media Research. Nielsen is currently modifying its ratings system byincreasing its household sample size. Our ratings could either be positively or negatively affected by thesechanges, depending on the demographic characteristics of the households addedto the Nielsen sample.

 

***Competition could reduce our Channel revenue and our ability to achieveprofitability.***

 

We operate in the pay television business, whichis highly competitive. If we are unable to compete effectively with largediversified entertainment companies that have substantially greater resourcesthan we have, our operating margins and market share could be reduced, and thegrowth of our business inhibited. In particular, we compete for distributionwith other pay television channels and, when distribution is obtained, forviewers and advertisers with pay television channels, broadcast televisionnetworks, radio, the Internet and other media. We also compete, to varyingdegrees, with other leisure-time activities such as movie theaters, theInternet, radio, print media, personal computers and other alternative sourcesof entertainment and information. Future technological developments may affectcompetition within this business.

 

A continuing trend towards business combinationsand alliances in both the domestic and foreign communications industries maycreate significant new competitors for us or intensify existing competition.Many of these combined entities have more than one channel and resources fargreater than ours. These combined entities may provide bundled packages ofprogramming, delivery and other services that compete directly with theproducts we offer. These entities may also offer services sooner and at morecompetitive rates than we do. In addition, these alliances may benefit fromboth localized content and the local political climate.

 

We may need to reduce our prices or licenseadditional programming to remain competitive, and we may be unable to sustainfuture pricing levels as competition increases. Our failure to achieve orsustain market acceptance of our programming at desired pricing levels couldimpair our ability to achieve profitability or positive cash flow, which wouldharm our business.

 

Distributors in the United States may attempt toincreasingly pressure smaller pay TV channels in terms of viewership, such asour domestic Hallmark Channel, to accept decreasing amounts for subscriberfees, to pay higher subscriber acquisition fees or to allow carriage of theChannel without the payment of subscriber fees. Factors that may lead to thispressure include the number of competing pay TV channels, the limited space availableon services of distributors in the United States and the desire of distributorsto maintain or reduce costs. Any reduction in subscriber fees revenue now or inthe future could have a material impact on our ability to achieve profitabilityand cash flow.

 

***New distribution technologies may fundamentally change the way wedistribute our Channels and could significantly decrease our revenue or requireus to incur significant capital expenditures.***

 

Our future success will depend, in part, on ourability to anticipate and adapt to technological changes and to offer, on atimely basis, services that meet customer demands and evolving industrystandards. The pay television industry has been, and is likely to continue tobe, subject to:

 

• rapid and significant technological change,including continuing developments in technology which do not presently havewidely accepted standards; and

 

• frequent introductions of new services andalternative technologies, including new technologies for providing video services.

 

For example, the advent of digital technology islikely to accelerate the convergence of broadcast, telecommunications, Internetand other media and could result in material changes in the economics,regulations, intellectual property usage and technical platforms on which ourbusiness relies, including lower retail rates for video services. These changescould fundamentally affect the scale, source, and volatility of our revenuestreams,

 

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cost structures, and profitability, and may require us to significantlychange our operations.

 

We also rely in part on third parties for thedevelopment of, and access to, communications and network technology. As aresult, we may be unable to obtain access to new technology on a timely basisor on satisfactory terms, which could harm our business and prospects.

 

Moreover, the increased capacity of digitaldistribution platforms, including the introduction of digital terrestrialtelevision, may reduce the competition for the right to carry channels andallow development of extra services at low incremental cost. These lowerincremental costs could lower barriers to entry for competing channels, andplace pressure on our operating margins and market position. In addition, agreater number of channels would likely increase competition among channels forviewers and advertisers, which could affect our ability to attract advertisingand new distribution at desired pricing levels, and could therefore hinder orprevent the growth of our subscriber base.

 

***If we fail to comply with applicable government regulations, ourbusiness could be harmed.***

 

If, as a provider of television channels, we failto comply with applicable present or future government regulations in anymarkets in which we operate, we could be prohibited from operating in thosemarkets and could be subject to monetary fines, either of which would increaseour operating costs, reduce our revenue and limit our ability to achieveprofitability. The scope of regulation to which we are subject varies fromcountry to country, although in many significant respects a similar approach istaken to the regulation of broadcasting across all of the markets in which weoperate. Typically, broadcasting regulation in each of the countries in whichwe operate requires that domestic broadcasters and platform providers securebroadcasting licenses from the domestic broadcasting authority. Additionally,most nations have broadcasting legislation and regulations, which set minimumstandards regarding program content, and prescribe minimum standards for thecontent and scheduling of television advertisements. Some countries requirethat a certain portion of programming carried by broadcasters be produceddomestically.

 

Moreover, broadcasting regulations are generallysubject to periodic and on-going governmental review and legislativeinitiatives, which may, in the future, affect the nature of programming we areable to offer and the means by which it is distributed. The timing, scope or outcomeof these reviews could be unfavorable to us, and any changes to currentbroadcasting legislation or regulations could require adjustments to ouroperations.

 

The Federal Communications Commission or Congressmay enact requirements that cable program services be offered to subscribers onan “a la carte” basis, i.e. be made available for purchase separately and notas part of a package of services. Such requirements could result in a reductionin the total number of subscribers to our domestic program services andadversely affect advertising revenue.

 

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

 

We only invest in instruments that meet highcredit and quality standards, as specified in our investment policy guidelines.These instruments, like all fixed income instruments, are subject to interestrate risk. The fixed income portfolio will decline in value if there is anincrease in interest rates. If market interest rates were to increaseimmediately and uniformly by 10% from levels as of June 30, 2004, thedecline of the fair value of the fixed income portfolio would not be material.

 

As of June 30, 2004, our cash, cashequivalents and short-term investments had a fair value of $9.5 million, whichwas invested in cash and short-term commercial paper. The primary purpose ofthese investing activities has been to preserve principal until the cash isrequired to fund operations. Consequently, the size of this portfoliofluctuates significantly as cash is provided by and used in our business.

 

The value of certain investments in thisportfolio can be impacted by the risk of adverse changes in securities andeconomic markets and interest rate fluctuations. At June 30, 2004, all ofour investments in this category were in fixed rate instruments or money markettype accounts. A decrease in interest rates has the effect of reducing ourfuture annual interest income from this portfolio, since funds would bereinvested at lower rates as the instruments

 

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mature. Over time, any net percentage decrease in our interest ratescould be reflected in a corresponding net percentage decrease in our interestincome. For the three and six months ended June 30, 2004, the impact ofinterest rate fluctuations, changed business prospects and all other factorsdid not have a material impact on the fair value of this portfolio, or on ourincome derived from this portfolio.

 

We have not used derivative financial instrumentsfor speculative purposes. As of June 30, 2004, we are not hedged orotherwise protected against risks associated with any of our investing orfinancing activities.

 

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

 

We are exposed to market risk, including changesto interest rates, foreign currency exchange rates and equity investmentprices. To reduce the volatility relating to these exposures, we may enter intovarious derivative investment transactions in the near term pursuant to ourinvestment and risk management policies and procedures in areas such as hedgingand counterparty exposure practices. We have not and will not use derivativesfor 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,foreign currency exchange rates or equity investment prices.

 

The estimated exposure discussed below isintended to measure the maximum amount we could lose from adverse marketmovements in interest rates, foreign currency exchange rates and equityinvestment prices, given a specified confidence level, over a given period oftime. Loss is defined in the value at risk estimation as fair market valueloss.

 

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

 

Our material interest bearing assets consisted ofcash equivalents and short-term investments. The balance of our interestbearing assets was $9.5 million, or less than 1% of total assets, as ofJune 30, 2004. Our material liabilities subject to interest rate riskconsisted of a capital lease obligation, our bank credit facility, our line ofcredit with HC Crown and our note payable to HC Crown. The balance of thoseliabilities was $836.7 million, or 66% of total liabilities, as ofJune 30, 2004. Net interest expense for the three and six months endedJune 30, 2004, was $15.9 million, 28%, of our total revenue and $31.7million, 28% 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.

 

***We are exposed to risks relating to foreign currency exchange rates andforeign economic conditions.***

 

We evaluate ourforeign currency exposure on a net basis. We receive subscriber fees andadvertising revenue from countries throughout the world. Increasingly, however,expenses arising from our foreign facilities as well as non-U.S. denominateddollar expenses are offsetting these revenues. Generally, payments requiredunder our agreements are denominated in U.S. dollars and, therefore, unaffectedby foreign currency exchange rate fluctuations. We have some exposure tochanges in exchange rates in Latin America, Europe, Asia, and Africa. However,our exposure to foreign exchange rates primarily exists with the British pound.When the U.S. dollar strengthens against the currencies in these countries, theU.S. dollar value of non-U.S. dollar denominated revenue decreases; when theU.S. dollar weakens, the U.S. dollar value of non-U.S. dollar denominatedrevenue increases. Accordingly, changes in exchange rates, and in particular, astrengthening of the U.S. dollar, may adversely affect our revenue as expressedin U.S. dollars.

 

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

 

***Disclosure Controls and Procedures***

 

The Company, under the supervision and with theparticipation of the Company’s management, including its Chief Executive Officerand Chief Financial Officer, carried out an evaluation of the effectiveness ofthe design and

 

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operation of the Company’s disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of1934) as of June 30, 2004.  Basedupon this evaluation, the Company’s Chief Executive Officer and Chief FinancialOfficer concluded that the Company’s disclosure controls and procedures areeffective as of that date for purposes of recording, processing,summarizing and timely reporting material information required to be disclosedin reports that the Company files under the Exchange Act.

 

***Changes in Internal Control Over FinancialReporting***

 

There were no changes in the Company’s internal control over financial reporting that occurred during the quarter ended June 30, 2004, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

44

 

**PARTII.  OTHER INFORMATION**

 

**Item 2.  *Change******s inSecurities, Use of Proceeds and Issuer Purchases of Equity Securities***

 

In May 2004, we issuedrestricted stock units as described in Note 2 to the Condensed Notes to theUnaudited Consolidated Financial Statements in Part I, Item 1, of this Reportunder the heading “Employee Incentives and Retention.”

 

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

 

Our2003 annual meeting of stockholders was held on June 3, 2004.  The following proposal was voted upon at themeeting, with the following number of votes cast for, against or withheld:

 

*Proposal One* – Elect 14 directors to our Board of Directors.

 

| **Name**                 | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** | **Abstentions and  Broker Non-Votes** |
|--------------------------|------------|---------------|------------|--------------------|------------|---------------------------------------|
|                     |       |          |       |               |       |                                  |
| Robert A. Halmi,  Jr.    |       | 377,791,140   |       | 1,160,607          |       | -0-                                   |
|                     |       |          |       |               |       |                                  |
| David J. Evans           |       | 377,919,300   |       | 1,032,447          |       | -0-                                   |
|                     |       |          |       |               |       |                                  |
| Wilford V. Bane,  Jr.    |       | 377,849,484   |       | 1,102,263          |       | -0-                                   |
|                     |       |          |       |               |       |                                  |
| Arnold L.  Chavkin       |       | 377,769,686   |       | 1,182,061          |       | -0-                                   |
|                     |       |          |       |               |       |                                  |
| Robert J. Druten         |       | 377,769,486   |       | 1,182,261          |       | -0-                                   |
|                     |       |          |       |               |       |                                  |
| Brian E. Gardner         |       | 377,787,171   |       | 1,164,576          |       | -0-                                   |
|                     |       |          |       |               |       |                                  |
| David E. Hall            |       | 377,780,171   |       | 1,171,576          |       | -0-                                   |
|                     |       |          |       |               |       |                                  |
| Donald J. Hall,  Jr.     |       | 377,889,563   |       | 1,062,184          |       | -0-                                   |
|                     |       |          |       |               |       |                                  |
| Irvine O.  Hockaday, Jr. |       | 377,889,463   |       | 1,062,284          |       | -0-                                   |
|                     |       |          |       |               |       |                                  |
| Anil Jagtiani            |       | 377,895,563   |       | 1,057,184          |       | -0-                                   |
|                     |       |          |       |               |       |                                  |
| David B. Koff            |       | 377,897,063   |       | 1,054,684          |       | -0-                                   |
|                     |       |          |       |               |       |                                  |
| Peter A. Lund            |       | 378,821,630   |       | 130,117            |       | -0-                                   |
|                     |       |          |       |               |       |                                  |
| John P. Mascotte         |       | 378,777,639   |       | 174,108            |       | -0-                                   |
|                     |       |          |       |               |       |                                  |
| Deanne R. Stedem         |       | 377,893,094   |       | 1,058,653          |       | -0-                                   |

 

All 14 persons listedabove were existing directors and were re-elected as our directors at thatmeeting.

 

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**Item 6.  *Exhibits andReports on Form 8-K***

 

(a)

 

**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*              |       | Letter Agreement, dated as of July 9, 2004, by and between Crown  Media Holdings, Inc. and Jeff Henry.                                                                                                               |
| 10.2*              |       | Amendment No. 1 to Employment Agreement, dates as of May 28, 2004, by  and between Crown Media Holdings, Inc. and David Evans.                                                                                            |
| 10.3               |       | Form of Amended and Restated Crown Media Holdings, Inc. Restricted  Stock Unit Agreement.                                                                                                                                 |
| 10.4               |       | Form of Crown Media Holdings, Inc. 2004 Restricted Stock Unit Agreement                                                                                                                                                   |
| 10.5               |       | Crown Media Holdings, Inc. 2004 Restricted Stock Unit Agreement, dated  as of May 28, 2004, by and between Crown Media Holdings, Inc. and David  Evans.                                                                   |
| 10.6               |       | Amended and Restated Crown Media Holdings, Inc. Restricted Stock Unit  Agreement, dated as of May 25, 2004, by and between Crown Media Holdings,  Inc. and David Evans.                                                   |
| 31.1               |       | Rule 13a-14(a)  Certification executed by the Company’s President and Chief Executive  Officer.                                                                                                                      |
| 31.2               |       | Rule 13a-14(a)  Certification executed by the Company’s Executive Vice President and Chief  Financial Officer.                                                                                                       |
| 32                 |       | Section 1350  Certifications.                                                                                                                                                                                        |

 

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* Management contract or compensating plan or arrangement.

 

(b)      Reports on Form 8-K

 

During the quarter ended June 30, 2004, we filed the following Form8-K report:

 

•                  Report filed on April 13, 2004, regardingItems 5 and 7; and

•                  Report filed on May 10, 2004, regarding Items 7and 12.

 

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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/ DAVID J.  EVANS |   |   | Director and Principal  Executive Officer |   | August 9, 2004 |
|       |  David J. Evans                                                         |   |
|       |                                                                         |   |   |   |   |
|       | By:       /s/ WILLIAM J. ALIBER           |   |   | Principal Financial and  Accounting Officer |   | August 9, 2004 |
|       | William J. Aliber                                                            |   |
|            |                                                                              |  |  |  |  |  |  |  |

 

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**INDEXTO 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*              |       | Letter  Agreement, dated as of July 9, 2004, by and between Crown Media Holdings,  Inc. and Jeff Henry.                                                                                                               |
| 10.2*              |       | Amendment No. 1  to Employment Agreement, dates as of May 28, 2004, by and between Crown Media  Holdings, Inc. and David Evans.                                                                                            |
| 10.3               |       | Form of Amended and Restated Crown Media Holdings, Inc. Restricted  Stock Unit Agreement.                                                                                                                                  |
| 10.4               |       | Form of Crown Media Holdings, Inc. 2004 Restricted Stock Unit Agreement                                                                                                                                                    |
| 10.5               |       | Crown Media Holdings, Inc. 2004 Restricted Stock Unit Agreement, dated  as of May 28, 2004, by and between Crown Media Holdings, Inc. and David  Evans.                                                                    |
| 10.6               |       | Amended and Restated Crown Media Holdings, Inc. Restricted Stock Unit  Agreement, dated as of May 25, 2004, by and between Crown Media Holdings,  Inc. and David Evans.                                                    |
| 31.1               |       | Rule 13a-14(a)  Certification executed by the Company’s President and Chief Executive  Officer.                                                                                                                       |
| 31.2               |       | Rule 13a-14(a)  Certification executed by the Company’s Executive Vice President and Chief  Financial Officer.                                                                                                        |
| 32                 |       | Section 1350  Certifications.                                                                                                                                                                                         |

 

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* Managementcontract or compensating plan or arrangement.

 

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