**UNITED STATES SECURITIES ANDEXCHANGE COMMISSION**

 

**Washington, D.C. 20549**

 

**Form 10-Q**

 

**(Mark One)**

| **x**                                                       | ** ** | **   QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|-------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------|
|                                                        |       |                                                                                                                  |
| **For the quarterly period ended  September 30, 2007** |
|                                                        |       |                                                                                                                  |
| **or**                                                      |
|                                                        |       |                                                                                                                  |
| **o**                                                       | ** ** | **   TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transition periodfrom                    to                    .**

 

**Commission File Number: 000-30700**

 

**Crown Media Holdings, Inc.**

(Exact Name of Registrant as Specified in ItsCharter)

 

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

 

**12700 Ventura Boulevard,**

**Suite 200**

**Studio City, California  91604**

(Address of Principal Executive Offices and ZipCode)

 

**(818) 755-2400**

(Registrant’s Telephone Number, Including AreaCode)

 

 

(Former Name, Former Address, and Former FiscalYear,

if Changed Since Last Report.)

 

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

 

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

 
| Large accelerated filer o | Accelerated filer x | Non-accelerated filer o |
|---------------------------|---------------------|-------------------------|

 

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

 

As of November 2,2007, the number of shares of Class A Common Stock, $.01 par valueoutstanding was 74,117,654, and the number of shares of Class B CommonStock, $.01 par value, outstanding was 30,670,422.

 

 

----

 

**TABLE OF CONTENTS**

 
| **PART I**  | **Financial  Information**                                                                                                                          |   |   |
|------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|             |                                                                                                                                                |   |   |
| Item 1           | Financial Statements  (Unaudited)                                                                                                                   |   |   |
|             | CROWN MEDIA HOLDINGS, INC. AND  SUBSIDIARIES                                                                                                        |   |   |
|             | Condensed Consolidated  Balance Sheets - December 31, 2006 andSeptember 30, 2007 (Unaudited)                                              |   |   |
|             | Condensed Consolidated  Statements of Operations and Comprehensive Loss (Unaudited)  - Three and Nine Months Ended September 30, 2006 and 2007 |   |   |
|             | Condensed Consolidated  Statements of Cash Flows (Unaudited)  - Nine Months Ended September 30, 2006 and 2007                                  |   |   |
|             | Notes to Unaudited Condensed  Consolidated Financial Statements                                                                                     |   |   |
|             |                                                                                                                                                |   |   |
| Item 2           | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                         |   |   |
|             |                                                                                                                                                |   |   |
| Item 3           | Quantitative  and Qualitative Disclosures About Market Risk                                                                                         |   |   |
|             |                                                                                                                                                |   |   |
| Item 4           | Controls and  Procedures                                                                                                                            |   |   |
|             |                                                                                                                                                |   |   |
| **PART II** | **Other Information**                                                                                                                               |   |   |
|             |                                                                                                                                                |   |   |
| Item I           | Legal Proceedings                                                                                                                                   |   |   |
|             |                                                                                                                                                |   |   |
| Item 1A          | Risk Factors                                                                                                                                        |   |   |
|             |                                                                                                                                                |   |   |
| Item 6           | Exhibits                                                                                                                                            |   |   |
|             |                                                                                                                                                |   |   |
| Signatures       |                                                                                                                                                |   |   |

 

2

----

 

*In this Form 10-Q theterms “Crown Media Holdings” and the “Company” refer to Crown Media Holdings, Inc.and, unless the context requires otherwise, subsidiaries of Crown MediaHoldings that operate or have operated our businesses, Crown Media UnitedStates, LLC (“Crown Media United States”), and until the completion of the saleof our film library in December 2006, Crown Media Distribution, LLC (“CrownMedia Distribution”). The term “common stock” refers to our Class A commonstock and Class B common stock, unless the context requires otherwise.*

* *

*The names Hallmark and other product or servicenames are trademarks or registered trademarks of their owners.*

* *

**PART I.FINANCIAL INFORMATION**

** **

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

 

**CROWN MEDIA HOLDINGS, INC. ANDSUBSIDIARIES**

**UNAUDITED CONDENSEDCONSOLIDATED BALANCE SHEETS**

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

 
| ** **                                                                                  | ** ** | **As of December 31,** | ** ** | **As of September 30,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                  | ** ** | **2006**                              | ** ** | **2007**                               | ** ** |
| ASSETS                                                                                      |       |                                  |       |                                   |       |
| Cash and cash equivalents                                                                   |       | $                                     | 13,965     |                                   | $          | 3 |   |
| Accounts receivable, less  allowance for doubtful accounts of  $246  and $299, respectively |       | 57,079                                |       | 58,285                                 |       |
| Program license fees—affiliates                                                        |       | 115                                   |       | 112                                    |       |
| Program license fees—non-affiliates                                                    |       | 111,909                               |       | 126,630                                |       |
| Receivable from buyer of  international business                                            |       | 24                                    |       | —                                 |       |
| Prepaid and other assets                                                                    |       | 4,202                                 |       | 4,545                                  |       |
| Prepaid program license fee  assets                                                         |       | 10,271                                |       | 12,937                                 |       |
| Total current assets                                                                        |       | 197,565                               |       | 202,512                                |       |
|                                                                                        |       |                                  |       |                                   |       |
| Accounts receivable                                                                         |       | 850                                   |       | 443                                    |       |
| Program license fees—affiliates                                                        |       | 274                                   |       | 190                                    |       |
| Program license fees—non-affiliates                                                    |       | 185,620                               |       | 148,085                                |       |
| Subscriber acquisition fees,  net                                                           |       | 41,665                                |       | 13,255                                 |       |
| Property and equipment, net                                                                 |       | 16,313                                |       | 15,775                                 |       |
| Goodwill                                                                                    |       | 314,033                               |       | 314,033                                |       |
| Prepaid and other assets                                                                    |       | 11,463                                |       | 8,439                                  |       |
| Total assets                                                                                |       | $                                     | 767,783    |                                   | $          | 702,732 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

3

----

 
| ** **                                                                                                                                                                                                  | ** ** | **As of December 31,** | ** ** | **As of September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                                                                                                                  | ** ** | **2006**                              | ** ** | **2007**                               | ** ** |
| LIABILITIES AND STOCKHOLDERS’  DEFICIT                                                                                                                                                                 |       |                                  |       |                                   |       |
| LIABILITIES:                                                                                                                                                                                                |       |                                  |       |                                   |       |
| Accounts payable and accrued  liabilities                                                                                                                                                                   |       | $                                     | 26,588     |                                   | $          | 29,492 |   |
| Accrued restricted stock units                                                                                                                                                                              |       | 1,513                                 |       | 4,216                                  |       |
| Subscriber acquisition fees  payable                                                                                                                                                                        |       | 2,071                                 |       | 865                                    |       |
| License fees payable to  affiliates                                                                                                                                                                         |       | 2,275                                 |       | 3,911                                  |       |
| License fees payable to  non-affiliates                                                                                                                                                                     |       | 96,085                                |       | 94,838                                 |       |
| Payables to RHI and related  companies                                                                                                                                                                      |       | 168                                   |       | —                                 |       |
| Payables to affiliates                                                                                                                                                                                      |       | 13,777                                |       | 15,499                                 |       |
| Payable to buyer of  international business                                                                                                                                                                 |       | 5,098                                 |       | 4,566                                  |       |
| Interest payable                                                                                                                                                                                            |       | 59                                    |       | 90                                     |       |
| Capital lease obligations                                                                                                                                                                                   |       | 672                                   |       | 721                                    |       |
| Deferred credit from technical  services agreement                                                                                                                                                          |       | 1,213                                 |       | 662                                    |       |
| Total current liabilities                                                                                                                                                                                   |       | 149,519                               |       | 154,860                                |       |
|                                                                                                                                                                                                        |       |                                  |       |                                   |       |
| Accrued liabilities                                                                                                                                                                                         |       | 25,291                                |       | 18,699                                 |       |
| License fees payable to  non-affiliates                                                                                                                                                                     |       | 88,951                                |       | 84,990                                 |       |
| Payable to buyer of  international business                                                                                                                                                                 |       | 4,771                                 |       | 2,274                                  |       |
| Credit facility                                                                                                                                                                                             |       | 87,633                                |       | 80,934                                 |       |
| Line of credit and interest  payable to HC Crown                                                                                                                                                            |       | 93,465                                |       | 99,398                                 |       |
| Line of credit and interest  payable to Hallmark Cards affiliate                                                                                                                                            |       | 53,364                                |       | 56,745                                 |       |
| Senior unsecured note to HC  Crown, including accrued interest                                                                                                                                              |       | 562,167                               |       | 605,977                                |       |
| Note and interest payable to  Hallmark Cards affiliate                                                                                                                                                      |       | 146,397                               |       | 155,674                                |       |
| Note and interest payable to  Hallmark Cards                                                                                                                                                                |       | —                                |       | 27,166                                 |       |
| Capital lease obligations                                                                                                                                                                                   |       | 15,498                                |       | 14,951                                 |       |
| Company obligated mandatorily  redeemable preferred  interest                                                                                                                                               |       | 16,483                                |       | 18,138                                 |       |
| Deferred credit from technical  services agreement                                                                                                                                                          |       | 3,188                                 |       | 2,299                                  |       |
| Total liabilities                                                                                                                                                                                           |       | 1,246,727                             |       | 1,322,105                              |       |
| COMMITMENTS AND CONTINGENCIES                                                                                                                                                                               |       |                                  |       |                                   |       |
| REDEEMABLE COMMON STOCK,  Class A common stock, $.01 par value; 0 and 4,357,066 shares issued and  outstanding as of December 31, 2006 and September 30, 2007                                |       | —                                |       | 31,937                                 |       |
| STOCKHOLDERS’ DEFICIT:                                                                                                                                                                                 |       |                                  |       |                                   |       |
| Class A common stock,  $.01 par value; 200,000,000 shares authorized; 74,117,654 and 69,760,588  shares issued and outstanding as of December 31, 2006 and  September 30, 2007, respectively |       | 741                                   |       | 698                                    |       |
| Class B common stock,  $.01 par value; 120,000,000 shares  authorized;  30,670,422 shares issued and outstanding as of December 31, 2006 and  September 30, 2007                             |       | 307                                   |       | 307                                    |       |
| Paid-in capital                                                                                                                                                                                             |       | 1,457,032                             |       | 1,406,456                              |       |
| Accumulated deficit                                                                                                                                                                                         |       | (1,937,024                            | )          | (2,058,771                             | )          |
| Total stockholders’ deficit                                                                                                                                                                            |       | (478,944                              | )          | (651,310                               | )          |
| Total liabilities and stockholders’  deficit                                                                                                                                                           |       | $                                     | 767,783    |                                   | $          | 702,732 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

4

----

 

**CROWN MEDIA HOLDINGS, INC. ANDSUBSIDIARIES**

**UNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS**

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

** **
| ** **                                                                                                                 | ** ** | **Three Months Ended****September 30,** | ** ** | **Nine Months Ended****September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                 | ** ** | **2006**                                     | ** ** | **2007**                                    | ** ** | **2006** | ** ** | **2007** | ** ** |
| Revenue:                                                                                                                   |       |                                         |       |                                        |       |   |   |   |   |
| Subscriber fees                                                                                                            |       | $                                            | 6,022      |                                        | $          | 7,389 |   | $ | 18,633 |   | $ | 21,391 |   |
| Advertising                                                                                                                |       | 40,229                                       |       | 47,819                                      |       | 121,228 |   | 142,750 |   |
| Advertising by Hallmark Cards                                                                                              |       | 2                                            |       | —                                      |       | 945 |   | 390 |   |
| Film asset license fees                                                                                                    |       | 989                                          |       | —                                      |       | 1,777 |   | — |   |
| Sublicense fees and other  revenue                                                                                         |       | 76                                           |       | 104                                         |       | 230 |   | 260 |   |
| Total revenue, net                                                                                                         |       | 47,318                                       |       | 55,312                                      |       | 142,813 |   | 164,791 |   |
| Cost of Services:                                                                                                          |       |                                         |       |                                        |       |   |   |   |   |
| Programming costs                                                                                                          |       |                                         |       |                                        |       |   |   |   |   |
| Affiliates                                                                                                                 |       | 3,652                                        |       | 11,247                                      |       | 9,154 |   | 21,149 |   |
| Non-affiliates                                                                                                             |       | 31,404                                       |       | 35,148                                      |       | 93,462 |   | 103,327 |   |
| Amortization of film assets                                                                                                |       | 4,560                                        |       | (4,739                                      | )          | 21,703 |   | (5,260 | ) |
| Impairment of film assets                                                                                                  |       | 40,946                                       |       | —                                      |       | 225,832 |   | — |   |
| Subscriber acquisition fee  amortization expense                                                                           |       | 7,747                                        |       | 7,048                                       |       | 23,260 |   | 22,728 |   |
| Amortization of capital lease  obligation                                                                                  |       | 289                                          |       | 289                                         |       | 868 |   | 868 |   |
| Other costs of services                                                                                                    |       | 1,786                                        |       | 2,933                                       |       | 8,838 |   | 8,193 |   |
| Total cost of services                                                                                                     |       | 90,384                                       |       | 51,926                                      |       | 383,117 |   | 151,005 |   |
| Selling, general and  administrative expense                                                                               |       | 10,682                                       |       | 11,578                                      |       | 32,489 |   | 39,828 |   |
| Marketing expense                                                                                                          |       | 3,483                                        |       | 3,565                                       |       | 8,851 |   | 11,850 |   |
| Depreciation and amortization  expense                                                                                     |       | 635                                          |       | 377                                         |       | 2,317 |   | 1,270 |   |
| Loss from operations                                                                                                       |       | (57,866                                      | )          | (12,134                                     | )          | (283,961 | ) | (39,162 | ) |
| Interest income                                                                                                            |       | 625                                          |       | 343                                         |       | 2,294 |   | 1,087 |   |
| Interest expense                                                                                                           |       | (27,086                                      | )          | (26,086                                     | )          | (75,371 | ) | (83,672 | ) |
| Loss before discontinued  operations and cumulative effect of change in accounting principle                               |       | (84,327                                      | )          | (37,877                                     | )          | (357,038 | ) | (121,747 | ) |
| (Loss) gain from sale of  discontinued operations, net of tax                                                              |       | (1                                           | )          | —                                      |       | 153 |   | — |   |
| Loss before cumulative effect  of change in accounting principle                                                           |       | (84,328                                      | )          | (37,877                                     | )          | (356,885 | ) | (121,747 | ) |
| Cumulative effect of change in  accounting principle                                                                       |       | —                                       |       | —                                      |       | (2,099 | ) | — |   |
| Net loss and comprehensive  loss                                                                                           |       | $                                            | (84,328    | )                                           | $          | (37,877 | ) | $ | (358,984 | ) | $ | (121,747 | ) |
| Weighted average number of  Class A and Class B shares  outstanding, basic and diluted                           |       | 104,788                                      |       | 104,788                                     |       | 104,788 |   | 104,788 |   |
| Loss per share before  discontinued operations and cumulative  effect of change in accounting principle, basic and diluted |       | $                                            | (0.80      | )                                           | $          | (0.36 | ) | $ | (3.41 | ) | $ | (1.16 | ) |
| (Loss) gain per share from  discontinued operations,  basic and  diluted                                                   |       | (0.00                                        | )          | —                                      |       | 0.00 |   | — |   |
| Cumulative effect of change in  accounting principle,  basic and  diluted                                                  |       | —                                       |       | —                                      |       | (0.02 | ) | — |   |
| Net loss per share, basic and  diluted                                                                                     |       | $                                            | (0.80      | )                                           | $          | (0.36 | ) | $ | (3.43 | ) | $ | (1.16 | ) |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

5

----

 

**CROWN MEDIA HOLDINGS, INC. ANDSUBSIDIARIES**

**UNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

 
| ** **                                                                                                                                          | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                                                          | ** ** | **2006**                                  | ** ** | **2007** | ** ** |
| CASH FLOWS FROM OPERATING  ACTIVITIES:                                                                                                              |       |                                      |       |   |   |
| Net loss                                                                                                                                            |       | $                                         | (358,984   | ) | $ | (121,747 | ) |
| Adjustments to reconcile net  loss to net cash used in operating activities:                                                                        |       |                                      |       |   |   |
| Gain from sale of discontinued  operations                                                                                                          |       | (153                                      | )          | — |   |
| Impairment of film assets                                                                                                                           |       | 225,832                                   |       | — |   |
| Depreciation and amortization                                                                                                                       |       | 156,484                                   |       | 147,935 |   |
| Accretion on company obligated  mandatorily redeemable preferred interest                                                                           |       | 1,460                                     |       | 1,655 |   |
| Provision for allowance for  doubtful accounts                                                                                                      |       | 254                                       |       | 95 |   |
| Cumulative effect of change in  accounting principle                                                                                                |       | 2,099                                     |       | — |   |
| Loss on sale of property and  equipment                                                                                                             |       | 205                                       |       | 36 |   |
| Stock-based compensation                                                                                                                            |       | (3,306                                    | )          | 5,671 |   |
| Changes in operating assets  and liabilities:                                                                                                       |       |                                      |       |   |   |
| Decrease (increase) in  accounts receivable                                                                                                         |       | 18,879                                    |       | (894 | ) |
| Decrease in receivable from  buyer of international business                                                                                        |       | 389                                       |       | 24 |   |
| Additions to program license  fees                                                                                                                  |       | (52,264                                   | )          | (101,576 | ) |
| (Additions) deletions to  subscriber acquisition fees                                                                                               |       | (224                                      | )          | 858 |   |
| Decrease in prepaid and other  assets                                                                                                               |       | (2,571                                    | )          | (1,124 | ) |
| Decrease in accounts payable,  accrued and other liabilities                                                                                        |       | (7,692                                    | )          | (1,561 | ) |
| Increase in interest payable                                                                                                                        |       | 55,200                                    |       | 70,915 |   |
| Decrease in subscriber  acquisition fees payable                                                                                                    |       | (10,071                                   | )          | (1,206 | ) |
| Decrease in license fees  payable to non-affiliates                                                                                                 |       | (50,127                                   | )          | (5,208 | ) |
| Increase in license fees  payable to affiliates                                                                                                     |       | 2,178                                     |       | 1,635 |   |
| Increase in payables to  affiliates                                                                                                                 |       | 1,247                                     |       | 1,723 |   |
| Decrease in deferred revenues                                                                                                                       |       | (254                                      | )          | — |   |
| Net cash used in operating  activities                                                                                                              |       | (21,419                                   | )          | (2,769 | ) |
| CASH FLOWS FROM INVESTING  ACTIVITIES:                                                                                                              |       |                                      |       |   |   |
| Purchases of property and  equipment                                                                                                                |       | (400                                      | )          | (970 | ) |
| Payments to buyer of  international business                                                                                                        |       | (7,451                                    | )          | (3,028 | ) |
| Proceeds from disposition of  property and equipment                                                                                                |       | —                                    |       | 3 |   |
| Net cash used in investing  activities.                                                                                                             |       | (7,851                                    | )          | (3,995 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                                                                               |       |                                      |       |   |   |
| Proceeds from the issuance of  common stock upon exercise of stock options                                                                          |       | 114                                       |       | — |   |
| Proceeds from tax sharing  agreement with Hallmark Cards                                                                                            |       | 11,982                                    |       | — |   |
| Borrowings under the credit  facility                                                                                                               |       | 15,000                                    |       | 7,145 |   |
| Payments on the credit facility                                                                                                                     |       | (3,500                                    | )          | (13,845 | ) |
| Principal payments on capital  lease obligations                                                                                                    |       | (454                                      | )          | (498 | ) |
| Net cash provided by (used in)  financing activities                                                                                                |       | 23,142                                    |       | (7,198 | ) |
| Net decrease in cash and cash  equivalents                                                                                                          |       | (6,128                                    | )          | (13,962 | ) |
| Cash and cash equivalents, beginning  of period                                                                                                     |       | 15,926                                    |       | 13,965 |   |
| Cash and cash equivalents, end  of period                                                                                                           |       | $                                         | 9,798      |   | $ | 3 |   |
|                                                                                                                                                |       |                                      |       |   |   |
| Supplemental disclosure of  cash and non-cash activities:                                                                                           |       |                                      |       |   |   |
| Interest paid                                                                                                                                       |       | $                                         | 14,221     |   | $ | 6,721 |   |
| Income taxes paid                                                                                                                                   |       | $                                         | 4          |   | $ | — |   |
| Tax sharing payment from  Hallmark Cards applied to note payable to Hallmark Cards affiliate                                                        |       | $                                         | 17,999     |   | $ | 6,510 |   |
| Payment to Hallmark Cards on  note payable to Hallmark Cards affiliate                                                                              |       | $                                         | 3,111      |   | $ | — |   |
| Reduction of additional  paid-in capital for obligation to return amounts previously received as  capital contributions under tax sharing agreement |       | $                                         | —     |   | $ | 25,192 |   |
| Reclassification of common  stock and paid-in capital to Redeemable Common Stock                                                                    |       | $                                         | —     |   | $ | 31,937 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

6

----

 

**CROWN MEDIA HOLDINGS, INC. ANDSUBSIDIARIES**

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**For the Three and Nine MonthsEnded September 30, 2006 and 2007**

 

**1. Business and Organization**

 

***Organization***

*** ***

Crown Media Holdings, Inc. (“Crown Media Holdings,”“Crown Media” or the “Company”), through its wholly-owned subsidiary, CrownMedia United States, LLC (“Crown Media United States”), owns and operates paytelevision channels (collectively the “Hallmark Channel,” the “Hallmark MovieChannel,” the “channel” or collectively the “channels”) dedicated to highquality, entertainment programming for adults and families in the UnitedStates. Significant investors in Crown Media Holdings include HallmarkEntertainment Investments Co. (“Hallmark Entertainment Investments” or “HEIC”,the Company’s majority shareholder and direct parent), a subsidiary of HallmarkCards, Incorporated (“Hallmark Cards”), the National Interfaith Cable Coalition, Inc.(“NICC”), and, indirectly through their investments in Hallmark EntertainmentInvestments, Liberty Media Corporation (“Liberty Media”) and J.P. MorganPartners (BHCA), L. P. (“J.P. Morgan”).

 

***Liquidity***

*** ***

Asof September 30, 2007, the Company had $3,000 in cash and cash equivalentson hand. As of September 30, 2007, the Company had borrowed $80.9 millionfrom a $130.0 million revolving bank credit facility, which matures May 31,2008.

 

The Company’s principal sources of funds are cash onhand, cash generated by operations and amounts available under the Company’srevolving bank credit facility. Previously, the Company’s tax sharing agreementwith Hallmark Cards has also been a source of cash. However, we do not expectto receive or pay any cash related to this agreement in the next twelve months.

 

Thesufficiency of the existing sources of liquidity to fund the Company’soperations is dependent upon continued growth in subscriber revenue andadvertising revenue. Any decline in the popularity of the Hallmark Channel, anysignificant future adverse modifications to the Company’s distributionagreements, an economic decline in the advertising market, an increase inprogram acquisition costs, an increase in competition or other adverseoperating conditions would negatively impact the Company’s liquidity and itsability to fund the current level of operations.

 

TheCompany expects to continue making investments in programming, marketing anddistribution. However, the Company’s recurring loss situation has demanded thatall areas of expenses, including programming, marketing and distribution beclosely monitored and controlled.

 

TheCompany currently believes that cash on hand, cash generated by operations andborrowing availability under its bank credit facility, when combined with thedeferral of any required payments on related-party debt and related interestmentioned below, will be sufficient to fund the Company’s operations and meetits liquidity needs through November 15, 2008.  The Company anticipates that its principaluses of cash during the next twelve months will continue to include the paymentof operating expenses, accounts payable and accrued expenses, license fees forprogramming, and interest under its bank credit facility. This paragraph is qualifiedin its entirety with respect potential consequences of the Put Right describedbelow.

 

TheCompany intends to extend or refinance the Bank credit facility prior to orupon its maturity. Any such extension or refinancing might require acontinuation of a letter of credit from Hallmark Cards or other steps by theCompany and, thus, is not assured. If the Company is not able to arrange forthe extension, refinancing or replacement of the bank credit facility prior toits maturity and either (1) the bank draws down on the irrevocable letterof credit provided by Hallmark Cards in support of the bank credit facility or 

 

7

----

 

(2) Hallmark Cards purchases the interests of the lending banks,Hallmark Cards would have all obligations and rights of the lending banks underthe bank credit facility. In that event, Hallmark Cards could demand payment ofoutstanding amounts at any time after November 15, 2008, under the termsof the waiver and standby purchase agreement (“Waiver Agreement”) describedbelow.

 

Upon maturity of the creditfacility on May 31, 2008, the lending group led by JP Morgan Chase has theright to elect to forego the receipt of cash to pay the principal amount of thecredit facility in full, which is provided for under the terms of anirrevocable letter of credit provided by Hallmark Cards, and instead may elect to initiate a process to foreclose onthe Company’s assets. Such foreclosure proceedings wouldadversely affect our ability to continue our operations. Prior to any suchpossible foreclosure proceedings, however, the Company, if it has not securedan extension of the credit facility or alternative financing, would causeHallmark Cards pursuant to the terms of the Waiver Agreement to exercise itsoption to purchase all of the outstanding indebtedness under the creditfacility and the credit facility would then be subject to terms of the WaiverAgreement.

 

Becauseof the Company’s possible inability to meet its obligations when they come duein November 2008, the Company anticipates that prior to November 15,2008, it will be necessary to either extend or refinance (i) the bankcredit facility and (ii) the promissory notes payable to affiliates ofHallmark Cards described in the Notes below. As part of a combination ofactions and in order to obtain additional funding, the Company may considervarious alternatives, including refinancing the bank credit facility, raisingadditional capital through the issuance of equity or debt securities, or other strategicalternatives.

 

***Effects of Transactions with NICC on Liquidity***

 

On October 28, 2007, NICCpurportedly exercised the Put Right, described below in Note 10, by makingformal demand that the Company purchase all of the 4,357,066 shares of Class Acommon stock owned by NICC.  The Companysubsequently informed NICC that exercise of the Put Right constituted a breachof a binding agreement in which, among other things, NICC agreed not toexercise the Put Right and which resulted from negotiations between thecompanies during September 2007. Whether the purported exercise by NICC ofthe Put Right will have an adverse impact on the Company’s liquidity depends onfuture developments that cannot be predicted at this time.  Some possible results are described below.

 

NICC proposed that its purchasedemand be settled on January 4, 2008. If settled, the purchase price per share, yet to be determined as of thedate of this Report, will be the 30-day average closing price from October 8,2007 through November 16, 2007, inclusive. The 21-day average closing price from October 8, 2007 through November 5,2007, inclusive, was $7.74.  The closingprice on November 5, 2007 was $6.80. Using either the 21-day average or the November 5, 2007, closingprice, the aggregate purchase price would be approximately $33.7 million or$29.6 million, respectively.

 

If the Company were required to or agreed to purchasethe Class A shares of NICC under the terms of the Put Right, the Companywould likely need to finance the purchase by selling all or a portion of therepurchased shares or obtaining additional capital through borrowings.  The Company’s ability to use proceeds from anequity or debt financing for the repurchase of the Class A shares oroperations is also dependent on obtaining approval from Hallmark Cards not touse such “Excess Cash Flow” as prepayments on outstanding debt to HallmarkCards as provided in the Waiver and Standby Purchase Agreement described belowin Note 8.  Such approval cannot beguaranteed.

 

Another possibility is that the Company and NICCproceed to litigation concerning the purported exercise of the Put Right.  In that event, NICC would be legally requiredto mitigate damages in a reasonable manner. Mitigation of damages could result in NICC’s selling all or part of the Class Ashares in the public market or through private sales.  Amounts received from such sales would reduceany damage allegedly sustained by NICC. If the Company is successful in defending any claim of NICC regardingthe Put Right, the attempted exercise of the Put Right would not have amaterial effect on the Company’s liquidity.

 

8

----

 

The purchase of the Class A shares would requirethe consent of the bank lenders under the credit facility because of a covenantconcerning restricted payments.  Delawarecorporate law limits the purchase of shares out of “net assets” in excess ofthe par value of issued shares.  Netassets may be valued on a basis other than the amounts on the balance sheet.  The Company has not conducted a valuation ofthe net assets to determine whether the repurchase of shares from NICC ispossible under this limitation.  TheCompany would conduct such a valuation before concluding that the purchase of Class Ashares owned by NICC would be allowed under Delaware law.

 

***Redeemable Common Stock***

*** ***

Forfinancial reporting purposes, as of September 30, 2007, the Company hasreclassified 4,357,066 shares allegedly subject to the Put Right from commonstock and paid-in capital to redeemable common stock.  The reasons are that NICC’s purportedexercise of the Put Right will be resolved only through further negotiation orlitigation and, thus, whether the common stock will be purchased under thealleged Put Right is beyond the sole control of the Company.

 

**2. Summary of SignificantAccounting Policies and Estimates**

 

***InterimFinancial Statements***

 

In the opinion of management, the accompanying condensedconsolidated balance sheets and related interim condensed consolidatedstatements of operations and cash flows include all adjustments, consisting ofnormal recurring items, necessary for their fair presentation in conformitywith accounting principles generally accepted in the United States. Interimresults are not necessarily indicative of results for a full year. Thesecondensed consolidated financial statements should be read in conjunction withthe audited consolidated financial statements and the notes to those statementsfor the year ended December 31, 2006, included in the Company’s AnnualReport on Form 10-K for the year ended December 31, 2006.

 

***Basis of Presentation***

*** ***

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

 

In December 2006, the Company completed the sale ofthe domestic rights to its film library assets. The accompanying condensedconsolidated statements of operations and cash flows do not reflect associatedrevenue and expenses as discontinued operations because the portions ofadvertising revenue and related cash collections that were derived from theCompany’s use of the film library assets to meet programming requirements ofthe Channel could not be clearly distinguished from advertising revenue andcash collections derived from the use of programming licensed from thirdparties.

 

***Use of Estimates***

*** ***

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

 

9

----

 

valuations, income taxes, reserves and other provisions forcontingencies are reasonable, based on information available at the time theyare made. These estimates, judgments and assumptions can affect the reportedamounts of assets and liabilities as of the date of the condensed consolidatedfinancial statements, as well as the reported amounts of revenue and expensesduring the periods presented. Actual results could differ from these estimates.

 

***Taxes on Income***

*** ***

Pursuant to the tax sharing agreement entered into withHallmark Cards in March 2003, the Company’s results of operations for taxpurposes became a part of the Hallmark Cards consolidated federal tax return asof and subsequent to March 2003. However, the Company continues to accountfor income taxes on a separate return basis. Accordingly, the Company accountsfor income taxes using an asset and liability method which requires therecognition of deferred tax assets and liabilities for the expected future taxconsequences attributable to differences between the financial statementcarrying amounts of existing assets and liabilities and their respective taxbases and net operating loss and tax credit carryforwards. Deferred tax assetsand liabilities 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 paymentsreceived from Hallmark Cards under the tax sharing agreement are recorded as anincrease in additional paid-in capital. Basedon the tax sharing agreement, the Company may ultimately owe Hallmark Cards forits share of the consolidated federal tax liability caused by the inclusion ofthe Company in the consolidated group. Such payments would be treated as areduction to paid-in capital to the extent of amounts previously received underthe tax sharing agreement.

 

***Net Loss per Share***

 

Basic net loss per share is computed by dividing the netloss for the period by the weighted average number of common shares outstandingduring the period. Diluted net loss per share is computed based on the weightedaverage number of common shares and potentially dilutive common sharesoutstanding. The calculation of diluted net loss per share excludes potentialcommon shares if the effect would be anti-dilutive. Potential common sharesconsist of incremental common shares issuable upon the exercise of stockoptions. Approximately 845,000 and 356,000 stock options for the three and ninemonths ended September 30, 2006 and 2007, respectively, have been excludedfrom the calculations of loss per share because their effect would have beenanti-dilutive.

 

***Reclassifications***

 

Certain reclassifications havebeen made to conform prior periods’ financial information to the currentpresentation.

 

During the second quarter of 2007, the Company reducedits estimate of a residual and participation liability related to the Company’suse of the film assets prior to the sale to RHI for $521,000 less than it hadoriginally accrued.  The Companyrecognized a gain on the sale of film assets in this amount during this timeperiod. During the third quarter of 2007,the Company reclassified the $521,000 gain on sale of film assets to  negative amortization of film assets.

 

***Recently Issued Accounting Pronouncements***

*** ***

In September 2006, theFASB issued Statement of Financial Account Standards No. 157, *Fair Value Measurements* (“SFAS 157”), which defines fairvalue, establishes a framework for measuring fair value and expands disclosuresabout fair value measurements. SFAS 157 will be effective for the Company as ofJanuary 1, 2008. The Company is currently evaluating the potential impactof adopting SFAS 157.

 

10

----

 

In February 2007, the FASB issued Statement ofFinancial Accounting Standards No. 159, *The FairValue Option for Financial Assets and Financial Liabilities*,including an amendment of FASB Statement No. 115 (“SFAS 159”). SFAS 159permits entities to choose, at specified election dates, to measure eligibleitems at fair value (the “fair value option”). A business entity shall reportunrealized gains and losses on items for which the fair value option has beenelected in earnings at each subsequent reporting period. SFAS 159 will beeffective for the Company as of January 1, 2008. The Company is evaluatingthe provisions of SFAS 159; it is unknown whether the Company will from time-to-timeelect the optional measurement provisions or whether SFAS 159 will otherwisehave any significant effect on the Company’s future reported financial positionor results of operations.

 

**3. Film Library Impairment**

 

In the second quarter of 2006 the Company retained aninvestment banking firm to solicit interest from third parties for thepotential purchase of the Crown Library. As a result of non-binding bids received in the second quarter and thethen proposed terms of an agreement dated October 5, 2006 for the sale ofthe Crown Library, management deemed it necessary to review its film assets forimpairment as of both June 30, 2006 and September 30, 2006.  The fair values used in the impairmentanalyses were derived by management taking into account the following: (1)  theimplied fair value from bid parties and a contractual sales price at June 30,2006 and September 30, 2006, respectively, with adjustments to take intoaccount the terms of the proposed sale including the estimated future cost ofthe Company’s indemnification of the buyer for retention of residual andparticipation liabilities arising from the buyer’s use of the Crown Library fora 10-year period following the closing of the sale; (2) the estimated fairvalue of rights for the Company’s non-exclusive use of certain films forshowing on its Hallmark Movie Channel for a limited period of time; and (3) theamount of accounts receivable related to the film library. The resultingnon-cash impairment charges of $40.9 million and $225.8 million for the threeand nine months ended September 30, 2006, respectively, are included inimpairment of film assets on the accompanying unaudited condensed consolidatedstatements of operations and comprehensive loss.

 

The non-binding bids received inthe second quarter of 2006 were solicited with an assumption that a buyer wouldacquire the library along with the obligation to remit residual andparticipation payments related to post-sale use of the library withoutfinancial assistance from the Company.  Managementsubsequently determined that it was likely that the Company would indemnify thepurchaser for such payments for a period of 10 years.  Because management believed that its estimateof the fair value of the 10-year indemnification differed significantly fromthe corresponding value ascribed by bidders, as only the bid from RHIEntertainment LLC included the term requiring Crown to retain the residual andparticipation liability, it was necessary to adjust the bids for management’sestimate of the fair value of the 10-year indemnification.  Accordingly, it was necessary to makeassumptions from the both the Company’s perspective and the perspective ofpotential buyers with respect to (a) future cash flows from use of thelibrary in the hands of a buyer, (b) average residual and participationrates applicable to such future sales, (c) future tax rates, and (d) discountrates that may be applicable to potential buyers.  It was also necessary to make assumptionswith respect to the estimated fair value of licenses to Crown to use athen-unspecified group of films for a limited period of time following asale.  Such assumptions included (a) thenumber of films to be licensed, (b) the length of such licenses, (c) futurecash flows, (d) average residual and participation rates applicable tosuch future sales, and (e) discount rates that may be applicable topotential buyers.

 

In connection with theimpairment analysis at September 30, 2006 management again estimated thefair value of the proposed 10-year indemnification for residuals andparticipations using the applicable assumptions described above.  Further, having then identified the group offilms as to which Crown was to receive licenses for limited future use, managementestimated the fair value of such licenses using assumptions that included (a) apresumption that the Company’s most recent rate card for exclusive third-partyuse was relevant and (b) a discount to be applied to such rates to reflectthe Company’s non-exclusive rights.

 

The bids used in management’svaluation of the film assets at June 30, 2006 and the purchase price andrelated terms of the proposed sale of the film library at September 30,2006 involve lump sum amounts with no values applied to individual films orgroups of films.  However, underapplicable accounting requirements the impairment analyses must be prepared ona film-by-film basis. Having concluded that since August 31, 2005, 

 

11

----

 

the date of the most recent film-by-film valuation,each individual film has retained its relative value with respect to the filmlibrary taken as a whole as of June 30 and September 30, 2006,management allocated the total estimated fair value at those dates on the basisof the estimated relative fair values of each film as of August 31,2005.  Non-cash impairment charges wererecorded at both June 30, 2006 and September 30, 2006 to reflect theamounts by which the carrying values of individual films exceeded therespective estimated fair values.

 

In preparing the impairment analyses management reliedupon various estimates which were based on information known at the time of theanalyses.

 

**4. Residual and ParticipationLiabilities**

 

On December 15, 2006, we completed the sale ofdomestic rights and certain international ancillary rights to our library ofapproximately 620 television movies, mini-series and series (the “Crown Library”)to RHI Entertainment LLC (“RHI”). Included in accounts payable and accrued liabilities is $10.6 million atDecember 31, 2006, and $11.8 million at September 30, 2007,respectively, related to residuals and participations that RHI would otherwisebe obligated to pay to third parties in connection with domestic film librarysales between the December 2006 sale and December 2016. The Company’sactual cost of this obligation will depend on the actual sales of these filmsby RHI but, in no event, will exceed $22.5 million. Any revisions to theseestimated liabilities will be reflected as gain (loss) from the sale of thefilm assets and reflected in continuing operations in future periods.

 

During the second quarter of 2007, the Company reducedits estimate of a residual and participation liability related to the Company’suse of the film assets prior to the sale to RHI for $521,000 less than it hadoriginally accrued.  Therefore, theCompany recognized negative amortization of film assets in this amount duringthis time period.

 

During the third quarter of 2007, the Companycompleted an analysis of its residual and participation liability, related tothe Company’s licenses of the film assets prior to the sale to RHI.  Using new information that became availableduring the third quarter of 2007, the Company was able to more accuratelyestimate amounts due and make payments on certain obligations, as well asanalyze and determine potential amounts due for exploitation of the filmsduring the referenced period.  TheCompany determined that it needed to reduce its liability by $4.7 million, andthus, recorded a negative amortization of film assets in this amount duringthis time period.

 

Also, included in accounts payable and accruedliabilities as December 31, 2006, and as of September 30, 2007, is$4.5 million and $4.9 million, respectively, for the estimated cost ofresiduals and participations that the buyer of our international business(which included the international rights to our film library) would otherwisebe obligated to pay to third parties in connection with international filmlibrary sales between the April 2005 sale and April 2015.  TheCompany’s actual cost of this obligation will depend on the actual internalusage or sales of these films by the buyer. Any revisions to these estimatedliabilities will be reflected as gain (loss) from sale of discontinuedoperations in future periods.

 

**5. Subscriber Acquisition Fees**

 

Subscriber acquisition fees are comprised of thefollowing:

 
| ** **                            | ** ** | **As of December 31,** | ** ** | **As of September 30,** | ** ** |
|---------------------------------------|------------|---------------------------------------|------------|----------------------------------------|------------|
| ** **                            | ** ** | **2006**                              | ** ** | **2007**                               | ** ** |
| ** **                            | ** ** | **(In thousands)**               | ** ** |
| Subscriber acquisition fees,  at cost |       | $                                     | 189,391    |                                   | $          | 178,939 |   |
| Accumulated amortization              |       | (147,726                              | )          | (165,684                               | )          |
| Subscriber acquisition fees,  net     |       | $                                     | 41,665     |                                   | $          | 13,255 |   |

 

*Ofthe net balance at September 30, 2007, the Company expects $8.6 millionwill be recognized as a reduction of subscriber fee revenue and $4.7 millionwill be recognized as subscriber acquisition fee expense in future periods.*

 

12

----

 

Asof December 31, 2006, and September 30, 2007, the unaudited condensedconsolidated balance sheets also reflect subscriber acquisition fees payable of$2.1 million and $865,000, respectively. For the three months ended September 30,2006 and 2007, the Company made cash payments of $0 and $250,000, respectively,relating to current subscriber acquisition fee obligations.  During the nine months ended September 30,2006 and 2007, the Company made cash payments of $10.3 million and $348,000,respectively, relating to current subscriber acquisition fee obligations.

 

**6. Program License Fees**

 

Program license fees are comprised of the following:

 
| ** **                                                 | ** ** | **As of December 31,** | ** ** | **As of September 30,** | ** ** |
|------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                 | ** ** | **2006**                    | ** ** | **2007**                     | ** ** |
| ** **                                                 | ** ** | **(In thousands)**     | ** ** |
| Program license fees—RHI  Entertainment  Distribution |       | $                           | 212,143    |                         | $          | 227,425 |   |
| Program license fees—NICC                             |       | 197                         |       | 197                          |       |
| Program license fees—other  affiliates                |       | 368                         |       | 368                          |       |
| Program license fees—other non-affiliates             |       | 326,552                     |       | 319,761                      |       |
| Program license fees, at cost                              |       | 539,260                     |       | 547,751                      |       |
| Accumulated amortization                                   |       | (241,342                    | )          | (272,734                     | )          |
| Program license fees, net                                  |       | $                           | 297,918    |                         | $          | 275,017 |   |

 

Programmingcosts for the three months ended September 30, 2006 and 2007, were $35.1million and $46.4 million, respectively. Programming costs for the nine months ended September 30, 2006 and2007, were $102.6 million and $124.5 million, respectively.

 

AtDecember 31, 2006, and September 30, 2007, $10.3 million and $12.9million of program license fees were included in prepaid program license feeassets on the accompanying unaudited condensed consolidated balance sheets asthe license periods had not commenced.

 

License fees payable are comprised of the following:

 
| ** **                                                 | ** ** | **As of December 31,** | ** ** | **As of September 30,** | ** ** |
|------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                 | ** ** | **2006**                    | ** ** | **2007**                     | ** ** |
| ** **                                                 | ** ** | **(In thousands)**     | ** ** |
| License fees payable—RHI  Entertainment  Distribution |       | $                           | 18,439     |                         | $          | 9,414 |   |
| License fees payable—NICC                             |       | 2,275                       |       | 3,911                        |       |
| License fees payable—non-affiliates                   |       | 166,597                     |       | 170,414                      |       |
| Total license fees payable                                 |       | 187,311                     |       | 183,739                      |       |
| Less current maturities                                    |       | (98,360                     | )          | (98,749                      | )          |
| Long-term license fees payable                             |       | $                           | 88,951     |                         | $          | 84,990 |   |

 

**7. Credit Facility**

 

AtSeptember 30, 2007, the Company had an amended credit agreement with asyndicate of banks, led by JP Morgan Chase Bank, under which the banks haveextended to the Company a secured revolving credit facility with availabilityof up to $130.0 million. At September 30, 2007, the outstanding balanceunder the credit facility was $80.9 million, and the Company had at that date$49.1 million of unused revolving credit capacity. The Company’s ability toborrow additional amounts under the credit facility is not limited orrestricted, so long as no covenants, representations or warranties areviolated. The Company and the lending banks originally entered into thefacility in 2001 and have subsequently amended the terms of this facility, withthe most recent amendment dated as of July 27, 2007. The facility isguaranteed by the Company’s 

 

13

----

 

subsidiaries and is secured by all tangible and intangible property ofCrown Media Holdings and its subsidiaries.

 

Eachborrowing under the bank credit facility bears interest at a Eurodollar rate oran alternate base rate as the Company may request at the time of borrowing inaccordance with the credit agreement. The Eurodollar rate is based on theLondon interbank market for Eurodollars and remains in effect for the timeperiod of the loan ranging from one, two, three, six or twelve months. Thealternate rate is based upon the prime rate of JP Morgan Chase Bank, acertificate of deposit rate or the Federal Funds effective rate, which isadjusted whenever the rates change. The Company is required to pay a commitmentfee of 0.15% per annum of the committed, but not outstanding, amounts under therevolving credit facility, payable in quarterly installments.

 

AtDecember 31, 2006, and September 30, 2007, the Company hadoutstanding borrowings of $87.6 million and $80.9 million, respectively, underthe credit facility and there were no letters of credit outstanding. At December 31,2006, $87.6 million of the outstanding balance bore interest at the Eurodollarrate (6.10% at December 31, 2006) and $0 bore interest at the JP MorganChase Bank prime rate. At September 30, 2007, $80.9 million of theoutstanding balance bore interest at the Eurodollar rate (5.88% at September 30,2007) and $0 bore interest at the JP Morgan Chase Bank prime rate. Under thecredit facility, $1.1 million bore interest at the JP Morgan Chase Bank primerate (7.75%) for three days during September 2007. Interest expense on borrowings under the credit facility for each of thethree months ended September 30, 2006 and 2007, was $3.5 million and $1.4million, respectively.  Interest expenseon borrowings under the credit facility for each of the nine months ended September 30,2006 and 2007, was $9.7 million and $4.3 million, respectively.

 

***Covenants***

*** ***

The credit facility, as amended, contains affirmativeand negative covenants.  The Company’sAnnual Report on Form 10-K contains a detailed description of thesecovenants. The Company was in compliance with these covenants at September 30,2007.

 

AmendmentNo. 12, dated as of March 2, 2007, extended the maturity date of therevolving credit facility to May 31, 2008. Additionally, the amendmentprovided for the Hallmark Cards letter of credit to be replaced by a JP MorganBank letter of credit for the $130.0 million, with an expiration date of June 10,2008.

 

Amendment No. 13, dated as of July 27, 2007,allowed the Company to grant a security interest in substantially all of theits assets to Hallmark Cards and permitted the Company to issue a promissorynote in favor of Hallmark Cards in the principal amount of $33.1 millionregarding the tax sharing agreement (the “Tax Note”).   Additional information regarding the Tax Noteis described below under Note 10 - Related Party Transactions - Tax SharingAgreement.

 

**8. Related Party Long-TermObligations**

 

***Waiverand Standby Purchase Agreement***

*** ***

Underthe Waiver and Standby Purchase Agreement dated March 21, 2006, as lastamended on October 17, 2007, Hallmark Cards agreed to defer all paymentsdue on any of the following obligations and, except where noted, payment ofinterest thereon until November 15, 2008, or an earlier date as describedbelow as the waiver termination date, whereupon all of these amounts becomeimmediately due and payable (the “Waiver Period”):

 

•       Line ofcredit and interest payable to HC Crown, dated December 14, 2001, in theoriginal principal amount of $75.0 million, payable to HC Crown. (Total amountoutstanding at December 31, 2006, and September 30, 2007, includingaccrued interest was $93.5 million and $99.4 million, respectively. See *Line of Credit and Interest Payable to HC Crown*below.)

 

14

----

 

•       $70.0million line of credit and interest payable to Hallmark Cards affiliate arisingout of the Company’s purchase of the Hallmark Entertainment film library.(Total amount outstanding at December 31, 2006, and September 30,2007, including accrued interest was $53.4 million and $56.7 million,respectively. See *Line of Credit and Interest Payable toHallmark Cards Affiliate*below.)

 

•       10.25%senior unsecured note, dated August 5, 2003, in the initial accreted valueof $400.0 million, payable to HC Crown. (Total amount outstanding at December 31,2006, September 30, 2007, including accrued interest was $562.2 millionand $606.0 million, respectively. See *Senior Unsecured Note*below.)

 

•       Note andinterest payable to Hallmark Cards affiliate, dated as of October 1, 2005,in the principal amount of $132.8 million, payable to Hallmark EntertainmentHoldings. (Total amount outstanding at December 31, 2006, and September 30,2007, including accrued interest was $146.4 million and $155.7 million,respectively. See *Note and Interest Payable to Hallmark CardsAffiliate*below.)

 

•            Note andinterest payable to Hallmark Cards in the amount of $33.1 million, dated as of July 27,2007. (Total amount outstanding at September 30, 2007, including accruedinterest was $27.2 million. See *Amounts Payable toHallmark Cards under Tax Sharing Agreement in Note 10* below.)

 

•       Allobligations of the Company under the bank credit facility by virtue of HallmarkCards’ deemed purchase of participations in all of the obligations under aletter of credit which Hallmark Cards has given in support of the facility orthe purchase by Hallmark Cards of all these obligations pursuant to the bankcredit facility.

 

HallmarkCards has agreed that it will not accelerate the maturity of any of theforegoing obligations or initiate collection proceedings during the WaiverPeriod. Interest will continue to accrue on these obligations during the WaiverPeriod. The Company will continue to pay interest on the credit facility duringthe Waiver Period.

 

Thewaiver termination date is November 15, 2008, or earlier upon occurrenceof any of the following events:  (a) theCompany fails to pay any principal or interest, regardless of amount, due onany indebtedness to unrelated parties with an aggregate principal amount inexcess of $5.0 million or any other event or condition occurs that results inany such indebtedness becoming due prior to its scheduled maturity, providedthat the waiver will not terminate if the Company reduces the principal amountof such indebtedness to $5.0 million or less within five business days of awritten notice of termination from Hallmark Cards; (b) certain bankruptcyevents occur; (c) the Company defaults in its payment of licensing feesunder the Second Amended and Restated Program License Agreement with RHIEntertainment Distribution (formerly known as Hallmark EntertainmentDistribution at which time it was a wholly-owned subsidiary of Hallmark Cards);(d) a representation and warranty of the Company in the Waiver Agreementis false or misleading in any material respect; or (e) the Company failsto pay interest on the bank credit facility described above to the extent thatHallmark Cards has purchased all or a portion of the indebtedness thereunder orto perform any covenants in the Waiver Agreement.

 

Underthe Waiver Agreement, if the lenders under the bank credit facility accelerateor seek to collect any of the indebtedness under the bank credit facility, thenthe Company may require that Hallmark Cards or its designated subsidiaryexercise an option to purchase such indebtedness. All expenses and feesincurred in connection with such a purchase would be added to the principalamount of the credit facility obligations.

 

TheWaiver Agreement does not limit any existing rights of Hallmark Cards or itsaffiliates to offset amounts owed to us under the Hallmark Tax SharingAgreement and Hallmark Cards’ share of the amounts payable under the December 1,2005, agreement with NICC (described below) against these obligations.Additionally, during the Waiver Period, Hallmark Cards is permitted to offsetfuture tax benefits it realizes pursuant to the Tax Sharing Agreement, firstagainst accrued and unpaid interest and then to the unpaid principal balance ofthe Tax Note until the earlier of such time as the balance equals zero or thematurity date of the Tax Note.

 

15

----

 

Pursuantto the Waiver Agreement, the Company must make prepayments on the outstandingdebt from 100% of any “Excess Cash Flow” during the Waiver Period.  “Excess Cash Flow” is defined as 1) the netproceeds of any debt or equity financings or sale of assets; 2) the netcash proceeds from the incurrence by the Company of indebtedness; 3) the netcash proceeds from the sale, transfer or release by the Company of assetsoutside the ordinary course of business; and 4) if positive, theconsolidated net cash flow from operations of Crown Holdings for any calendarquarter as shown in an SEC report, less cash funds used to pay currentoperating expenses and to pay or establish reasonable reserves for futureexpenses, indebtedness payments, and capital improvements and replacements asdetermined by the Board of Directors of the Company.

 

***Hallmark Letter of Credit***

*** ***

Pursuantto Amendment No. 12 to the bank credit facility, Hallmark Cards hasprovided an irrevocable letter of credit issued by JP Morgan Chase Bank in theamount of $130.0 million, as credit support for our obligations under thecredit facility with an expiration date of June 10, 2008.

 

***Related Party Long-TermObligations***

 

The aggregate maturities of related party long-termdebt for each of the five years subsequent to September 30, 2007, are asfollows:

 
| ** **                                                                                                                                                                                          | ** ** | **Payments Due by Period** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                                          | ** ** | **Total**                  | ** ** | **1 year** | ** ** | **2 years** | ** ** | **3 years** | ** ** | **4 years** | ** ** | **5 years** | ** ** |
| ** **                                                                                                                                                                                          | ** ** | **(In thousands)**         | ** ** |
| ** **                                                                                                                                                                                          | ** ** | ** **                 | ** ** |
| Line of credit and interest payable to HC Crown,  with principal due November 15, 2008 (8.37% Eurodollar rate at  December 31, 2006 and 8.36% Eurodollar rate at September 30, 2007) |       | $                          | 99,398     |   | $ | — |   | $ | 99,398 |   | $ | — |   | $ | — |   | $ | — |   |
| Note and interest payable to Hallmark Entertainment  Holdings due November 15, 2008 (8.37% Eurodollar rate at  December 31, 2006 and 8.36% Eurodollar rate at September 30, 2007)    |       | 56,745                     |       | — |   | 56,745 |   | — |   | — |   | — |   |
| 10.25 % Senior unsecured note to HC Crown, including  accrued interest, due August 5, 2011                                                                                                     |       | 605,977                    |       | — |   | — |   | — |   | 605,977 |   | — |   |
| Note and interest payable to Hallmark Entertainment  Holdings due November 15, 2008 (8.37% Eurodollar rate at  December 31, 2006 and 8.36% Eurodollar rate at September 30, 2007)    |       | 155,674                    |       | — |   | 155,674 |   | — |   | — |   | — |   |
| Note and interest payable to Hallmark Cards, with  principal due July 27, 2009 (8.36% Eurodollar rate at September 30,  2007)                                                             |       | 27,166                     |       | — |   | 27,166 |   | — |   | — |   | — |   |
|                                                                                                                                                                                                |       |                       |       |   |   |   |   |   |   |   |   |   |   |
|                                                                                                                                                                                                |       | $                          | 944,960    |   | $ | — |   | $ | 338,983 |   | $ | — |   | $ | 605,977 |   | $ | — |   |

 

***Interest Paid to HC Crown***

*** ***

Interestexpense paid to HC Crown was $1.1 million for the three months ended September 30,2006, and $457,000 for the three months ended September 30, 2007. Interestexpense paid to HC Crown was $3.3 million for the nine months ended September 30,2006, and $1.4 million for the nine months ended September 30, 2007.

 

16

----

 

**9. Related Party Transactions**

 

***TaxSharing Agreement***

*** ***

***Overview***

*** ***

OnMarch 11, 2003, Crown Media Holdings became a member of Hallmark Cardsconsolidated federal tax group and entered into a federal tax sharing agreementwith Hallmark Cards (the “tax sharing agreement”). Hallmark Cards includesCrown Media Holdings in its consolidated federal income tax return.Accordingly, Hallmark Cards has benefited from past tax losses of Crown MediaHoldings and may benefit from future federal tax losses, which may be generatedby Crown Media Holdings. Based on the tax sharing agreement, Hallmark Cards hasagreed to pay Crown Media Holdings directly or by reduction of principal andinterest due under the July 27, 2007, promissory note with Hallmark Cards,all of the benefits realized by Hallmark Cards as a result of including CrownMedia Holdings in its consolidated income tax return. These benefits areestimated and paid 75% in cash or can be netted against the amounts payableunder the Note Payable to Hallmark Cards on a quarterly basis and the balancewhen Crown Media Holdings becomes a federal taxpayer. Under the tax sharingagreement, at Hallmark Cards’ option, the 25% balance may be applied as anoffset against any amounts owed by Crown Media Holdings to any member of theHallmark Cards consolidated group under any loan, line of credit or otherpayable, subject to limitations under any loan indentures or contractsrestricting such offsets. During the third quarter of 2006, Hallmark Cards used$18.0 million of the approximately $18.0 million available of this 25% balanceto reduce the principal amount due under the March 21, 2006, promissorynote with Hallmark Entertainment Holdings.

 

Duringthe third quarter of 2007, Hallmark Cards used $6.5 million due to the Companyunder the tax sharing agreement to reduce the principal and interest amount dueunder the July 27, 2007, promissory note with Hallmark Cards.

 

TheCompany received $7.0 million in cash payments under the tax sharing agreementduring the three months ended September 30, 2006. The Company did notreceive any cash payments under the tax sharing agreement during the threemonths ended September 30, 2007. The Company received $12.0 million incash payments and $0 in cash payments under the Tax Sharing Agreement duringand the nine months ended September 30, 2006 and 2007, respectively. Anypayments received from Hallmark Cards or credited against amounts owed by CrownMedia Holdings to any member of the Hallmark Cards consolidated group under thetax sharing agreements are recorded as an addition to paid-in capital in theaccompanying unaudited condensed consolidated balance sheets.

 

*Amounts Payable to Hallmark Cards under Tax SharingAgreement*

 

TheInternal Revenue Service examined Hallmark Cards’ consolidated tax returnsfiled for fiscal years 2003 and 2004 anddetermined in 2007 that, with respect to a portion of the losses attributableto the Company for fiscal years 2003 and 2004, Hallmark Cards should not havecarried back such losses to its consolidated federal tax returns filed forfiscal years 2001 and 2002. These losses are available as carry-forwards in theconsolidated federal tax return beginning in 2005 and later years.  Furthermore, the examination changed theamount of foreign tax credits that had previously been conveyed to the Companyunder the Tax Sharing Agreement. Because the Company’s share of the taxbenefits realized from such losses and credits ($25.2 million) were eithercontributed to the Company in cash or applied as an offset against amounts owedby the Company to other members of the consolidated group, the Company isobligated to return this amount to Hallmark Cards plus interest related theretoin the amount of $7.9 million. As a result, the Company recorded a $33.1million payable to Hallmark Cards with a corresponding $25.2 million reductionof additional paid-in capital and a $7.9 million charge to interest expense,all of which were recognized during the three months ended June 30, 2007.

 

On July 27, 2007, the Company replaced a payableto Hallmark Cards with a $33.1 million promissory note payable to HallmarkCards due in July 2009 with interest at LIBOR plus 3% per annum (the “Note”).The Note may be prepaid in whole or in part with no penalty. The Company is notrequired to make any cash payments prior to maturity. Until the Note andrelated interest is paid in full, Hallmark Cards will offset any future taxbenefits it realizes pursuant to the Tax Sharing Agreement, first againstaccrued and unpaid interest and then against the unpaid principal balance. In September 2007,Hallmark Cards offset $6.5 million against $508,000 of accrued and unpaidinterest and $6.0 million of unpaid principal. Additionally, in September 2007,the Company recorded an additional $85,000 charge to interest expense relatedto the receipt of an invoice for the actual amount owed in regard to the 

 

17

----

 

return of tax benefits under the Tax Sharing Agreement as describedabove.

 

The Note and any payment thereunder are subordinatedto the bank credit facility extended to the Company by JP Morgan Chase Bank.

 

*Accountingfor Uncertainty in Income Taxes*

 

TheCompany adopted FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes* (“FIN 48”), on January 1, 2007.FIN 48 requires a new evaluation process for all tax positions taken. If theprobability for sustaining a tax position is greater than 50%, then the taxposition is warranted and recognition should be at the highest amount whichwould be expected to be realized upon ultimate settlement. As of the date ofadoption of FIN 48 and at September 30, 2007, the total amount ofunrecognized tax benefits for uncertain tax positions was $0. As a result ofthe implementation of FIN 48, the Company recognized no increase or decrease inthe amount of unrecognized tax benefits for uncertain tax positions.

 

The Companyrecognizes interest and penalties related to uncertain tax positions in incometax expense. As of the date of adoption and on September 30, 2007, we haveno accrued interest related to uncertain tax positions.

 

Byvirtue of its inclusion in Hallmark Cards consolidated tax returns, the Companyis subject to examination by the Internal Revenue Service for periodssubsequent to March 10, 2003. Further, net operating loss carryforwards (“NOL’s”)are subject to examination in the year they are utilized regardless of whether thetax year in which they were generated has been closed by statute. The amountsubject to disallowance is limited to the NOL utilized. Accordingly, theCompany is subject to examination for NOL’s generated prior to March 11,2003 if and when such NOL’s are utilized in future tax returns.

 

The Companyfiles state tax returns in major jurisdictions such as California, Colorado andNew York, and has also been included in the combined state tax returns ofHallmark or Hallmark Entertainment Holdings, Inc. The state returns aregenerally subject to examination for years after 2001.

 

***Services Agreement with Hallmark Cards***

*** ***

For each of the three months ended September 30,2006 and 2007, Crown Media Holdings had accrued $133,000 and $137,000,respectively, under the intercompany services agreement with Hallmark Cards.For each of the nine months ended September 30, 2006 and 2007, Crown MediaHoldings had accrued $398,000 and $410,000, respectively, under the agreement.At December 31, 2006, and September 30, 2007, non-interest bearingunpaid accrued service fees and unreimbursed expenses of $11.5 million and$13.0 million, respectively, were included in payable to affiliates in theaccompanying unaudited condensed consolidated balance sheets. At December 31,2006, and September 30, 2007, out-of-pocket expenses and third party feeswere $914,000 and $1.1 million, respectively.

 

***Trademark License Agreements***

 

On August 1, 2007, Hallmark Licensing, Inc.extended its trademark agreements with the Company to September 1, 2008. Suchtrademark agreements allow Crown Media United States to name its networkservices “Hallmark Channel” and “Hallmark Movie Channel.”

 

***Payment from Hallmark Cards***

 

On September 1, 2006, Hallmark Cards applied $3.1million owed by Hallmark Cards and its affiliates to the Company, against the$70.4 million promissory note of the Company with Hallmark EntertainmentHoldings. The $3.1 million was related to the December 1, 2005, agreementwith NICC.

 

18

----

 

**10. Company Obligated MandatorilyRedeemable Preferred Interest and NICC License Agreements**

 

VISNManagement Corporation (“VISN,” a subsidiary of NICC) owns a $25.0 millionCompany-obligated mandatorily redeemable preferred interest in Crown MediaUnited States (the “preferred interest”) issued in connection with aninvestment by the Company in Crown Media United States.

 

OnNovember 13, 1998, the Company, Vision Group, VISN and Henson CableNetworks, Inc. signed an amended and restated agreement governing certainoperations of Crown Media United States, as amended at various times through December 1,2005 (the “NICC Agreement”). The Company has informed NICC that parts of theNICC Agreement have been terminated by the new agreement mentioned below.

 

TheNICC Agreement provided that in the event there is a change of control of CrownMedia Holdings prior to the December 31, 2007, expiration of the NICCAgreement, the Company shall immediately pay NICC a $15.0 million “terminationpayment.” Also, under the NICC Agreement, Crown Media Holdings would berequired to redeem the Preferred Interest for $25.0 million plus accruedinterest at LIBOR from November 27, 2005. NICC has advised the Companythat it believes the $15.0 million “termination payment” referred to above ispayable upon a change of control of the Company whenever occurring and thus, itclaims, the right to the payment survives indefinitely past the December 31,2007, expiration of the NICC Agreement. The Company believes that thisobligation ended with the new agreement mentioned below and would in any eventend on December 31, 2007.

 

TheNICC Agreement also granted NICC a conditional right to require the Company torepurchase all of the shares of the Company’s Class A common stock thenowned by NICC (the “Put Right”). There having been no change in control of theCompany, on July 1, 2007, NICC and the Company commenced a required 60-daynegotiating period regarding continuation of the programming commitments. This60-day period expired August 29, 2007, without agreement between theparties. As a result, the Put Right became contractuallyexercisable on August 30, 2007, with a November 1, 2007, expiration.However, the Company believes that it subsequently reached a binding agreementwith NICC, under which NICC agreed it would not exercise the Put Right. Asnoted above, NICC disagrees that a binding agreement was reached and notifiedthe Company on October 28, 2007, that it was exercising the Put Right.

 

Asof September 30, 2007, NICC had not exercised the Put Right. Whether theCompany eventually prevails in its belief that in September 2007 NICCagreed not to exercise the Put Right in exchange for other consideration is amatter beyond the Company’s sole control. Accordingly, the accompanyingunaudited condensed consolidated balance sheet as of September 30, 2007,reflects 4,357,066 shares of Class A common stock as redeemable commonstock at a price per share of $7.33 with corresponding reductions of commonstock and paid-in capital. Such price per share was determined as if NICCexercised the Put Right on September 30, 2007, and comprises an average ofclosing prices from September 10, 2007 through October 19, 2007,inclusive.

 

** **NICC purportedly exercised the Put Rightby written notice on October 28, 2007 and proposed that the purchase besettled on January 4, 2008. See *Liquidity* underNote 1 for a more complete discussion of this matter including (1) theCompany’s assertion that the Put Right was no longer exercisable and (2) certainfinancial and legal considerations.

 

Duringthe three months ended September 30, 2006, and 2007, Crown Media UnitedStates paid NICC $3.8 million and $4.0 million, respectively, related to theNICC Agreement. During the nine months ended September 30, 2006 and 2007,Crown Media United States paid NICC $15.1 million and $15.3 million,respectively, related to the NICC Agreement.

 

19

----

 

**11.  RHI Entertainment**

 

On January 12, 2006, HallmarkCards sold the equity interests in Hallmark Entertainment, LLC, and, thusindirectly, Hallmark Entertainment Distribution to the management of HallmarkEntertainment, LLC and affiliates of Kelso & Company. Since 1995,Hallmark Entertainment Distribution had been a subsidiary of HallmarkEntertainment, LLC, which in turn was a wholly-owned subsidiary of HallmarkCards.  Following Hallmark Cards sale ofthe companies, Hallmark Entertainment, LLC and Hallmark EntertainmentDistribution were renamed RHI Entertainment, LLC and RHI EntertainmentDistribution, LLC, respectively.

 

Until the December 15, 2006 saleof the film library assets, Crown Media Holdings had agreements with RHIEntertainment Distribution (or Hallmark Entertainment Distribution) forservices in connection with the operation of the film library assets and thelicensing of programming produced or distributed by RHI EntertainmentDistribution. Crown Media Holdings continues to license programming from RHIEntertainment Distribution.

 

***Program License Agreements with RHI EntertainmentDistribution***

*** ***

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

 

Underboth the current and previous agreements with RHI Entertainment Distribution,if Crown Media United States sub-licenses any licensed program to a thirdparty, it must equally share with RHI Entertainment Distribution the excess, ifany, of the sublicensing fee over the initial program license fee paid by theCrown Media United States. Crown Media United States did not sub-license anylicensed program to a third party during either of the three or nine monthsended September 30, 2006 or 2007.

 

Programmingcosts related to the RHI Entertainment Distribution program agreements were$11.9 million and $16.2 million for the three months ended September 30,2006, and 2007, respectively. Programming costs related to the RHIEntertainment Distribution program agreements were $32.4 million and $46.3million for the nine months ended September 30, 2006, and 2007,respectively. As of December 31, 2006, and September 30, 2007, $18.4million and $9.4 million, respectively, are included in license fees payable tonon-affiliates in the accompanying unaudited condensed consolidated balancesheets. Crown Media Holdings paid RHI Entertainment Distribution $16.6 millionand $7.9 million for license fees during the three months ended September 30,2006 and 2007, respectively. Crown Media Holdings paid RHI EntertainmentDistribution $36.7 million and $37.5 million for license fees during the ninemonths ended September 30, 2006 and 2007, respectively.

 

**12. Share-Based Compensation**

 

Crown Media Holdings has one stock option plan, theAmended and Restated Crown Media Holdings, Inc. 2000 Long Term IncentivePlan (the “Plan”). The Plan covers three types of share-based compensation:Stock Options, Restricted Stock Units (“RSU”) and Share Appreciation Rights (“SAR”)that are subject to SFAS 123R. Compensation cost for stock options issued toemployees represented the excess of the quoted market price of the Company’sstock at the measurement date of the grant over the exercise price of theoption.

 

***Stock-BasedCompensation***

*** ***

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

 

20

----

 

The Company recorded $503,000 ofcompensation expense related to restricted stock units for the three monthsended September 30, 2006, on our unaudited condensed consolidatedstatement of operations as a component of selling, general and administrativeexpense. The Company recorded a $3.3 million compensation credit related torestricted stock units and $10,000 compensation expense related to stockoptions for the nine months ended September 30, 2006, on our unauditedcondensed consolidated statement of operations as a component of selling,general and administrative expense.

 

The Company recorded $784,000 ofcompensation expense related to restricted stock units for the three monthsended September 30, 2007, on our unaudited condensed consolidatedstatement of operations as a component of selling, general and administrativeexpense. The Company recorded $4.2 million of compensation expense related torestricted stock units for the nine months ended September 30, 2007, onour unaudited condensed consolidated statement of operations as a component ofselling, general and administrative expense.

 

Asof September 30, 2007, there was no unrecognized compensation cost,adjusted for estimated forfeitures, related to non-vested stock options grantedto our employees. Total unrecognized compensation cost will be adjusted forfuture changes in estimated forfeitures.

 

***Stock Option Information***

 

A summary of the status of Crown Media Holdings, Inc.Stock Option Plan at September 30, 2007, and changes during the periodthen ended is presented below:

 
| ** **                       | ** ** | **Shares**              | ** ** | **Exercise  Price  Per Option** | ** ** | **Weighted-   Average  Exercise  Price  Per Option** | ** ** | **Weighted-  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|----------------------------------|------------|-------------------------|------------|--------------------------------------|------------|----------------------------------------------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|
| ** **                       | ** ** | **(in thousands)** | ** ** | ** **                           | ** ** | ** **                                                     | ** ** | ** **                                           | ** ** | ** **                      | ** ** |
| Balance, December 31, 2006  |       | 810                     |       |                                 |       | $                                                              | 10.24      |                                                 | 2.09       |                            | $          | 0.00 |   |
| Options forfeited                |       | (454                    | )          | $8.94-$16.38                         |       | $                                                              | 9.12       |                                                 |       |                            |       |   |
| Balance, September 30, 2007 |       | 356                     |       |                                 |       | $                                                              | 11.68      |                                                 | 3.75       |                            | $          | 0.00 |   |
| Exercisable                      |       | 356                     |       |                                 |       | $                                                              | 11.68      |                                                 | 3.75       |                            | $          | 0.00 |   |

 
| ** **                                                       | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                                | ** ** |
|------------------------------------------------------------------|------------|------------------------------|------------|-------------------------------------------------------------|------------|
| **Range of Exercise Prices Per Option** | ** ** | **Shares  Outstanding**      | ** ** | **Weighted Average  Remaining  Contractual Life** | ** ** | **Weighted Average  Exercise Price  Per Option** | ** ** | **Exercisable  Shares** | ** ** | **Weighted Average  Exercise Price  Per Option** | ** ** |
| ** **                                                       | ** ** | **(In thousands)**      | ** ** | **(In years)**                                         | ** ** | ** ** | ** ** | **(In thousands)** | ** ** | ** ** | ** ** |
| $ 8.94 - 10.50                                    |       | 65                           |       | 2.4                                                         |       | $ | 9.09 |   | 65 |   | $ | 9.09 |   |
| $10.51 - 12.60                                         |       | 234                          |       | 4.3                                                         |       | $ | 11.47 |   | 234 |   | $ | 11.47 |   |
| $12.61 - 14.70                                         |       | 24                           |       | 2.6                                                         |       | $ | 14.00 |   | 24 |   | $ | 14.00 |   |
| $14.71 - 21.00                                         |       | 33                           |       | 3.5                                                         |       | $ | 16.52 |   | 33 |   | $ | 16.52 |   |
|                                                             |       | 356                          |       |                                                        |       |   |   | 356 |   |   |   |

 

***Restricted Stock Unit Information***

 

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

 

In January 2006, the Companysettled vested Employment RSUs of one executive for approximately $4.4 million.In June 2006, the Company settled vested 2003 and 2004Employment RSUs for approximately $1.5 million in cash. In June 2006, the Companysettled vested 2003 and 2004 Board of Director RSUs for approximately $80,000in cash. In August 2006, the Company settled vested 2005 Employment RSUsfor approximately $442,000 in cash. The Company settled the CEO’s RSUs for$165,000 in February 2006 and $76,000 in May 2006. The CEO’sPerformance RSUs lapsed without vesting. In August 2006, the Company 

 

21

----

 

settled vested 2005 Board ofDirector RSUs for approximately $34,000 in cash.Additionally, in August 2006,one executive retired, and the Company settled vested Employment RSUs forapproximately $16,000 in cash. In June 2007, the Company settled vested2004 Employment RSUs for approximately $704,000 in cash.  It also settled vested 2004 Board of DirectorRSUs for approximately $29,000 in cash. In August 2007, the Companysettled vested 2005 Employment RSUs for approximately $616,000 in cash.  It also settled vested 2005 Board of DirectorRSUs for approximately $52,000 in cash and 2006 Board of Directors RSUs forapproximately $141,000 in cash.

 

UnderSFAS 123R, the fair value of the 2004 and 2005 Employment RSU grants areestimated using a Black-Scholes option pricing model. The fair value of the 2004and 2005 Performance RSU grants are estimated at each reporting date using aMonte Carlo Lattice option pricing model. The Company applies a forfeiture rateto the RSUs as required by SFAS No. 123R.

 
| ** **                                 | ** ** | ** ** | ** ** | **Weighted-Average  Remaining** | ** ** |
|--------------------------------------------|------------|------------|------------|---------------------------------|------------|
| **Employment RSUs**                   | ** ** | **Units**  | ** ** | **Contractual Term**       | ** ** |
| Nonvested Balance, December 31, 2006  |       | 814,967    |       | 2.27                            |       |
| Units settled in cash                      |       | (193,334   | )          |                            |       |
| Units forfeited                            |       | (16,983    | )          |                            |       |
| Nonvested Balance, September 30, 2007 |       | 604,650    |       | 1.93                            |       |

 

The closing price of a share of our common stock was$4.49 on September 30, 2006, and was $3.63 on December 31, 2006. Theclosing price of a share of our common stock was $7.19 on September 30,2007.

 
| ** **                                 | ** ** | ** ** | ** ** | **Weighted-Average  Remaining** | ** ** |
|--------------------------------------------|------------|------------|------------|---------------------------------|------------|
| **Performance RSUs**                  | ** ** | **Units**  | ** ** | **Contractual Term**       | ** ** |
| Nonvested Balance, December 31, 2006  |       | 1,304,700  |       | 1.25                            |       |
| Units forfeited                            |       | (170,350   | )          |                            |       |
| Nonvested Balance, September 30, 2007 |       | 1,134,350  |       | 0.60                            |       |

 

At December 31, 2006, the 2004 Performance RSUswere valued at $0.00 per unit and the 2005 Performance RSUs were valued at$0.12 per unit. At September 30, 2007, the 2005 Performance RSUs werevalued at $0.65 per unit. The 2004 Performance RSUs expired in May 2007.The chief executive officer Performance grant expired in May 2006.Valuation of these Performance RSU grants is based upon market conditions.

 

The following table includes assumptions used to valuethe Performance RSUs at December 31, 2006.

 
| ** **               | ** ** | **2004 Grant** | ** ** | **2005 Grant** | ** ** |
|--------------------------|------------|---------------------|------------|---------------------|------------|
| Expected volatility      |       | 40.80               | %          | 47.20               | %          |
| Expected dividends       |       | 0                   |       | 0                   |       |
| Expected Term (in years) |       | 0.41                |       | 1.63                |       |
| Risk-free rate           |       | 5.09                | %          | 4.82                | %          |

 

The following table includes assumptions used to valuethe Performance RSUs at September 30, 2007.

 
| ** **               | ** ** | **2005 Grant** | ** ** |
|--------------------------|------------|---------------------|------------|
| Expected volatility      |       | 44.97               | %          |
| Expected dividends       |       | 0                   |       |
| Expected Term (in years) |       | 0.88                |       |
| Risk-free rate           |       | 4.05                | %          |

 

22

----

 

UnderSFAS 123R, the fair value at December 31, 2006, of each 2006 Employmentand Performance RSU grant is estimated at $3.63 based upon the closing price of a share of our common stock asof the December 31, 2006, reporting date. Under SFAS 123R, the fairvalue at September 30, 2007, of each 2006 Employment and Performance RSUgrant is estimated at $7.19 based upon the closingprice of a share of our common stock as of the September 30, 2007,reporting date. Valuation of the 2006 Employment RSUs is based solely on aservice condition. Valuation of the 2006 Performance RSUs is based upon aservice condition and a performance condition.

 
| ** **                                 | ** ** | ** ** | ** ** | **Weighted-Average  Remaining** | ** ** |
|--------------------------------------------|------------|------------|------------|---------------------------------|------------|
| **Board of Directors RSUs** | ** ** | **Units**  | ** ** | **Contractual Term**       | ** ** |
| Nonvested Balance, December 31, 2006  |       | 81,150     |       | 2.32                            |       |
| Units granted                              |       | 40,740     |       |                            |       |
| Units settled in cash                      |       | (32,502    | )          |                            |       |
| Nonvested Balance, September 30, 2007 |       | 89,388     |       | 2.25                            |       |

 

***ChiefExecutive Officer (“CEO”) Share Appreciation Rights Agreement***

*** ***

Thefair value of the CEO’s SAR grant under an agreement dated October 3,2006, is estimated at each reporting date using a Monte Carlo Lattice optionpricing model. At December 31, 2006,the CEO’s SARs were valued at $872,616 using the closing price of a share ofour common stock on December 31, 2006, of $3.63. At September 30,2007, the CEO’s SARs were valued at $4.1 million using the closing price of ashare of our common stock on September 30, 2007, of $7.19. Valuation ofthis SAR grant is based upon market and service conditions. The Companyrecorded $358,000 in compensation expense related to SARs for the three monthsended September 30, 2007, on our unaudited condensed consolidatedstatement of operations as a component of selling, general and administrativeexpense. The Company recorded $1.4 million in compensation expense related toSARs for the nine months ended September 30, 2007, on our unauditedcondensed consolidated statement of operations as a component of selling,general and administrative expense. The SARs have been recorded in accountspayable and accrued liabilities in the accompanying unaudited condensedconsolidated balance sheets as of December 31, 2006, and September 30,2007.

 

The following table includes assumptions used to valuethe SARs at December 31, 2006.

 
| Expected volatility            |   | 46.91   | %      |
|--------------------------------|--------|---------|--------|
| Expected dividends             |   | 0       |   |
| Expected Term (in years)       |   | 3.56    |   |
| Risk-free rate                 |   | 4.72    | %      |
| Average Number of SARs granted |   | 240,390 |   |

 

The following table includes assumptions used to valuethe SARs at September 30, 2007.

 
| Expected volatility            |   | 43.60   | %      |
|--------------------------------|--------|---------|--------|
| Expected dividends             |   | 0       |   |
| Expected Term (in years)       |   | 2.75    |   |
| Risk-free rate                 |   | 4.03    | %      |
| Average Number of SARs granted |   | 575,182 |   |

 

**13. Employee Benefits**

 

***Deferred Compensation Plans***

*** ***

TheCompany sponsors a deferred compensation plan for its management. Participantsin this plan earn interest on their deferred compensation. Related liabilitiesof $3.3 million and $2.5 million at December 31, 

 

23

----

 

2006, and September 30, 2007, respectively, are included in theaccompanying unaudited condensed consolidated balance sheets among current andlong-term accrued liabilities. The Company suspended this plan for 2006, and nodeferral of employee compensation earned was allowed in 2006. The Companycontinued to pay interest on amounts deferred in previous years and paid outthese amounts in accordance with the terms of the plan. The Company reactivatedthe plan on January 1, 2007.

 

TheCompany also sponsors a deferred compensation plan for its Board of Directors.Participants in this plan earn interest on their deferred compensation. Relatedliabilities of $589,000 and $306,000 at December 31, 2006, and September 30,2007, respectively, are included in the accompanying unaudited condensedconsolidated balance sheets among current and long-term accrued liabilities.The Company suspended this plan for 2006, and no deferral of directorcompensation earned was allowed in 2006. The Company continued to pay intereston amounts deferred in previous years and paid out these amounts in accordancewith the terms of the plan. The Company reactivated this plan on January 1,2007.

 

**14. Customer and SegmentInformation**

 

During 2007, domestic channel operations comprise theCompany’s sole operating segment.  During2006, the Company’s continuing operations comprised domestic channel operationsand film distribution.  The Companyexited the latter segment upon the December 2006 sale of its film assets.

 

Five of our distributors each accounted for more than10% of our consolidated subscriber revenue for both the three months ended September 30,2006 and 2007, and together accounted for a total of 93% of consolidatedsubscriber revenue for both of those periods, respectively.  Three and four of our distributors eachaccounted for more than 15% of our subscribers for the three months ended September 30,2006 and 2007, respectively, and together accounted for 65% and 77% of oursubscribers on those dates, respectively.

 

Five of our distributors each accounted for more than10% of our consolidated subscriber revenue for both the nine months ended September 30,2006 and 2007, and together accounted for a total of 91% and 92% ofconsolidated subscriber revenue for those periods, respectively.  Three and four of our distributors eachaccounted for more than 15% of our subscribers for the nine months ended September 30,2006 and 2007, respectively, and together accounted for 65% and 77% of oursubscribers on those dates, respectively.

 

**15. Commitments and Contingencies**

 

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

 

In accordance with the Purchaseand Sale Agreement dated February 23, 2005, Sparrowhawk Media Limited hasmade several warranty and indemnity claims against the Company of approximately$2.0 million. The Company recorded an accrual related to this claim during theyear ended December 31, 2006, which is included in accounts payable andaccrued liabilities in the accompanying unaudited condensed consolidatedbalance sheets. The Company estimated that it may be liable within the range of$500,000 to $1.0 million related to these claims at December 31, 2006, and$250,000 to $750,000 related to these claims at September 30, 2007.

 

On July 27, 2007, a lawsuit was brought againstCrown Media Holdings, Inc. and our former Chief Financial Officer, WilliamAliber, in the U.S. District Court for the Northern District of Illinois.  The plaintiff, Robert Lieblang, claims tohave purchased our common shares on the market from August 31, 2005 to April 13,2006 and to have sold those shares in April 2006 and in August 2006.  The plaintiff alleges that he relied to his detrimenton allegedly false and misleading statements by the defendants regarding thepossible sale of Crown Media Holdings. We announced the exploration of strategic alternatives including thepossibility of selling the Company in August 2005; in April 2006, weannounced the termination of an extensive review of strategic alternativesincluding a possible sale.  Plaintiffalleges claims under Section 10(b) of the Securities Exchange Act(and Rule 10b-5), the Illinois Consumer Fraud Act and common law fraud.  The complaint seeks compensatory damages ofapproximately $2.0 million plus interest and $6.0 million in punitivedamages.  The Company has retainedcounsel to defend Mr. Aliber and the Company has submitted the claims toan insurer under an insurance policy. The Company expects 

 

24

----

 

that it will vigorously defend itself against these claims. The Companyhas recorded $500,000 in legal expense related to the deductible under itsinsurance policy as of September 30, 2007. The Company believes that it isnot responsible for amounts incurred that exceed the $500,000 deductible underan insurance policy.

 

**16. Subsequent Events**

 

On October 28, 2007, NICC purportedly exercisedthe Put Right, described above in Note 10, by making a formal demand that theCompany purchase all of the 4,357,066 shares of Class A common stock ownedby NICC.

 

25

----

 

**ITEM 2.  *Management’sDiscussion and Analysis of Financial Condition and Results of Operations***

 

The following discussion andanalysis of the Company’s financial condition and results of operations shouldbe read in conjunction with “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2006.

 

**Description of Business andOverview**

 

*Current Business*

* *

Crown Media Holdings, Inc. (“Crown Media Holdings,”“Crown Media” or the “Company”), through its subsidiary, owns and operates paytelevision channels (collectively the “Hallmark Channel,” the “Hallmark MovieChannel,” the “channel” or collectively the “channels”) dedicated tohigh-quality entertainment programming for adults and families, in the UnitedStates.

 

With84.5 million subscribers (as provided by Nielsen Research) in the United Statesat September 30, 2007, the Hallmark Channel is the 38th mostwidely distributed advertising-supported cable channel in the United States.For the third quarter of 2007, the Hallmark Channel finished the quarter as the11th highest rated advertising-supported cable channel for total dayratings and the9th highest rated advertising-supportedcable channel in prime time as measured by Nielsen Research.

 

TheHallmark Movie Channel focuses on movies and mini-series. It has generatedadvertising revenue in 2007, and as distribution continues to expand, thefinancial contribution of the Hallmark Movie Channel may grow. The HallmarkMovie Channel is operated through Crown Media Holdings existing infrastructureat a small incremental cost, which has and will continue to increase since thesale of our domestic film library, and we have and will continue to acquiremore third-party programming for the Hallmark Movie Channel.

 

*CurrentChallenges and Developments*

* *

TheHallmark Channel faces numerous operating challenges. Among them aremaintaining and expanding the distribution of the channels, broadeningviewership demographics and improving viewership ratings, and increasingadvertising sales revenue.

 

Distributionagreements are important because they affect our number of subscribers, whichin turn has a major impact on our subscriber fees, the number of personsviewing our programming, and the rates charged for advertising. The current andlong-term distribution challenges are renewing our distribution arrangementswith the multiple system operators as they expire. Our major distribution agreements have terms which expireat various times through March 2012. Agreements which provideapproximately two-thirds of our subscriber base at September 30, 2007,will expire and be the subject of renewal negotiations on or prior to December 31,2007.****While theeconomics of the renewals and potential cash incentive payments are unknown andcould have a significant impact on our business, we believe that the ratingssuccess of the Hallmark Channel and the positive family-friendly environment wehave created with our programming schedule will assist us in our renewaldiscussions. Any renewals of these distribution agreements may also besignificant as to whether we are able to maintain or increase our subscriberfees. Since January 1, 2007, the Companyhas renewed its agreements with three major distributors, accountingfor 23% of our subscriber base at September 30, 2007.  One of those renewal agreements was amulti-year agreement in March 2007 with EchoStar Communication Corporationthat provided for a repositioning of the Hallmark Channel on the DISH Network,resulting in an addition of approximately 6.4 million Nielsen subscribers in May 2007,and for carrying the Hallmark Movie Channel on a package of the DISH Network,increasing distribution of that Channel by more than 4.0 million subscribers. Also as previously announced, the Company executed in May 2007,a multi-yearrenewal of its distribution agreement with the National Cable TelevisionCooperative (“NCTC”). Under the terms of the renewal, the Company will continueto be available to NCTC’s 1,100 member companies.

 

26

----

 

Ouragreements with major distributors contain “most favored nations” clauses.  These clauses typically provide that, in theevent we enter into an agreement with another distributor on more favorableterms, these terms must be offered to the distributor, subject to variousexceptions and conditions.  These clausescover matters such as subscriber fees, launch support, local advertising timeand other financial and operating provisions. We take these provisions into account when renewing agreements.

 

Domestictelephone companies are entering the business of distributing televisionchannels to households through their wire-lines. We have agreements withseveral telephone companies and cooperatives of telephone companies, whichpermit the carriage of the Hallmark Channel and the Hallmark Movie Channel, andare negotiating with others. We expect that subscribers to these telephoneservices will in large part be customers previously served by cable andsatellite television companies, which continue to carry our programming.

 

Theuniverse of cable TV subscribers in the United States is approximately 100million homes.  The top 30 cable TVnetworks in the United States have 90 million or more subscribers.  Our goal is to reach 90 million subscribersin the next one to two years.

 

Threefactors have contributed to the ratings of the Hallmark Channel: acquiredseries and movies, original productions and marketing. Certain acquired serieshave consistently delivered strong ratings across all day-parts. Original productionsare our most high profile programs and generate the channel’s highest ratings.Original productions are significant in helping our distribution andadvertising sales teams sell the channel. Substantially all of our originalprogramming has in the past been provided by RHI Entertainment, but we are nowacquiring some of this programming from other producers. The Company typicallyincurs additional marketing expenses surrounding original productions andcertain acquired movies.

 

Wesold approximately 50% of our inventory for advertising on our Channels in theupfront market (generally sales in June, July and August for the lastquarter of 2007 and the first three quarters of 2008), compared to 46%  sold in the 2006 upfront market. We were ableto achieve significant increases in our CPMs in the 2007 upfront marketcompared to the 2006 upfront market. The balance of advertising inventory hasbeen made available in the scatter market, which in the past and in the firstthree quarters of 2007 has yielded higher advertising rates than the upfrontmarket.

 

Historically, Nielsen cable television ratings werebased on viewing of networks’ programming content.  Beginning in the fourth quarter of 2007,Nielsen began measuring and providing performance data based on viewing ofcommercial content as well as programming content.  The new ratings information also includesdata for viewing of program content through digital recording devices (DVR’s),if that viewing occurs within three days of the program’s air date.  After the first three weeks of the fourthquarter, the Company experienced a decrease in viewers of approximately 3% to3.5% under the new ratings, which management viewed as acceptable.  The Company has factored the new ratinginformation into our advertising rates, and at this time the Company does notexpect a significant impact from the new rating information on its netadvertising rates.

 

At September 30, 2007, the Hallmark Movie Channelwas distributed to nearly 10.0 million subscribers, an increase of nearly 4.0million subscribers in the third quarter of 2007.  This increase in distribution will improvethe Company’s ability to generate advertising revenue from the Hallmark MovieChannel beginning in the fourth quarter of 2007 and continuing into 2008.  The Company expects the Hallmark MovieChannel to become a more significant component of its advertising revenue in2008.

 

**Critical Accounting Policies,Judgments and Estimates**

 

The preparation of consolidatedfinancial statements in conformity with accounting principles generallyaccepted in the United States requires Crown Media Holdings to make a number ofestimates and assumptions during the reporting period.

 

27

----

 

TheCompany believes that the estimates, judgments and assumptions made whenaccounting for items and matters such as customer retention patterns, allowancefor bad debts, useful lives of assets, cash flow projections used in variousasset valuations, income taxes, reserves and other provisions for contingenciesare reasonable, based on information available at the time they are made. Theseestimates, judgments and assumptions can affect the reported amounts of assetsand liabilities as of the date of the condensed consolidated financial statements,as well as the reported amounts of revenue and expenses during the periodspresented. Actual results could differ from these estimates.

 

For further informationregarding our critical accounting policies, judgments and estimates, please seethe Notes to Unaudited Condensed Consolidated Financial Statements contained inItem 1 of this Report and “Critical Accounting Policies, Judgments andEstimates” in Item 7 of the Company’s Annual Report on Form 10-K for theyear ended December 31, 2006, as filed with the SEC. These policies,judgments and estimates concern, among other things, allowance for doubtfulaccounts, program license fees, subscriber acquisition fees, long-lived assets,residual and participation liabilities, revenue recognition and stock-basedcompensation.

 

**Effects of Transactions with Relatedand Certain Other Parties**

 

In 2007 and in prior years, we entered into a numberof significant transactions with Hallmark Cards and its subsidiaries. Thesetransactions include, among other things, programming, trademark licenses,administrative services, a line of credit, a tax sharing agreement, theissuance of five promissory notes and a Waiver Agreement. For informationregarding such transactions and transactions with other related parties, pleasesee “Effects of Transactions with Related and Certain Other Parties” in Item 7of the Company’s Annual Report on Form 10-K for the year ended December 31,2006, filed with the SEC and Notes 7, 8, 9, and 10  of Notes to Unaudited Condensed ConsolidatedFinancial Statements contained in Item 1 of this Report.

 

On August 1, 2007, Hallmark Licensing, Inc.extended the trademark agreements to September 1, 2008.  Such trademark agreements allow Crown MediaUnited States to name its network services “Hallmark Channel” and “HallmarkMovie Channel.”

 

In consideration for Hallmark Cards to executeAmendment No. 4 to the Waiver Agreement, on July 27, 2007, theCompany executed Copyright Security Agreement and Security and Pledge Agreementfor the benefit of Hallmark Cards.  Underthe agreements, the Company and its subsidiaries grant security interests toHallmark Cards in any copyright license and program license agreements and allother personal property.

 

***Recently Issued Accounting Pronouncements***

*** ***

In September 2006, theFASB issued Statement of Financial Account Standards No. 157, *Fair Value Measurements* (“SFAS 157”), which defines fairvalue, establishes a framework for measuring fair value and expands disclosuresabout fair value measurements. SFAS 157 will be effective for the Company as ofJanuary 1, 2008. The Company is currently evaluating the potential impactof adopting SFAS 157.

 

In February 2007, the FASB issued Statement ofFinancial Accounting Standards No. 159, *The FairValue Option for Financial Assets and Financial Liabilities*,including an amendment of FASB Statement No. 115 (“SFAS 159”). SFAS 159permits entities to choose, at specified election dates, to measure eligibleitems at fair value (the “fair value option”). A business entity shall reportunrealized gains and losses on items for which the fair value option has beenelected in earnings at each subsequent reporting period. SFAS 159 will beeffective for the Company as of January 1, 2008. The Company is evaluatingthe provisions of SFAS 159; it is unknown whether the Company will fromtime-to-time elect the optional measurement provisions or whether SFAS 159 willotherwise have any significant effect on the Company’s future reportedfinancial position or results of operations.

 

## **Selected Historical ConsolidatedFinancial Data of Crown Media Holdings**

##  

In the table below, we provideselected historical condensed consolidated financial and other data of CrownMedia Holdings and its subsidiaries. The following selected unaudited condensedconsolidated statements of 

 

28

----

 

operations data for three and nine months ended September 30,2006 and 2007, are derived from the unaudited financial statements of CrownMedia Holdings and its subsidiaries (except ratings and subscriberinformation). This data should be read together with the unaudited condensedconsolidated financial statements and related notes included elsewhere in this Form 10-Q.

 

29

----

 
| ** **                                               | ** ** | ** **                                 | ** ** | ** **   | ** ** | **Percent  %**                            | ** ** | ** **   | ** ** | ** ** | ** ** | **Percent  %** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------|------------|--------------|------------|-------------------------------------------|------------|--------------|------------|------------|------------|----------------|------------|
| ** **                                               | ** ** | **Three  Months Ended September 30,** | ** ** | **2007 vs.** | ** ** | **Nine  Months Ended September 30,** | ** ** | **2007 vs.** | ** ** |
| ** **                                               | ** ** | **2006**                                   | ** ** | **2007**     | ** ** | **2006**                                  | ** ** | **2006**     | ** ** | **2007**   | ** ** | **2006**       | ** ** |
| Revenues:                                                |       |                                       |       |         |       |                                      |       |         |       |       |       |           |       |
| Subscriber fees                                          |       | $                                          | 6,022      |         | $          | 7,389                                     |       | 23           | %          | $          | 18,633     |           | $          | 21,391 |   | 15 | % |
| Advertising                                              |       | 40,231                                     |       | 47,819       |       | 19                                        | %          | 122,173      |       | 143,140    |       | 17             | %          |
| Film asset license fees                                  |       | 989                                        |       | —       |       | -100                                      | %          | 1,777        |       | —     |       | -100           | %          |
| Sublicense fees and other revenue                        |       | 76                                         |       | 104          |       | 37                                        | %          | 230          |       | 260        |       | 13             | %          |
| Total revenues                                           |       | 47,318                                     |       | 55,312       |       | 17                                        | %          | 142,813      |       | 164,791    |       | 15             | %          |
| Cost of Services:                                        |       |                                       |       |         |       |                                      |       |         |       |       |       |           |       |
| Programming costs                                        |       | 35,056                                     |       | 46,395       |       | 32                                        | %          | 102,616      |       | 124,476    |       | 21             | %          |
| Amortization of film assets                              |       | 4,560                                      |       | (4,739       | )          | -204                                      | %          | 21,703       |       | (5,260     | )          | -124           | %          |
| Impairment of film assets                                |       | 40,946                                     |       | —       |       | -100                                      | %          | 225,832      |       | —     |       | -100           | %          |
| Subscriber acquisition fee amortization                  |       | 7,747                                      |       | 7,048        |       | -9                                        | %          | 23,260       |       | 22,728     |       | -2             | %          |
| Operating costs                                          |       | 2,075                                      |       | 3,222        |       | 55                                        | %          | 9,706        |       | 9,061      |       | -7             | %          |
| Total cost of services                                   |       | 90,384                                     |       | 51,926       |       | -43                                       | %          | 383,117      |       | 151,005    |       | -61            | %          |
| Selling, general and administrative expense              |       | 11,317                                     |       | 11,955       |       | 6                                         | %          | 34,806       |       | 41,098     |       | 18             | %          |
| Marketing expense                                        |       | 3,483                                      |       | 3,565        |       | 2                                         | %          | 8,851        |       | 11,850     |       | 34             | %          |
| Loss from continuing operations before interest  expense |       | (57,866                                    | )          | (12,134      | )          | -79                                       | %          | (283,961     | )          | (39,162    | )          | -86            | %          |
| Interest expense, net of interest income                 |       | (26,461                                    | )          | (25,743      | )          | -3                                        | %          | (73,077      | )          | (82,585    | )          | 13             | %          |
| Loss from continuing operations                          |       | (84,327                                    | )          | (37,877      | )          | -55                                       | %          | (357,038     | )          | (121,747   | )          | -66            | %          |
| Gain (loss) on sale of discontinued operations           |       | (1                                         | )          | —       |       | -100                                      | %          | 153          |       | —     |       | -100           | %          |
| Cumulative effect of change in accounting principal      |       | —                                     |       | —       |       | 100                                       | %          | (2,099       | )          | —     |       | 100            | %          |
| Net loss                                                 |       | $                                          | (84,328    | )            | $          | (37,877                                   | )          | -55          | %          | $          | (358,984   | )              | $          | (121,747 | ) | -66 | % |
|                                                     |       |                                       |       |         |       |                                      |       |         |       |       |       |           |       |
| **Other Data:**                                          | ** ** | ** **                                 | ** ** | ** **   | ** ** | ** **                                | ** ** | ** **   | ** ** | ** ** | ** ** | ** **     | ** ** |
| Net cash (used in) provided by operating activities      |       | $                                          | (3,029     | )            | $          | 5,368                                     |       | -277         | %          | $          | (21,419    | )              | $          | (2,769 | ) | -87 | % |
| Capital expenditures                                     |       | $                                          | (373       | )            | $          | (387                                      | )          | 4            | %          | $          | (400       | )              | $          | (970 | ) | 143 | % |
| Net cash provided by (used in) financing activities      |       | $                                          | 3,327      |         | $          | (10,870                                   | )          | -427         | %          | $          | 23,142     |           | $          | (7,198 | ) | -131 | % |
| Total domestic day household ratings (1)(3)              |       | 0.785                                      |       | 0.710        |       | -10                                       | %          | 0.750        |       | 0.700      |       | -7             | %          |
| Total domestic primetime household ratings (2)(3)        |       | 1.295                                      |       | 1.137        |       | -12                                       | %          | 1.191        |       | 1.129      |       | -5             | %          |
| Subscribers at period end                                |       | 74,721                                     |       | 84,535       |       | 13                                        | %          | 74,721       |       | 84,535     |       | 13             | %          |

 

----

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

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

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

 

### ***Results ofOperations***

### ** **

#### *Three Months Ended September 30, 2006 Comparedto Three Months Ended September 30, 2007*

####  

*Revenue. *Our revenue from continuing operations, whichis comprised of subscriber fees and advertising, increased 17% to $55.3 millionfor the three months ended September 30, 2007. Our 23% increase to $7.4 million in subscriberfee revenue for the three months ended September 30, 2007, was a result ofa net effective rate that was 

 

30

----

 

higher on average and increases in the number ofsubscribers under certain new and existing agreements. A key aspect of thechange in net subscriber rates was lower subscriber acquisition fees recordedas a reduction of revenues. Subscriber acquisition fee expense recorded as areduction of revenue was $1.9 million for the three months ended September 30,2007, and $2.2 million for the comparable period in 2006. Subscribers haveincreased as a result of the EchoStar distribution agreement signed in March 2007and as a result of internal growth pursuant to previously amended distributionagreements.

 

The increase in advertisingrevenue to $47.8 million for the three months ended September 30, 2007,compared to $40.2 million for the three months ended September 30, 2006,reflects the growth in subscribers and an increase in advertising rates, offsetin part lower than expected ratings. Generally, as we have expanded oursubscribers and provided higher rated programming, our advertising revenue hasincreased. The number of advertisers was 439 June 30, 2007, and 448 at September 30,2007, as compared to 435 at September 30, 2006.

 

Among the 69 ad-supported cable channels in the UnitedStates market, the Hallmark Channel ranked 11th in total day with a0.710 household rating for the three months ending September 30, 2007 and9th for primetime with a 1.137 household rating for the sameperiod based on Nielsen ratings. This ratings performance is significant,particularly because the Hallmark Channel is not a fully distributed network.Most of the channels that rate above the Hallmark Channel have higher levels ofdistribution. Total day and primetimehousehold ratings decreased in the third quarter of 2007 compared to the thirdquarter of 2006 due to the loss of *M*A*S*H* inprimetime and changes to our programming schedule to incorporate freshprogramming.

 

Revenue from our film assets totaled $0 for the three months endedSeptember 30, 2007, compared with $989,000 for the comparable periodin 2006.  The Company sold its film assets in December 2006.

 

*Cost ofservices. *Cost ofservices as a percent of revenue decreased to 94% in 2007, as compared to 191%in 2006. This decrease relates primarily to the sale of our film assets in December 2006.

 

Total programming costs for the three months ended September 30,2007, increased 32% due directly to theexpensing (instead of amortizing over a period of time) of certain NICCprogramming, the write off of certain NICC programming, and a greater number ofhigher-cost original programs being amortized in the current period as comparedto the prior period. In addition, in August 2007, the Company wrote off$5.5 million of prepaid programming assets and $1.4 million of long-term otherassets related to the December 2005 NICC agreement. We expect continuedincreases in programming costs in 2007 compared to 2006, because of the sale ofour film assets in December 2006 and for purposes of maintaining orimproving ratings and enhancing our demographics. The Company recorded$4.6 million in amortization of film assets and $40.9 million in impairment offilm assets prior to the sale of our film assets in December 2006. Duringthe third quarter of 2007, the Company recorded $4.7 million negativeamortization of film assets related to a change in estimate of the Company’sresidual and participation liability resulting from an analysis of the Company’sthird-party licenses and use of the film assets prior to the sale to RHI usinginformation that became available during that the third quarter of 2007. TheCompany reduced its residual and participation accrual by $4.7 million basedupon the outcome of this analysis.

 

The Company’s negative bad debtexpense (meaning a credit), which is a part of operating costs, was $1.0million for the three months ended September 30, 2006, as compared to theCompany’s bad debt expense of $108,000 for the three months ended September 30,2007. There were also decreases in expenses associated with the library,such as outside sales commission and tape duplication.

 

Subscriber acquisition fee amortization expenseresults when subscriber acquisition costs previously incurred are amortizedover the remaining life of the relevant distribution agreement.

 

*Selling,general and administrative expense.* Our selling, general and administrativeexpense increased 6% due to a $281,000 increase and a $358,000 increase incompensation expense related to the obligations of restricted stock units andstock appreciation rights, respectively, a $607,000 increase in commissionsexpense, and a $385,000 increase in salaries expense, offset in part by a$258,000 decrease in depreciation and amortization expense primarily related toassets becoming fully depreciated and a $767,000 decrease in severance expense.Our closing stock price was $4.12 at June 30, 2006, and $7.20 at June 30,2007. Our closing stock price was $4.49 at September 

 

31

----

 

30, 2006, and $7.19 at September 30, 2007. The closing stockprices are used to value both our restricted stock units and our stockappreciation rights. Increases/decreases in our closing stock price causeincreases/decreases in our compensation expense.

 

*Marketing expense. *Our marketing expense remained constant period over period.  See the discussion of marketing expense forthe nine months ended September 30, 2007, for additional information onpromotions in July 2007.

 

*Interest expense.*The interestexpense, net of interest income, for the third quarter of 2007 remained constantperiod over period.

 

*Loss from Continuing Operations. *Loss from operations forthe three months ended September 30, 2007, was $37.9 million. Loss fromcontinuing operations for the three months ended September 30, 2006, was$84.3 million. Our loss from continuing operations decreased primarily becauseof an increase in advertising revenue, offset by an increase in programmingcosts, along with the absence of impairment charges related to our film assets,which were sold in December 2006.

 

#### *Nine Months Ended September 30, 2006 Comparedto Nine Months Ended September 30, 2007*

####  

*Revenue. *Our revenue from continuing operations, whichis comprised of subscriber fees and advertising, increased 15% to $164.8million for the nine months ended September 30, 2007. Our 15% increase to $21.4 million in subscriberfee revenue for the nine months ended September 30, 2007, was a result ofhigher net effective rates on average, primarily due to a decrease insubscriber acquisition fees applied against revenue, and an increase in thenumber of subscribers. Subscriber acquisition fee expense recorded as areduction of revenue was $4.8 million for the nine months ended September 30,2007, and $6.5 million for the comparable period in 2006, primarily due to therenewal of distribution agreements and the resulting reversal of certainsubscriber acquisition fees associated with the previous agreements during thefirst quarter of 2007. Subscriber fees were also positively impacted by theexpiration of free carriage periods during 2006 and 2007. Subscribers haveincreased as a result of the EchoStar distribution agreement signed in March 2007and as a result of internal growth pursuant to previously amended distributionagreements.

 

The increase in advertisingrevenue to $143.1 million for the nine months ended September 30, 2007,compared to $122.2 million for the nine months ended September 30, 2006,reflects the growth in subscribers and an increase in advertising rates for thereasons indicated above for the third quarter, offset in part by lower thanexpected ratings.

 

Among the 69 ad-supported cable channels in the UnitedStates market, the Hallmark Channel ranked10th in totalday with a 0.700 household rating for the nine months ending September 30,2007 and 9th for primetime with a 1.129 household rating for thesame period based on Nielsen ratings. This ratings performance is significant,particularly because the Hallmark Channel is not a fully distributed network.Most of the channels that rate above the Hallmark Channel have higher levels ofdistribution.

 

Revenue from our film assets totaled $0 for the nine months ended September 30,2007, compared with $1.8 million for the comparable period in2006.  The Company sold its film assets in December 2006.

 

*Cost ofservices. *Cost ofservices as a percent of revenue decreased to 92% in 2007, as compared to 268%in 2006. This decrease relates primarily to the sale of our film assets in December 2006.

 

Total programming costs for the nine months ended September 30,2007, increased 21% due directly to theexpensing (instead of amortizing over a period of time) of certain NICCprogramming, the write off of certain programming, and a greater number ofhigher-cost original programs being amortized in the current period as comparedto the prior period. In the first quarter of 2007, we also had $1.7 million inwrite-offs of certain programming. Additionally, in August 2007,the Company wrote off $5.5 million of prepaid programming assets and $1.4million of long term other assets related to the December 2005 NICCagreement. The Company recorded $21.7 million in amortization of film assetsand the $225.8 million in impairment of film assets prior to the sale of ourfilm assets in December 2006. During the second quarter of 2007, theCompany reduced its estimate of a 

 

32

----

 

residual and participation liability for $521,000 less than it hadoriginally accrued for it in conjunction with the sale of its filmlibrary.  Therefore, the Company recognizednegative amortization of film assets during the second quarter of 2007. Duringthe third quarter of 2007, the Company recorded $4.7 million negativeamortization of film assets related to a change in estimate of the Company’sresidual and participation liability resulting from an analysis of the Company’sthird-party licenses and use of the film assets prior to the sale to RHI usinginformation that became available during the third quarter of 2007. The Companyreduced its residual and participation accrual by $4.7 million based upon theoutcome of this analysis.

 

The Company’s bad debt expensewas $254,000 for the nine months ended September 30, 2006, as compared tothe Company’s bad debt expense of $95,000 for the nine months ended September 30,2007. This decrease in bad debt expense was due to the Company’s increasedcollection efforts in 2007. There were also decreases in expensesassociated with the library, such as outside sales commission and tapeduplication

 

Subscriberacquisition fee amortization expense results from subscriber acquisition costsincurred previously by us and amortized over the remaining life of the relevantdistribution agreement.

 

*Selling,general and administrative expense.* Our selling, general and administrativeexpense increased 18% due to a $7.4 million increase and a $1.4 millionincrease in compensation expense related to the obligations of restricted stockunits and stock appreciation rights, respectively, a $939,000 increase in bonusexpense, offset in part by a $1.0 million decrease in depreciation andamortization expense primarily related to assets becoming fully depreciated anda $3.7 million decrease in severance expense.

 

*Marketing expense. *Our marketing expense increased 34% primarily due tothe Company’s marketing promotions surrounding Valentine’s Day, Mother’s Dayand a July promotional tower during 2007. The Company promoted itsoriginal movie “Avenging Angel” and its Western month in July.****During the same period in 2006, the Company held onepromotion during January and one promotion in July.

 

*Interest expense. *Interest expense, net of interest income, increasedfor the nine months ended September 30, 2007, compared to September 30,2006, by $9.5 million.  This increaserelates primarily to the $7.9 million recorded in the second quarter of 2007 inconnection with the return of $25.2 million of tax benefits received earlierfrom Hallmark Cards under the Tax Sharing Agreement. In the third quarter of2007, the Company recorded an additional $85,000 of interest expense related tothe $25.2 million return. See Note 10 to the Unaudited Condensed ConsolidatedFinancial Statements in this Report.  Theremainder of this increase relates to the $4.9 million increase in interest onour $400.0 million senior unsecured note, the $1.2 million increase in intereston our $132.8 million note payable to Hallmark Cards affiliates, the $376,000increase in interest on our $70.4 million note payable to Hallmark Cardsaffiliates commencing March 21, 2006, the $681,000 increase in interest onour $86.3 million note payable to Hallmark Cards affiliates, the $507,000increase in interest on our $33.1 million note payable to Hallmark Cards, andoffset in part by the $5.4 million decrease in interest on our bank creditfacility and $848,000 decrease in our bank line of credit fees due to a lowerprincipal balance.  The majority of theaforementioned increases, excluding amounts relating to the return of taxbenefits, occurred due to increases in principal balances. The decreasesrelated to our bank credit facility resulted from a reduction in theoutstanding balance and the available credit limit following the December 2006sale of our film assets.

 

*Loss from Continuing Operations. *Loss from operations forthe nine months ended September 30, 2007, was $121.7 million. Loss fromcontinuing operations for the nine months ended September 30, 2006, was$357.0 million. Our loss from continuing operations decreased primarily becauseof an increase in advertising revenue, offset by an increase of programmingcosts, along with the absence of impairment charges related to our film assets,which were sold in December 2006.

 

*Cumulative effect of change inaccounting principle.  *OnJanuary 1, 2006, we adopted SFAS 123R. The total compensation cost related to 2004 and 2005 performance RSUsgranted under the Plan net of estimated forfeitures was $2.1 million, which wasrecorded as a cumulative catch-up adjustment during the nine months ended September 30,2006. Under prior accounting treatment, the performance RSUs were notclassified as a liability as it was 

 

33

----

 

deemed improbable that these RSUs would settlebased upon the performance of our Class A common stock.

 

## **Liquidity and Capital Resources**

##  

Cash used in operatingactivities from continuing operations was $21.4 million and $2.8 million forthe nine months ended September 30, 2006 and 2007.**Loss from continuing operations for thenine months ended September 30, 2006 and 2007, was $357.0 million and $121.7million, respectively. During the ninemonths ended September 30, 2006, the Company made payments of $10.3million for subscriber acquisition fees. During the nine months ended September 30,2007, the Company made payments of $348,000 for subscriber acquisition fees.The Company’s cash receipts were $164.1 million and $178.3 million for the ninemonths ending September 30, 2006 and 2007, respectively.

 

Cash used in investingactivities was $7.9 million and $4.0 million for the nine months ended September 30,2006 and 2007, respectively. During the nine months ended September 30,2006, the Company paid $7.5 million to the buyer of the international business.During the nine months ended September 30, 2007, the Company paid $3.0million to the buyer of the international business.

 

Cash provided by financingactivities was $23.1 million for the nine months ended September 30, 2006.Cash used in financing activities was $7.2 million for the nine months ended September 30,2007. During the nine months ended September 30, 2006 and 2007, wereceived proceeds of $12.0 million and $0, respectively, from our tax sharingagreement with Hallmark Cards. We borrowed $15.0 million and $7.1 million underour credit facility to cover the cash we used in operating and investingactivities during the nine months ended September 30, 2006 and 2007,respectively. We made $3.5 million and $13.8 million of payments on the creditfacility during the nine months ended September 30, 2006 and 2007,respectively.

 

Cash at September 30, 2007,was $3,000 due to the Company’s implementation of a new cash management systemduring the third quarter of 2007.  Underthis new cash management system, the Company is paying down amounts borrowedunder its bank credit facility with certain available funds.

 

The Company entered into a note and interest payableto Hallmark Cards in the amount of $33.1 million on July 27, 2007,relating to the tax sharing agreement. The total amount outstanding at September 30,2007, including accrued interest was $27.2 million, which is due on July 27,2009.

 

*Cash Flows*

 

Asof September 30, 2007, the Company had $3,000 in cash and cash equivalentson hand. As of September 30, 2007, the Company had borrowed $80.9 millionfrom a $130.0 million revolving bank credit facility, which matures May 31,2008.

 

The Company’s principal sources of funds are cash onhand, cash generated by operations and amounts available under the Company’srevolving bank credit facility. Previously, the Company’s tax sharing agreementwith Hallmark Cards has also been a source of cash. However, we do not expectto receive or pay any cash related to this agreement in the next twelve months.

 

Thesufficiency of the existing sources of liquidity to fund the Company’soperations is dependent upon continued growth in subscriber revenue andadvertising revenue. Any decline in the popularity of the Hallmark Channel, anysignificant future adverse modifications to the Company’s distributionagreements, an economic decline in the advertising market, an increase inprogram acquisition costs, an increase in competition or other adverseoperating conditions would negatively impact the Company’s liquidity and itsability to fund the current level of operations.

 

TheCompany expects to continue making investments in programming, marketing anddistribution. However, the Company’s recurring loss situation has demanded thatall areas of expenses, including programming, marketing and distribution beclosely monitored and controlled.

 

34

----

 

TheCompany currently believes that cash on hand, cash generated by operations andborrowing availability under its bank credit facility, when combined with thedeferral of any required payments on related-party debt and related interest mentionedbelow, will be sufficient to fund the Company’s operations and meet itsliquidity needs through November 15, 2008. The Company anticipates that its principal uses of cash during the nexttwelve months will continue to include the payment of operating expenses,accounts payable and accrued expenses, license fees for programming, andinterest under its bank credit facility. This paragraph is qualified in itsentirety with respect to potential consequences of  the Put Right described below.

 

TheCompany intends to extend or refinance the Bank credit facility prior to orupon its maturity. Any such extension or refinancing might require acontinuation of a letter of credit from Hallmark Cards or other steps by theCompany and, thus, is not assured. If the Company is not able to arrange forthe extension, refinancing or replacement of the bank credit facility prior toits maturity and either (1) the bank draws down on the irrevocable letterof credit provided by Hallmark Cards in support of the bank credit facility or (2) HallmarkCards purchases the interests of the lending banks, Hallmark Cards would haveall obligations and rights of the lending banks under the bank credit facility.In that event, Hallmark Cards could demand payment of outstanding amounts atany time after November 15, 2008, under the terms of the waiver andstandby purchase agreement (“Waiver Agreement”) described below.

 

Upon maturity of the creditfacility on May 31, 2008, the lending group led by JP Morgan Chase has theright to elect to forego the receipt of cash to pay the principal amount of thecredit facility in full, which is provided for under the terms of anirrevocable letter of credit provided by Hallmark Cards, and instead may elect to initiate a process to foreclose onthe Company’s assets. Such foreclosure proceedings wouldadversely affect our ability to continue our operations. Prior to any suchpossible foreclosure proceedings, however, the Company, if it has not securedan extension of the credit facility or alternative financing, would causeHallmark Cards pursuant to the terms of the Waiver Agreement to exercise itsoption to purchase all of the outstanding indebtedness under the creditfacility and the credit facility would then be subject to terms of the Waiver Agreement.

 

Becauseof the Company’s possible inability to meet its obligations when they come duein November 2008, the Company anticipates that prior to November 15,2008, it will be necessary to either extend or refinance (i) the bankcredit facility and (ii) the promissory notes payable to affiliates ofHallmark Cards described in the Notes below. As part of a combination ofactions and in order to obtain additional funding, the Company may considervarious alternatives, including refinancing the bank credit facility, raisingadditional capital through the issuance of equity or debt securities, or otherstrategic alternatives.

 

*Effectsof Transactions with NICC on Liquidity*

 

On October 28, 2007, NICCpurportedly exercised the Put Right, described below in Note 10, by makingformal demand that the Company purchase all of the 4,357,066 shares of Class Acommon stock owned by NICC.  The Companysubsequently informed NICC that exercise of the Put Right constituted a breachof a binding agreement in which, among other things, NICC agreed not toexercise the Put Right and which resulted from negotiations between thecompanies during September 2007. Whether the purported exercise by NICC ofthe Put Right will have an adverse impact on the Company’s liquidity depends onfuture developments that cannot be predicted at this time.  Some possible results are described below.

 

NICC proposed that its purchasedemand be settled on January 4, 2008. If settled, the purchase price per share, yet to be determined as of thedate of this Report, will be the 30-day average closing price from October 8,2007 through November 16, 2007, inclusive. The 21-day average closing price from October 8, 2007 through November 5,2007, inclusive, was $7.74.  The closingprice on November 5, 2007 was $6.80. Using either the 21-day average or the November 5, 2007, closingprice, the aggregate purchase price would be approximately $33.7 million or$29.6 million, respectively.

 

If the Company were required to or agreed to purchasethe Class A shares of NICC under the terms of the Put Right, the Companywould likely need to finance the purchase by selling all or a portion of therepurchased shares or 

 

35

----

 

obtaining additional capital through borrowings.  The Company’s ability to use proceeds from anequity or debt financing for the repurchase of the Class A shares oroperations is also dependent on obtaining approval from Hallmark Cards not touse such “Excess Cash Flow” as prepayments on outstanding debt to HallmarkCards as provided in the Waiver and Standby Purchase Agreement described belowin Note 8.  Such approval cannot beguaranteed.

 

Another possibility is that the Company and NICCproceed to litigation concerning the purported exercise of the Put Right.  In that event, NICC would be legally requiredto mitigate damages in a reasonable manner. Mitigation of damages could result in NICC’s selling all or part of the Class Ashares in the public market or through private sales.  Amounts received from such sales would reduceany damage allegedly sustained by NICC. If the Company is successful in defending any claim of NICC regardingthe Put Right, the attempted exercise of the Put Right would not have a materialeffect on the Company’s liquidity.

 

The purchase of the Class A shares would requirethe consent of the bank lenders under the credit facility because of a covenantconcerning restricted payments.  Delawarecorporate law limits the purchase of shares out of “net assets” in excess ofthe par value of issued shares.  Netassets can be valued on a basis other than the amounts on the balancesheet.  The Company has not conducted avaluation of the net assets to determine whether the repurchase of shares fromNICC is possible under this limitation. The Company would conduct such a valuation before concluding that thepurchase of Class A shares owned by NICC would be allowed under Delawarelaw.

 

***Bank Credit Facility, HC Crown Loans, andTax Sharing Agreement***

 

Forinformation regarding our bank credit facility, HC Crown loans and Tax SharingAgreement, please see “Bank Credit Facility, HC Crown Loans, and Tax SharingAgreement” of the Company’s Annual Report on Form 10-K for the year ended December 31,2006, as filed with the SEC and Notes 7, 8 and 9 of Notes to UnauditedCondensed Consolidated Financial Statements contained in Item 1 of this Report.

 

## **RiskFactors and Forward-Looking Statements**

##  

The discussion set forth in this Form 10-Qcontains statements concerning potential future events. Such forward-lookingstatements are based on assumptions by Crown Media Holdings management, as ofthe date of this Form 10-Q including assumptions about risks anduncertainties 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. If any ofmanagement’s assumptions prove incorrect or should unanticipated circumstancesarise, Crown Media Holdings’ actual results, levels of activity, performance,or achievements could materially differ from those anticipated by suchforward-looking statements.

 

Among the factors that could cause actual resultsto differ materially are those discussed in this Report below and in theCompany’s filings with the Securities and Exchange Commission, including theRisk Factors stated in the Company’s Annual Report on Form 10-K for theyear ended December 31, 2006. Such Risk Factors include, but are notlimited to, the following:  competitionfor distribution of channels, viewers, advertisers and the acquisition ofprogramming; fluctuations in the availability of programming; fluctuations indemand for programming which we air on our channels; our ability to address ourliquidity needs; our incurrence of losses; and our substantial indebtednessaffecting our financial condition and results.

 

Stated below are certain Risk Factors which containsignificant changes from those stated in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2006. Crown Media Holdings will not updateany forward-looking statements contained in that Form 10-K to reflectfuture events or developments.

 

36

----

 

If wedo not successfully address the risks described below and in our prior Reportsmentioned above, our business, prospects, financial condition, results ofoperations or cash flow could be materially adversely affected. The tradingprice of our Class A common stock could decline because of any of theserisks.

 

**Risks Relating to Our Business**

 

***Our liquidity is dependent on externalfunds.***

 

Because we currently operate ata loss, we may have a negative cash flow and any unanticipated significantexpense or any development that hampers our growth in revenue or decreases anyof our revenue would result in the need for additional external funds in orderto continue operations. We have no arrangements for any such additionalexternal financings, whether debt or equity, and are not certain whether anysuch new external financing would be available on acceptable terms. Any newdebt financing would require the cooperation and agreement of existing lenders.

 

Further, as discussed in thisReport under “Liquidity and Capital Resources” above, we need to (1) extend,refinance or replace our bank line of credit on or prior to May 31, 2008,or to extend or replace borrowings from Hallmark Cards by November 15,2008, that would result from the banks drawing upon the irrevocable letter ofcredit supporting the bank credit facility, (2) extend or refinanceoutstanding notes payables to Hallmark Cards and its subsidiaries on or priorto November 15, 2008, and (3) potentially raise capital through asale of equity or debt to cover any amounts, if any, payable to NICC for itspurported exercise of the Put Right.

 

Upon maturity of the credit facility on May 31, 2008,the lending group led by JP Morgan Chase has the right to forego the receipt ofcash to pay the principal amount of the credit facility in full, which isprovided for under the terms of an irrevocable letter of credit provided byHallmark Cards, and instead initiate a process to foreclose on the Company’sassets. Such foreclosure proceedings, which we view as a remote possibility,could affect our ability to continue our operations. Prior to any such possibleforeclosure proceedings, the Company would consider various alternatives asindicated above.  The Company could alsocause Hallmark Cards, pursuant to the terms of the Waiver Agreement, toexercise its option to purchase all of the outstanding indebtedness under thecredit agreement. The credit facility would then be subject to Hallmark Cardsagreement not to demand payment prior to November 15, 2008.

 

### **AvailableInformation**

### ** **

**We will makeavailable free of charge through our website, www.hallmarkchannel.com, theAnnual Report, our quarterly reports on Form 10-Q, our current reports on Form 8-K,and amendments to such reports, as soon as reasonably practicable after weelectronically file or furnish such material with the Securities and ExchangeCommission.**

 

**Additionally,we will make available, free of charge upon request, a copy of our Code ofBusiness Conduct and Ethics, which is applicable to all of our employees,including our senior financial officers. Requests for a copy of this codeshould be addressed to the General Counsel at Crown Media Holdings, Inc.,12700 Ventura Boulevard, Studio City, California  91604.**

 

**Item 3.  *Quantitative andQualitative Disclosures About Market Risk***

 

We only invest in instrumentsthat meet high credit and quality standards, as specified in our investmentpolicy guidelines. These instruments, like all fixed income instruments, aresubject to interest rate risk. The fixed income portfolio will decline in valueif interest rates increase. If market interest rates were to increaseimmediately and uniformly by 10% from levels as of September 30, 2007, thedecline of the fair value of the fixed income portfolio would not be material.

 

As of September 30, 2007,our cash and cash equivalents consisted of cash and short-term commercial paperwith a fair value of $3,000. The primary purpose of these investing activitieshas been to preserve principal until the 

 

37

----

 

cash is required to fund operations. Consequently,the size of this portfolio fluctuates significantly as cash is provided by andused in our business.

 

The value of certain investmentsin this portfolio can be impacted by the risk of adverse changes in securitiesand economic markets and interest rate fluctuations. At September 30,2007, all of our investments in this category were in fixed rate instruments ormoney market type accounts. A decrease in interest rates has the effect ofreducing our future annual interest income from this portfolio, since fundswould be reinvested at lower rates as the instruments mature. Over time, anynet percentage decrease in our interest rates could be reflected in acorresponding net percentage decrease in our interest income. For the three andnine months ended September 30, 2007, the impact of interest ratefluctuations, changed business prospects and all other factors did not have amaterial impact on the fair value of this portfolio, or on our income derivedfrom this portfolio.

 

Under the Company’s new cashmanagement policy, excess funds over a certain amount are used to pay downamounts owed under its bank credit facility. The Company expects to maintainlower cash balances than previously reported.

 

We have not used derivativefinancial instruments for speculative purposes. As of September 30, 2007,we are not hedged or otherwise protected against risks associated with any ofour investing or financing activities.

 

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

 

We are exposed to market risk,including changes to interest rates. To reduce the volatility relating to theseexposures, we may enter into various derivative investment transactions in thenear term pursuant to our investment and risk management policies andprocedures in areas such as hedging and counterparty exposure practices. Wehave not and will not use derivatives for speculative purposes.

 

Though we intend to use riskmanagement control policies, there will be inherent risks that may only bepartially offset by our hedging programs should there be any unfavorablemovements in interest rates or equity investment prices.

 

***Our interest income and expense is subjectto fluctuations in interest rates.***

 

Our material interest bearing assets consisted of cashequivalents. The balance of our interest bearing assets was $3,000, or lessthan 1% of total assets, as of September 30, 2007. Our materialliabilities subject to interest rate risk consisted of our bank creditfacility, our line of credit and interest payable to HC Crown, our line ofcredit and interest payable to a Hallmark Cards affiliate, our note andinterest payable to Hallmark Cards, and our note and interest payable to aHallmark Cards affiliate. The balance of those liabilities was $420.0 million,or 32% of total liabilities, as of September 30, 2007. Net interestexpense for the three months ended September 30, 2007, was $25.7 million,47%, of our total revenue. Net interest expense for the nine months ended September 30,2007, was $82.6 million, 50%, of our total revenue. Our net interest expense ofthese liabilities is sensitive to changes in the general level of interestrates, primarily U.S. and LIBOR interest rates. In this regard, changes in U.S.and LIBOR interest rates affect the fair value of interest bearing liabilities.

 

If market interest rates were to increase or decrease by1% from levels as of September 30, 2007, our interest expense for thequarter would change correspondingly by approximately $1.0 million and $3.0million for each of the three and nine months.

 

**Item 4.  *Controls and Procedures.***

 

***a.  Disclosure Controls andProcedures***

 

Our management evaluated, with the participation ofour Chief Executive Officer and our Chief Financial Officer, the effectivenessof our disclosure controls and procedures as of the end of the period coveredby this 

 

38

----

 

Quarterly Report on Form 10-Q. Based on this evaluation, our ChiefExecutive Officer and our Chief Financial Officer have concluded that ourdisclosure controls and procedures were effective as of the end of the periodcovered by this Quarterly Report on Form 10-Q.

 

***b.  Changes in Internal Controlover Financial Reporting***

 

There was no change in the Company’s internal controlover financial reporting that occurred during the quarter ended September 30,2007, that materially affected, or was reasonably likely to materially affect,the Company’s internal control over financial reporting.

 

**PART II.  OTHER INFORMATION**

 

**Item I.  *Legal Proceedings***

 

On July 27, 2007, a lawsuit was brought againstCrown Media Holdings, Inc. and our former Chief Financial Officer, WilliamAliber, in the U.S. District Court for the Northern District of Illinois.  The plaintiff, Robert Lieblang, claims tohave purchased our common shares on the market from August 31, 2005 to April 13,2006 and to have sold those shares in April 2006 and in August 2006.  The plaintiff alleges that he relied to hisdetriment on allegedly false and misleading statements by the defendantsregarding the possible sale of Crown Media Holdings.  We announced the exploration of strategicalternatives including the possibility of selling the Company in August 2005;in April 2006 we announced the termination of an extensive review ofstrategic alternatives including a possible sale.  Plaintiff alleges claims under Section 10(b) ofthe Securities Exchange Act (and Rule 10b-5), the Illinois Consumer FraudAct and common law fraud.  The complaintseeks compensatory damages of approximately $2.0 million plus interest and $6.0million in punitive damages.  We haveretained counsel to defend Mr. Aliber and the Company and have submittedthe claims to an insurer under an insurance policy.  We expect that we will vigorously defendourselves against these claims.

 

**Item 1A.  *Risk Factors***

 

See “Risks Relating to Our Business” in Part I,Item 2 above for information on changes to risk factors.

 

**Item 6.  *Exhibits***

 

**INDEX TO EXHIBITS**

 
| **Exhibit Number** |   | **Exhibit Title**                                                                                                                                                                                                                                                     |
|-------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                    |   |                                                                                                                                                                                                                                                                       |
| 3.1                     |   | Amended and Restated  Certificate of Incorporation (previously filed as Exhibit 3.1 to our  Registration Statement on Form S-1/A (Amendment No. 2), Commission  File No. 333-95573, and incorporated herein by reference).                             |
| 3.2                     |   | Amendment to the Amended and  Restated Certificate of Incorporation (previously filed as Exhibit 3.2  to our Quarterly Report on Form 10-Q filed on July 31, 2001 (File  No. 000-30700; Film No. 1693331) 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                    |   | Amendment No. 5 to Waiver and Standby Purchase  Agreement dated October 17, 2007, by and between Hallmark Cards  Incorporated and Crown Media Holdings, Inc.                                                                                                |
| 31.1                    |   | Rule 13a-14(a) Certification executed by  the Company’s Acting Chief Executive Officer.                                                                                                                                                                     |
| 31.2                    |   | Rule 13a-14(a) Certification executed by  the Company’s Executive Vice President and Chief Financial Officer.                                                                                                                                               |
| 32                      |   | Section 1350 Certifications.                                                                                                                                                                                                                                          |

 

39

----

 

**SIGNATURES**

 

Pursuant to the requirements ofthe Securities Exchange Act of 1934, this report has been signed below by thefollowing persons on behalf of the registrant and in the capacities and on thedates indicated.

 

 
|       | CROWN MEDIA HOLDINGS, INC. |
|------------|----------------------------|
|       |                       |   |   |
| ** ** | **Signature**              | ** ** | **Title** | ** ** | **Date** | ** ** |
|       |                       |   |   |   |   |   |
|       | By:                        | /s/  HENRY S. SCHLEIFF |   | Principal Executive |   | November 8, 2007 |   |
|       |                       |   |   | Officer |   |   |   |
|       |                       | Henry S. Schleiff |   |   |   |   |   |
|       |                       |   |   |   |   |   |
|       | By:                        | /s/  BRIAN C. STEWART |   | Principal |   | November 8, 2007 |   |
|       |                       |   |   | Financial and |   |   |   |
|       |                       | Brian C. Stewart |   | Accounting Officer |   |   |   |
|            |                            |  |  |  |  |  |  |  |  |

 

40

----