**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**Form 10-Q**

 

**(Mark One)**

**ý****        QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the quarterly period endedSeptember 30, 2004**

 

**or**

 

**o****        TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the transition periodfrom                to                .**

 

**Commission File Number: 000-30700**

 

**Crown MediaHoldings, Inc.**

(Exact Name of Registrant as Specified in Its Charter)

 
| **Delaware**                                               |   | **84-1524410**                        |
|------------------------------------------------------------|--------|---------------------------------------|
| (State or Other Jurisdiction  of                           |   | (I.R.S. Employer  Identification No.) |
| Incorporation or Organization)                             |   |                                  |
|                                                       |   |                                  |
| **6430 S. Fiddlers Green Circle,**                         |
| **Suite 225,**                                             |
| **Greenwood Village, Colorado  80111**                     |
| (Address of Principal  Executive Offices and Zip Code)     |
|                                                       |   |                                  |
| **(303) 220-7990**                                         |
| (Registrant’s Telephone  Number, Including Area Code) |
|                                                       |   |                                  |
|                                                       |   |                                  |
| (Former Name, Former Address,  and Former Fiscal Year,     |
| if Changed Since Last Report.)                             |

 

Indicate by check markwhether the registrant:  (1) has filedall reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  Yes ý    Noo

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inExchange Act Rule 12b-2).  Yes ý    Noo

 

As of November 12, 2004,the number of shares of Class A Common Stock, $.01 par value outstanding was73,863,037, and the number of shares of Class B Common Stock, $.01 par value,outstanding was 30,670,422.

 

 

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**TABLE OF CONTENTS**

 
| **PART I**  | **Financial Information**                                                                                                            |   |
|-------------|--------------------------------------------------------------------------------------------------------------------------------------|--------|
|        |                                                                                                                                 |   |
| Item 1      | Financial  Statements (Unaudited)                                                                                                    |   |
|        | CROWN  MEDIA HOLDINGS, INC. AND SUBSIDIARIES                                                                                         |   |
|        | Consolidated Balance  Sheets – December 31, 2003 and September 30, 2004 (Unaudited)                                             |   |
|        | Consolidated  Statements of Operations and Comprehensive Loss (Unaudited) - Three and Nine  Months Ended September 30, 2003 and 2004 |   |
|        | Consolidated  Statements of Cash Flows (Unaudited) - Nine Months Ended September 30, 2003  and 2004                                  |   |
|        | Notes  to Unaudited Consolidated Financial Statements                                                                                |   |
|        |                                                                                                                                 |   |
| Item  2     | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                          |   |
|        |                                                                                                                                 |   |
| Item 3      | Quantitative  and Qualitative Disclosures About Market Risk                                                                          |   |
|        |                                                                                                                                 |   |
| Item 4      | Controls  and Procedures                                                                                                             |   |
|        |                                                                                                                                 |   |
| **PART II** | **Other Information**                                                                                                                |   |
|        |                                                                                                                                 |   |
| Item 6      | Exhibits                                                                                                                             |   |
|        |                                                                                                                                 |   |
| Signatures  |                                                                                                                                 |

 

3

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*In this Form 10-Q the terms “CrownMedia Holdings” or the “Company,” refer to Crown Media Holdings, Inc.  and, unless the context requires otherwise,subsidiaries of Crown Media Holdings that operate or have operated ourbusinesses, Crown Media International, LLC (“Crown Media International”), CrownMedia United States, LLC (“Crown Media United States”), Crown MediaDistribution, LLC (“Crown Media Distribution”), Crown Entertainment Limited (“CrownEntertainment”), and Crown Media Trust (“Crown Media Trust”). The term “commonstock” refers to our Class A common stock and Class B common stock, unless thecontext requires otherwise.*

 

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

 

**PART I. FINANCIAL INFORMATION**

 

**Item1.  *FinancialStatements (Unaudited)***

 

**CROWN MEDIA HOLDIN**GS, INC. AND SUBSIDIARIES

**CONSOLIDATED BALANCE SHEETS**

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

 
| ** **                                                                                          | ** ** | **As of  December 31,  2003** | ** ** | **As of  September 30,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| ** **                                                                                          | ** ** | ** **                    | ** ** | **(Unaudited)**                | ** ** |
| **ASSETS**                                                                                          |       |                          |       |                           |       |
|                                                                                                |       |                          |       |                           |       |
| Cash and cash equivalents                                                                           |       | $                             | 4,306      |                           | $          | 7,569 |   |
| Accounts receivable, less  allowance for doubtful accounts of $6,703 and $5,845,  respectively |       | 57,905                        |       | 57,045                         |       |
| Program license fees —  affiliates, net                                                        |       | 27,127                        |       | 31,961                         |       |
| Program license fees —  non-affiliates, net                                                    |       | 65,571                        |       | 70,617                         |       |
| Subtitling and dubbing, net                                                                         |       | 2,827                         |       | 2,611                          |       |
| Receivable from affiliate                                                                           |       | 12,083                        |       | 14,087                         |       |
| Prepaid and other assets                                                                            |       | 15,143                        |       | 15,528                         |       |
| Total current assets                                                                                |       | 184,962                       |       | 199,418                        |       |
| Accounts receivable, net of  current portion                                                        |       | 5,891                         |       | 8,653                          |       |
| Program license fees —  affiliates, net of current portion                                     |       | 47,748                        |       | 42,645                         |       |
| Program license fees —  non-affiliates, net of current portion                                 |       | 106,047                       |       | 94,522                         |       |
| Subtitling and dubbing, net of  current portion                                                     |       | 2,020                         |       | 1,461                          |       |
| Film assets, net                                                                                    |       | 750,737                       |       | 672,073                        |       |
| Subscriber acquisition fees,  net                                                                   |       | 113,196                       |       | 108,972                        |       |
| Property and equipment, net                                                                         |       | 29,235                        |       | 22,574                         |       |
| Goodwill                                                                                            |       | 314,033                       |       | 314,033                        |       |
| Debt issuance costs, net                                                                            |       | 6,478                         |       | 5,268                          |       |
| Prepaid and other assets, net  of current portion                                                   |       | 1,363                         |       | 1,172                          |       |
| Total assets                                                                                        |       | $                             | 1,561,710  |                           | $          | 1,470,791 |   |
|                                                                                                     |            |                               |            |                                |            |  |  |  |  |

** **

**4**

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** **

**CROWN MEDIA HOLDINGS, INC. ANDSUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

**(In thousands, except shareamounts)**

 
| ** **                                                                                                                                                              | ** ** | **As of  December 31,  2003** | ** ** | **As of****September 30,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                                              | ** ** | ** **                    | ** ** | **(Unaudited)**                  | ** ** |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                          |       |                          |       |                             |       |
|                                                                                                                                                                    |       |                          |       |                             |       |
| LIABILITIES:                                                                                                                                                            |       |                          |       |                             |       |
| Accounts payable and accrued  liabilities                                                                                                                               |       | $                             | 34,417     |                             | $          | 34,402 |   |
| Subscriber acquisition fees  payable                                                                                                                                    |       | 9,119                         |       | 17,987                           |       |
| License fees payable to  affiliates                                                                                                                                     |       | 30,671                        |       | 106,872                          |       |
| License fees payable to  non-affiliates                                                                                                                                 |       | 87,720                        |       | 76,486                           |       |
| Payables to affiliates                                                                                                                                                  |       | 7,827                         |       | 12,465                           |       |
| Payable to Hallmark  Entertainment Holdings, Inc.                                                                                                                       |       | —                        |       | 52,052                           |       |
| Payable to Hallmark Entertainment,  Inc.                                                                                                                                |       | —                        |       | 47,948                           |       |
| Interest payable to HC Crown                                                                                                                                            |       | 2,655                         |       | 5,105                            |       |
| Credit facility and interest  payable                                                                                                                                   |       | 510                           |       | 310,548                          |       |
| Capital lease obligation                                                                                                                                                |       | 1,559                         |       | 1,661                            |       |
| Deferred revenue                                                                                                                                                        |       | 2,163                         |       | 2,488                            |       |
| Total current liabilities                                                                                                                                               |       | 176,641                       |       | 668,014                          |       |
| Accrued liabilities, net of  current portion                                                                                                                            |       | 18,906                        |       | 20,796                           |       |
| Subscriber acquisition fees  payable, net of current portion                                                                                                            |       | 1,500                         |       | 915                              |       |
| License fees payable to  affiliates, net of current portion                                                                                                             |       | 60,229                        |       | 2,764                            |       |
| License fees payable to  non-affiliates, net of current portion                                                                                                         |       | 82,090                        |       | 71,029                           |       |
| Line of credit payable to HC  Crown                                                                                                                                     |       | 75,000                        |       | 75,000                           |       |
| Payable to Hallmark  Entertainment Holdings, Inc.                                                                                                                       |       | 52,052                        |       | —                           |       |
| Payable to Hallmark  Entertainment, Inc.                                                                                                                                |       | 47,948                        |       | —                           |       |
| Senior unsecured note to HC Crown,  including accrued interest.                                                                                                         |       | 417,083                       |       | 449,603                          |       |
| Credit facility, net of  current portion                                                                                                                                |       | 300,000                       |       | —                           |       |
| Capital lease obligation, net  of current portion                                                                                                                       |       | 7,731                         |       | 6,472                            |       |
| Company obligated mandatorily  redeemable preferred interest, including accretion                                                                                       |       | 9,079                         |       | 10,802                           |       |
| Total liabilities                                                                                                                                                       |       | 1,248,259                     |       | 1,305,395                        |       |
| Commitments and contingencies                                                                                                                                           |       |                          |       |                             |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                              |       |                          |       |                             |       |
| Class A common stock, $.01 par  value; 200,000,000 shares authorized; issued and outstanding shares of  73,863,037 as of December 31, 2003 and September 30, 2004       |       | 739                           |       | 739                              |       |
| Class B common stock, $.01 par  value; 120,000,000 shares authorized; issued and  outstanding shares of 30,670,422 as of December  31, 2003 and September 30, 2004 |       | 307                           |       | 307                              |       |
| Paid-in capital                                                                                                                                                         |       | 1,308,880                     |       | 1,348,345                        |       |
| Accumulated other  comprehensive income                                                                                                                                 |       | 2,013                         |       | 2,319                            |       |
| Accumulated deficit                                                                                                                                                     |       | (998,488                      | )          | (1,186,314                       | )          |
| Total stockholders’ equity                                                                                                                                         |       | 313,451                       |       | 165,396                          |       |
| Total liabilities and  stockholders’ equity                                                                                                                        |       | $                             | 1,561,710  |                             | $          | 1,470,791 |   |
|                                                                                                                                                                         |            |                               |            |                                  |            |  |  |  |  |

 

See accompanying notes to unaudited consolidatedfinancial statements.

 

5

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**CROWN MEDIA HOLDINGS, INC. ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENTS OFOPERATIONS AND COMPREHENSIVE LOSS**

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

 
| ** **                                                                                   | ** ** | **Three  Months Ended  September 30,** | ** ** | **Nine  Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                   | ** ** | **2003**                               | ** ** | **2004**                              | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                                                   | ** ** | **(Unaudited)**                        | ** ** |
| Revenue:                                                                                     |       |                                   |       |                                  |       |   |   |   |   |
| Subscriber fees, net                                                                         |       | $                                      | 17,543     |                                  | $          | 20,038 |   | $ | 51,433 |   | $ | 60,190 |   |
| Advertising                                                                                  |       | 20,468                                 |       | 29,775                                |       | 65,798 |   | 90,483 |   |
| Advertising by Hallmark Cards                                                                |       | 347                                    |       | 256                                   |       | 1,047 |   | 1,050 |   |
| Film asset license fees                                                                      |       | 12,606                                 |       | 5,534                                 |       | 20,010 |   | 17,968 |   |
| Other revenue                                                                                |       | 22                                     |       | 171                                   |       | 79 |   | 256 |   |
| Total revenue, net                                                                           |       | 50,986                                 |       | 55,774                                |       | 138,367 |   | 169,947 |   |
| Cost of services:                                                                            |       |                                   |       |                                  |       |   |   |   |   |
| Programming costs:                                                                           |       |                                   |       |                                  |       |   |   |   |   |
| Affiliates                                                                                   |       | 10,010                                 |       | 12,125                                |       | 28,734 |   | 33,958 |   |
| Non-affiliates                                                                               |       | 19,717                                 |       | 20,621                                |       | 48,510 |   | 59,651 |   |
| Amortization of film assets                                                                  |       | 11,371                                 |       | 8,941                                 |       | 24,957 |   | 24,407 |   |
| Impairment of film assets                                                                    |       | —                                 |       | 57,931                                |       | — |   | 57,931 |   |
| Subscriber acquisition fee  amortization                                                     |       | 6,468                                  |       | 7,010                                 |       | 19,074 |   | 19,042 |   |
| Depreciation and amortization  of technical facilities                                       |       | 1,185                                  |       | 1,182                                 |       | 3,556 |   | 3,548 |   |
| Operating costs                                                                              |       | 11,736                                 |       | 11,277                                |       | 33,819 |   | 31,140 |   |
| Total cost of services                                                                       |       | 60,487                                 |       | 119,087                               |       | 158,650 |   | 229,677 |   |
| Selling, general and  administrative expense                                                 |       | 17,743                                 |       | 19,679                                |       | 44,193 |   | 54,288 |   |
| Marketing expense                                                                            |       | 3,474                                  |       | 2,899                                 |       | 17,645 |   | 16,859 |   |
| Reorganization credit                                                                        |       | —                                 |       | —                                |       | — |   | (279 | ) |
| Depreciation and amortization  expense                                                       |       | 2,548                                  |       | 2,167                                 |       | 7,619 |   | 6,897 |   |
| Loss from operations                                                                         |       | (33,266                                | )          | (88,058                               | )          | (89,740 | ) | (137,495 | ) |
| Loss on early extinguishment  of debt                                                        |       | (39,812                                | )          | —                                |       | (39,812 | ) | — |   |
| Guaranteed preferred  beneficial accretion                                                   |       | —                                 |       | —                                |       | (23,218 | ) | — |   |
| Interest expense, net                                                                        |       | (15,374                                | )          | (16,801                               | )          | (30,230 | ) | (48,483 | ) |
| Loss before income tax  provision                                                            |       | (88,452                                | )          | (104,859                              | )          | (183,000 | ) | (185,978 | ) |
| Income tax provision                                                                         |       | (593                                   | )          | (904                                  | )          | (2,132 | ) | (1,848 | ) |
| Loss before cumulative effect  of a change in  accounting  principle                    |       | (89,045                                | )          | (105,763                              | )          | (185,132 | ) | (187,826 | ) |
| Cumulative effect of change in  accounting principle                                         |       | 16,328                                 |       | —                                |       | 16,328 |   | — |   |
| Net loss                                                                                     |       | $                                      | (72,717    | )                                     | $          | (105,763 | ) | $ | (168,804 | ) | $ | (187,826 | ) |
| Other comprehensive income  (loss):                                                          |       |                                   |       |                                  |       |   |   |   |   |
| Foreign currency translation  adjustment                                                     |       | (315                                   | )          | (175                                  | )          | 95 |   | 306 |   |
| Comprehensive loss                                                                           |       | $                                      | (73,032    | )                                     | $          | (105,938 | ) | $ | (168,709 | ) | $ | (187,520 | ) |
| Weighted average number of  Class A and Class B shares  outstanding,  basic and diluted |       | 104,473                                |       | 104,533                               |       | 104,468 |   | 104,533 |   |
|                                                                                         |       |                                   |       |                                  |       |   |   |   |   |
| Loss from before cumulative  effect of change in  accounting  principle                 |       | $                                      | (0.85      | )                                     | $          | (1.01 | ) | $ | (1.77 | ) | $ | (1.80 | ) |
| Cumulative effect of change in  accounting principle                                         |       | 0.15                                   |       | 0.00                                  |       | 0.15 |   | 0.00 |   |
| Net loss per share, basic and  diluted                                                       |       | $                                      | (0.70      | )                                     | $          | (1.01 | ) | $ | (1.62 | ) | $ | (1.80 | ) |
|                                                                                              |            |                                        |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to unaudited consolidatedfinancial statements.

 

6

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**CROWN MEDIA HOLDINGS, INC. ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(In thousands)**

 
| ** **                                                                       | ** ** | **Nine  Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------------------------|------------|
|                                                                             |       | **2003**                              | ** ** | **2004** |   |
| ** **                                                                       | ** ** | **(Unaudited)**                       | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                            | ** ** | ** **                            | ** ** |
| Net loss                                                                         |       | $                                     | (168,804   | ) | $ | (187,826 | ) |
| Adjustments to reconcile net  loss to net cash used in operating activities:     |       |                                  |       |   |   |
| Cumulative effect of change in  accounting principle                             |       | (16,328                               | )          | — |   |
| Loss on early extinguishment  of debt                                            |       | 39,812                                |       | — |   |
| Impairment of film assets                                                        |       | —                                |       | 57,931 |   |
| Depreciation and amortization                                                    |       | 137,864                               |       | 159,673 |   |
| Accretion on guaranteed  preferred beneficial interest                           |       | 22,018                                |       | — |   |
| Loss on change in fair value  of derivative liability                            |       | 1,200                                 |       | — |   |
| Accretion on convertible debt                                                    |       | 9,468                                 |       | — |   |
| Accretion on company obligated  mandatorily redeemable  preferred  interest |       | 537                                   |       | 1,723 |   |
| Provision for allowance for  doubtful accounts                                   |       | 2,546                                 |       | 71 |   |
| Gain on sale of property and  equipment                                          |       | (31                                   | )          | (124 | ) |
| Stock-based compensation                                                    |       | 3,367                                 |       | 8,319 |   |
| Changes in operating assets  and liabilities:                                    |       |                                  |       |   |   |
| Increase in accounts  receivable                                                 |       | (9,536                                | )          | (1,949 | ) |
| Additions to program license  fees                                               |       | (177,829                              | )          | (90,147 | ) |
| Additions to subtitling and  dubbing                                             |       | (2,409                                | )          | (2,227 | ) |
| Additions to subscriber  acquisition fees                                        |       | (2,031                                | )          | (23,100 | ) |
| Increase in prepaid and other  assets                                            |       | (4,302                                | )          | (2,633 | ) |
| Increase (decrease) in  accounts payable and accrued liabilities.                |       | 69,356                                |       | (26,648 | ) |
| Increase in interest payable                                                     |       | 4,265                                 |       | 35,010 |   |
| Increase (decrease) in  subscriber acquisition fees payable                      |       | (32,255                               | )          | 8,911 |   |
| Increase in license fees  payable to affiliates                                  |       | 23,183                                |       | 18,736 |   |
| Decrease in payables to  affiliates                                              |       | (6,779                                | )          | (141 | ) |
| Increase in deferred revenue                                                     |       | 2,059                                 |       | 325 |   |
| Net cash used in operating  activities                                           |       | (104,629                              | )          | (44,096 | ) |
| CASH FLOWS FROM INVESTING  ACTIVITIES:                                           |       |                                  |       |   |   |
| Purchases of property and  equipment                                             |       | (3,135                                | )          | (1,225 | ) |
| Proceeds from disposition of  property and equipment                             |       | 62                                    |       | 191 |   |
| Net cash used in investing  activities                                           |       | (3,073                                | )          | (1,034 | ) |
| CASH FLOWS FROM FINANCING  ACTIVITIES:                                           |       |                                  |       |   |   |
| Proceeds from tax sharing  agreement with Hallmark Cards                         |       | 31,950                                |       | 39,465 |   |
| Borrowings under the HC Crown  note payable                                      |       | 70,000                                |       | — |   |
| Borrowings under the HC Crown  senior unsecured note                             |       | 400,000                               |       | — |   |
| Borrowings under the credit  facility                                            |       | 11,000                                |       | 15,000 |   |
| Payments on the credit  facility                                                 |       | (67,250                               | )          | (5,000 | ) |
| Repurchase of trust preferred  securities                                        |       | (326,674                              | )          | — |   |
| Distribution to holders of  guaranteed preferred beneficial interest             |       | (7,406                                | )          | — |   |
| Principal payments under  capital lease obligation                               |       | (1,064                                | )          | (1,157 | ) |
| Net cash provided by financing  activities                                       |       | 110,556                               |       | 48,308 |   |
| Effect of exchange rate  changes on cash                                         |       | (66                                   | )          | 85 |   |
| Net increase in cash and cash  equivalents                                       |       | 2,788                                 |       | 3,263 |   |
| Cash and cash equivalents,  beginning of period                                  |       | 335                                   |       | 4,306 |   |
| Cash and cash equivalents, end  of period                                        |       | $                                     | 3,123      |   | $ | 7,569 |   |
| Supplemental disclosure of  cash and non-cash activities:                        |       |                                  |       |   |   |
| Interest paid                                                                    |       | $                                     | 11,050     |   | $ | 10,453 |   |
| Interest paid on preferred  securities                                           |       | $                                     | 8,944      |   | $ | — |   |
| Income taxes paid                                                                |       | $                                     | 2,132      |   | $ | 1,848 |   |
| Payment on HC Crown note  payable commitment  fee in stock                  |       | $                                     | 281        |   | $ | — |   |
|                                                                                  |            |                                       |            |  |  |  |  |  |

 

See accompanying notes to unaudited consolidatedfinancial statements.

 

7

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**CROWN MEDIA HOLDINGS, INC. ANDSUBSIDIARIES**

**NOTES TO UNAUDITEDCONSOLIDATED FINANCIAL STATEMENTS**

**For the Three and Nine MonthsEnded September 30, 2003 and 2004**

 

**1. Business and Organization**

 

***Organization***

 

Crown Media Holdings, Inc. (“Crown Media Holdings” orthe “Company”), through its subsidiaries, owns and operates pay televisionchannels (collectively the “Hallmark Channel” or the “channel”) dedicated tohigh quality, entertainment programming for adults and families, in the UnitedStates and in various countries throughout the world. The internationaloperations of the Hallmark Channel are operated by Crown Media InternationalLLC (“Crown Media International”) and, in the United Kingdom, by CrownEntertainment Limited (“Crown Entertainment”). Crown Media Internationalcommenced its operations outside the United States in 1995. Domestically, theHallmark Channel is operated and distributed by Crown Media United States LLC (“CrownMedia United States”). Crown Media International acquired an interest in CrownMedia United States in 1998 and as a result of subsequent transactions CrownMedia Holdings owned 100% of the common interests of Crown Media United Statesby March 2001. Significant investors in Crown Media Holdings include HallmarkEntertainment Investments Co. (“Hallmark Entertainment Investments”), asubsidiary of Hallmark Cards, Incorporated (“Hallmark Cards”), the NationalInterfaith Cable Coalition, Inc. (“NICC”), and, indirectly through theirinvestments in Hallmark Entertainment Investments, Liberty Media Corporation (“LibertyMedia”) and J.P. Morgan Partners (BHCA), L. P. (“J.P. Morgan”).

 

***PotentialSale of the International Business***

 

InApril 2004, the Company announced that it is exploring strategic alternativesfor its international operations and the international rights to its filmlibrary, including, but not necessarily limited to, a sale or other corporatetransaction in an effort to maximize shareholder value.

 

TheCompany is in current negotiations for the sale of its international operationsand the international rights to its film library. However, the Company has notreached a final agreement regarding the terms of any such sale. The Companycannot provide assurance that an agreement for any such sale will be executedor that such a sale will be executed or consummated. In addition, any salewould require the consent of existing lenders under the bank credit facility.The Company is required under its amended debt agreements to use substantiallyall of the net proceeds from such a sale to pay down its credit facility andcertain of its obligations to affiliates. Under the amendment to the credit facility executed on October 28, 2004,the Company agreed, in the event of a sale of the international businesses, toa reduction in the maximum borrowings under the facility from the currentallowable borrowings of $320.0 million to $180.0 million.

 

***Liquidity***

 

*Cash Flows*

 

As ofSeptember 30, 2004, the Company had $7.6 million in cash and cash equivalentson hand and $10.0 million available under its bank credit facility. The Company’sprincipal sources of funds are currently cash inflows from operations, cash onhand, periodic cash inflows expected under the tax sharing agreement withHallmark Cards and amounts available for borrowing under its bank creditfacility. On October 28, 2004, the Company received an additional tax sharingpayment of $9.3 million.

 

TheCompany’s principal uses of funds during 2004 and 2005 have been, and areexpected to be, the payment of operating expenses, payments for licensing ofprogramming and subscriber acquisition fees, and interest payments 

 

8

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under its bank creditfacility. As part of the Company’s growth strategy, the Company expects tocontinue making investments in programming and distribution during 2004 and2005.

 

As ofSeptember 30, 2004, the Company believes that cash inflows from its operations,cash on hand, remaining availability under its credit facility and paymentsanticipated under the tax sharing agreement with Hallmark Cards, all of whichare currently its principal sources of funds, will be sufficient to meet itsliquidity needs through the amended maturity date of its credit facility. Asdisclosed in note 8, subsequent to the end of the third quarter, the Companyamended its credit facility which included an acceleration of the maturity andtermination date of the facility from August 2006 to September 1, 2005.  This revision, along with agreements withcertain affiliates of Hallmark Cards, has resulted in approximately $470.0million of obligations becoming due and payable on September 1, 2005.  Of this amount, $130.0 million of outstandingobligations will become due and payable, if earlier, upon the sale of theCompany’s international operations and international film rights.

 

TheCompany is currently negotiating for the sale of the international operationswhich would provide cash resources to retire a portion of these obligations dueand payable on September 1, 2005.  TheCompany intends to either extend or refinance the credit facility prior to itsmaturity date. In addition, other financing alternatives could include theissuance of additional equity or debt securities. There can be no assurance,however, that the credit facility can or will be extended or refinanced or thatadditional funding will be available, if at all, on terms acceptable to theCompany.

 

If theCompany is unable to successfully complete the sale of the internationalbusiness and restructure its obligations that become due in September 2005, theCompany will not have sufficient available funds to repay such obligations.

 

**2. Summary of Significant Accounting Policies**

 

***Interim Financial Statements***

 

In theopinion of management, the accompanying consolidated balance sheets and relatedinterim consolidated statements of operations and cash flows, include alladjustments, consisting of normal recurring items necessary for their fairpresentation in conformity with accounting principles generally accepted in theUnited States. Interim results are not necessarily indicative of results for afull year. These consolidated financial statements should be read inconjunction with the audited consolidated financial statements and the notes tothose statements for the year ended December 31, 2003 including the Company’sAnnual Report on Form 10-K for the year ended December 31, 2003.

 

***Principles of Consolidation***

 

The consolidated financial statements include theconsolidated accounts of Crown Media Holdings, including those of its whollyowned subsidiaries. All significant intercompany balances and transactions havebeen eliminated in consolidation.

 

***Cash and Cash Equivalents***

 

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

 

***Subscriber Acquisition Fees***

 

CrownMedia United States has distribution agreements with every major pay televisiondistributor (based on  number ofsubscribers) in the United States. These distributors carry the HallmarkChannel on certain of their cable, satellite, terrestrial television, orsatellite master antenna television systems. Under certain of these agreements,Crown Media United States is obligated to pay subscriber acquisition fees, ifdefined subscriber levels are met, in 

 

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order to obtain additionalcarriage of the Hallmark Channel by those distributors. Such costs areaccrued when Crown Media United States receives notice from the distributorsthat they have met the penetration percentage or subscriber count defined inthe underlying agreements.

 

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

 

Subscriber acquisition fees are comprised of thefollowing:

 
| ** **                            | ** ** | **As of  December 31,  2003** | ** ** | **As of  September 30,  2004** | ** ** |
|---------------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| ** **                            | ** ** | ** **                    | ** ** | **(unaudited)**                | ** ** |
| ** **                            | ** ** | **(In  thousands)**           | ** ** |
| Subscriber acquisition fees,  at cost |       | $                             | 191,377    |                           | $          | 214,477 |   |
| Accumulated amortization              |       | (78,181                       | )          | (105,505                       | )          |
| Subscriber acquisition fees,  net     |       | $                             | 113,196    |                           | $          | 108,972 |   |

 

As of December 31, 2003, and September 30, 2004, theconsolidated balance sheets also reflect subscriber acquisition fees payable of$10.6 million and $18.9 million, respectively. For the three months endedSeptember 30, 2003 and 2004, Crown Media United States made cash payments of$10.1 million and $10.7 million, respectively. For the nine months endedSeptember 30, 2003 and 2004, Crown Media United States made cash payments of$34.3 million and $14.2 million, respectively.

* *

Under certain of theagreements with distributors mentioned above, additional subscriber acquisitionfees will become payable by the Company if defined incremental subscriberlevels are reached. Under certain of the agreements, the Company may also berequired to pay substantial marketing support payments, if subscribers exceedproscribed benchmarks, as defined in the respective agreements. These marketingsupport payments are expensed when it becomes probable that subscribers willmeet such benchmarks.

 

***Program License Fees***

 

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

 

***Subtitling and Dubbing***

 

Subtitling and dubbing represent costs incurred toprepare programming for airing in international markets. These costs arecapitalized as incurred and are amortized over the shorter of the program’sairing window for programming licensed from unaffiliated third-parties or theprogram’s estimated life for programming licensed from Hallmark EntertainmentDistribution and the Company’s film assets. Subtitling and dubbing costsrelated to programming licensed from Hallmark Entertainment Distribution areamortized over a maximum period of 3 years. Amortizationexpense for subtitling and dubbing costs was $980,000 and $1.0 million for thethree months ended September 30, 2003 and 2004, respectively. Amortizationexpense for subtitling and dubbing costs was $3.3 million and $3.0 million forthe nine months ended September 30, 2003 and 2004, respectively.

 

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| ** **                              | ** ** | **As of  December 31,  2003** | ** ** | **As of  September 30,  2004** | ** ** |
|-----------------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| ** **                              | ** ** | ** **                    | ** ** | **(unaudited)**                | ** ** |
| ** **                              | ** ** | **(In  thousands)**           | ** ** |
| Subtitling and dubbing assets,  at cost |       | $                             | 7,863      |                           | $          | 7,410 |   |
| Accumulated amortization                |       | (3,016                        | )          | (3,338                         | )          |
| Subtitling and dubbing assets,  net     |       | $                             | 4,847      |                           | $          | 4,072 |   |

 

***Property and Equipment***

 

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

 

***Accounting for Trust Preferred Securities***

 

In December 2001, Crown Media Holdings formed a special-purposeentity, Crown Media Trust. Crown Media Trust issued trust preferred securitiesin Crown Media Trust’s name to investors in a private placement and loaned theproceeds to Crown Media Holdings. This loan was designed so that interest andprincipal payments matched the dividend and any redemption requirements on thetrust preferred securities issued by Crown Media Trust. Interest received byCrown Media Trust from Crown Media Holdings funded distributions to the holdersof the preferred securities.

 

Crown Media Holdings owned 100% of the common equity inCrown Media Trust. The trust preferred securities included terms that allowedthe holder to earn a return above the stated dividend rate on the securitiesunder certain conditions. Based on fair value calculations using discountedcash flows and Black-Scholes models, a portion of the proceeds from thepreferred securities was allocated and classified in Crown Media Holdings’balance sheet as guaranteed preferred beneficial interest in Crown Media Trust’sdebentures and a portion was classified as convertible debt. Issuance costsrelated to the guaranteed preferred beneficial interest portion were nettedagainst the guaranteed preferred beneficial interest and accreted as additionalexpense in earnings. Issuance costs related to the convertible debt portionwere recorded as a deferred debt issuance costs asset and were amortized asadditional interest expense, using the effective interest method.

 

On December 17, 2001, Crown Media Holdings completed the$265.0 million private placement of the trust preferred securities to a groupof institutional investors. Under the terms of the private placement, CrownMedia Holdings issued units to the investors, each unit consisted of onepreferred security of Crown Media Trust, and one contingent appreciationcertificate, issued by Crown Media Holdings.

 

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

 

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

 

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***Revenue Recognition***

 

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

 

Advertisingrevenues are recognized as earned in the period in which the advertising istelecast and are generally billed monthly in arrears. If the collectibility ofthis revenue is not reasonably assured with any individual customer, therevenue is not recognized until cash is received. Advertising revenues arerecorded net of agency commissions. Agency commissions are calculatedbased on a stated percentage applied to gross billing revenue for the Company’sbroadcasting operations. Customers remit the gross billing amount to the agencyand the agency remits gross billings less their commission to the Company.Payments received in advance of being earned are recorded as deferred revenue.

 

Advertising revenue and expenses in barter transactionsare recorded at the fair value of the advertising to be provided. The fairvalue is determined based upon amounts paid in cash for similar advertisementsfrom buyers unrelated to the other party in the barter transaction. When therevenue does not meet the requirements of EITF No. 99-17, *Accountingfor Advertising Barter Transactions,* no revenue is recognized. Nobarter revenue or related expenses were recorded for the three months endedSeptember 30, 2003. For the nine months ended September 30, 2003, revenue fromadvertising barter transactions of $94,000, and the corresponding barterexpenses were included as a component of both advertising revenue and marketingexpenses in the accompanying consolidated statements of operations. For boththe three and nine months ended September 30, 2004, revenue from advertisingbarter transactions of $401,000, and the corresponding barter expenses wereincluded as a component of both advertising revenue and marketing expenses inthe accompanying consolidated statements of operations.

 

Revenue from film asset licensing agreements isrecognized in accordance with Statement of Position (“SOP”) 00-02,*Accounting by Distributors or Producers of Films*.Revenues are recognized when all of the following have occurred:  an agreement is executed, the film isavailable for exhibition by the licensee, the license fee is fixed orreasonably determinable, collectibility is reasonably assured and the cost ofeach film is known or reasonably determinable. Revenue from film assetlicensing agreements containing multiple film titles is allocated among thevarious film titles based on their relative fair values. Payments received fromlicensees prior to the availability of a film are recorded as deferred revenue.

 

Revenues from foreign sources for the three months endedSeptember 30, 2003 and 2004, represented 40% and 41%, respectively, of totalrevenue. Revenues from foreign sources for the nine months ended September 30,2003 and 2004, represented 44% and 41%, respectively, of total revenue. Suchrevenues, generally denominated in United States dollars, were primarily fromsales to customers in Australia, Denmark, Israel, Mexico, Poland, Romania,Russia, South Africa, Spain, and the United Kingdom, during all periodspresented. The Company records revenue from certain foreign countries only whenthe cash is received due to the uncertainty regarding collection. For the threemonths ended September 30, 2003 and 2004, $315,000 and $235,000, respectively,was invoiced, but not recorded as revenue. For the nine months ended September30, 2003 and 2004, $3.2 million and $832,000, respectively, was invoiced, butnot recorded as revenue.

 

***Cost of Services***

 

Cost of services includes signal distribution expenses,depreciation of the Company’s Network Operations Center and amortization of thecapital lease for uplink and transponder space, amortization of program licensefees, subtitling and dubbing amortization and costs, subscriber acquisitionamortization in excess of subscriber revenue and costs, and amortization offilm assets.

 

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***Long-Lived Assets***

 

In accordance with SFAS No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets,* long-lived assets, such as property, plant andequipment, and purchased intangibles subject to amortization, are reviewed forimpairment whenever events or changes in circumstances indicate that thecarrying amount of an asset may not be recoverable. Recoverability of assets tobe held and used is measured by a comparison of the carrying amount of an assetto estimated undiscounted future cash flows expected to be generated by theasset. If the carrying amount of an asset exceeds its estimated future cashflows, an impairment charge is recognized by the amount by which the carryingamount of the asset exceeds the fair value of the asset. Assets to be disposedwould be separately presented in the balance sheet and reported at the lower ofthe carrying amount of fair value less costs to sell, and are no longerdepreciated. The assets and liabilities of a disposed group classified as heldfor sale would be presented separately in the appropriate asset and liabilitysections of the balance sheet. The Company reviews its goodwill for impairmentunder SFAS No. 142 and its film assets for impairment under SOP 00-2, asdiscussed below.

 

As a result of the Company exploring the sale ofits international channel operations and the international rights to its filmlibrary, the Company analyzed itsinternational channel operations for impairment during the three months endingSeptember 30, 2004.  The Company’sprojections of future cash flows to be generated by the international channeloperations exceeded the carrying value of the net assets within theinternational channel operations asset group and therefore, the asset group wasdeemed to be recoverable.  For purposes ofthis assessment, the Company allocated the probability-weighted cash flows,taking in to account the probability of selling the business or continuing tooperate the business, to the international channel operations and theinternational rights to the film assets based upon the relative fair values ofthe asset groups.

 

***Film Assets***

 

In September 2001, theCompany acquired certain film assets from Hallmark Entertainment Distribution.The Company amortizes its film assets using theindividual-film-forecast-computation method over a maximum period of 10 yearsfrom the date of acquisition. The individual-film-forecast-computation methodamortizes such assets in the same ratio that current period actual revenuebears to estimated unrecognized ultimate revenues. The Company’s projections ofultimate revenue regarding sales of certain rights related to its film assetsto third parties and anticipated internal use of its film assets are based onthe history of each film and similar films, sales and marketing plans, andother factors, all of which require significant judgment by management. Inaccordance with SOP 00-02, the Company assesses the ultimate revenueprojections on a quarterly basis.

 

The Company reviews therecoverability of each film in accordance with SOP 00-02 and on a quarterlybasis assesses whether events or circumstance have changed which indicate thatthe fair value of a film is lower than its unamortized cost or carrying value.If the carrying value of any individual film assets exceeds its fair value, thefilm asset is written-down to its fair value. A discounted cash flow model isused to estimate the fair value of the individual films. Future cash flows arebased on the terms of any existing contractual arrangements plus the projectedcash inflows from future license sales. The Company considers the followingfactors, among others, in estimating future cash inflows for each film:  (a) if previously released, the film’sperformance in historical markets, (*b*)the public’s perception of the film’s story, cast, director, or producer, (*c*) historical results of similar films, (*d*) historical results of the cast,director, or producer on prior films, and (*e*)running time of the film.  In estimating a film’s fair value, the Companyconsiders those cash outflows necessary to generate the film’s cashinflows.  Therefore, future exploitation and participation costs arefactored into the estimation of fair value. On an annual basis, the Company isrequired by the covenants in its credit agreement to have an outside expertperform a valuation of the film library as a whole.

 

In thethird quarter of 2004, the Company reviewed each of its film assets forimpairment as a result of the Company exploring the sale of its internationaloperations and the international rights to its film library. The Company computedfair value of each film using the discounted cash flow model outlined above andalso considered the indications of fair value for the international rights toits film library as a group.  A non-cashimpairment charge was recorded in the third quarter 2004 for each film wherethe calculated fair value was less than its carrying value at September 30,2004. The resulting impairment charge was $57.9 million.

 

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Amortization expense forthe film assets was $11.4 million and $8.9 million for the three months endedSeptember 30, 2003 and 2004, respectively. Amortization expense for the filmassets was $25.0 million and $24.4 million for the nine months ended September30, 2003 and 2004, respectively. At September 30, 2004, the Company expects toamortize $55.0 million to $65.0 million of film assets during the year endingDecember 31, 2004.

 
| ** **                               | ** ** | **As of  December 31,  2003** | ** ** | **As of  September 30,  2004** | ** ** |
|------------------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| ** **                               | ** ** | ** **                    | ** ** | **(unaudited)**                | ** ** |
| ** **                               | ** ** | **(In  thousands)**           | ** ** |
| Film assets                              |       | $                             | 810,928    |                           | $          | 810,928 |   |
| Residual assets                          |       | 9,129                         |       | 12,656                         |       |
| Accumulated amortization and  impairment |       | (69,320                       | )          | (151,511                       | )          |
| Film assets, net                         |       | $                             | 750,737    |                           | $          | 672,073 |   |

 

***Goodwill***

 

The Company has allocatedall of its goodwill to its domestic reporting unit, Crown Media United States,since the goodwill was recorded as a result of a series of transactions wherebythe Company became the owner of 100% of the membership units of Crown MediaUnited States.  In accordance with SFAS No. 142, *Goodwill and OtherIntangible Assets*, Crown Media Holdings ceased amortizing goodwillon January 1, 2002, and performs an impairment analysis of its goodwill on anannual basis and if events and circumstances indicate that the carrying amountmay not be recoverable.  Annually, theCompany employs a valuation expert to evaluate the carrying value of theCompany’s goodwill for impairment, as required by SFAS No. 142.  The Company has selected November 30 as itsannual goodwill impairment review date. The valuation utilized adiscounted cash flow methodology to estimate the fair value of the domesticreporting unit. The estimated cash flow available for distribution over aten-year period was added to the estimated terminal value and discounted to thepresent using the domestic reporting unit’s estimated weighted average cost ofcapital.  The assumptions utilized in thediscounted cash flow model required significant judgment by management and itsvaluation expert. As this valuation exceeded the carrying value of the domesticreporting unit as of November 30, 2003, the step one test described by SFAS No.142 was deemed to have been passed and the step two test was not performed.

 

***Taxes on Income***

 

Pursuant to the Tax Sharing Agreement entered into withHallmark Cards on March 11, 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 11, 2003. However, the Company continues to account for income taxes on a separatereturn basis. The Company accounts for income taxes using an asset andliability method that requires the recognition of deferred tax assets andliabilities for the expected future tax consequences attributable todifferences between the financial statement carrying amounts of existing assetsand liabilities and their respective tax bases and net operating loss and taxcredit carryforwards. Deferred tax assets and liabilities are measured usingenacted tax rates expected to be applied to taxable income in the years inwhich those temporary differences are expected to be recovered or settled. TheCompany reduces deferred tax assets by a valuation allowance if it is morelikely than not that some portion or all of the deferred tax assets will not berealized. Any payments received from Hallmark Cards under the TaxSharing Agreement are recorded as an increase in paid-in capital and any futurereversal of the valuation allowance will be recorded as a reduction in paid-incapital, to the extent payments were received for such benefits under the TaxSharing Agreement.

 

***Translation of Foreign Currency***

 

The balance sheets and statements of operations ofcertain Crown Media Holdings’ foreign subsidiaries are measured using localcurrency as the functional currency. Revenues, expenses and cash flows of suchsubsidiaries are translated into United States dollars at the average exchangerates prevailing during the period. Assets and liabilities are translated atthe rates of exchange at the balance sheet date. Translation gains and lossesare deferred as a component of accumulated other comprehensive income (loss).Foreign currency transaction gains and losses

 

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recordedupon the remeasurement of financial assets and liabilities denominated incurrencies other than the functional currency of the subsidiary are included indetermining net loss for the period.

 

***Net Loss Per Share***

 

Basic net loss per share is computed by dividing the netloss for the period by the weighted average number of common shares outstandingduring the period. Diluted net loss per share is computed based on the weightedaverage number of common shares and potentially dilutive common sharesoutstanding. The calculation of diluted net loss per share excludes potentialcommon shares if the effect would be antidilutive. Potential common sharesconsist of incremental common shares issuable upon the exercise of stockoptions and restricted stock units. Approximately 1.7 million and 1.4 millionstock options for the three and nine months ended September 30, 2003 and 2004,respectively, have been excluded from the calculations of diluted earnings pershare because their effect would have been antidilutive. Approximately 2.0million restricted stock units for the three and nine months ended September30, 2003, respectively, have been excluded from the calculations of dilutedearnings per share because their effect would have been antidilutive.Approximately 2.8 million restricted stock units for the three and nine monthsended September 30, 2004, respectively, have been excluded from thecalculations of diluted earnings per share because their effect would have beenantidilutive.

 

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

 

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

 

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

 

In May 2004, the Company’s Board of Directors approvedan additional grant to employees of 1,065,000 RSUs. The Employment RSUs, whichconstitute 70% of the award granted in 2004, vest in equal one-thirdinstallments over the next three years on the anniversary of the grant dateeach year. The Company is accruing expense related to the Employment RSUsratably over each installment’s vesting period. The Performance RSUs,constituting 30% of the award granted in 2004, vest on the 3rdanniversary of the grant date, provided that the price of the Crown commonstock is $14 or higher on that date. The Company will begin to accruecompensation expense for the Performance RSUs when it becomes probable that theprice of the Company’s stock will be $14 or more on the 3rd

 

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anniversary of the grant date. The Company’s Board maydetermine whether the RSUs are settled in cash or common stock. Crown MediaHoldings is adjusting compensation expense at the end of each reporting periodbased on the fair value of the common stock required to settle the RSUs. Suchcompensation expense is calculated using variable plan accounting.

 

In May 2004, the Company granted 115,000 RSUs to aCompany executive and changed the original vesting terms of this employee’s2003 grant such that one-half of the grant will vest in January 2005 and theother half will vest in January 2006. Compensation expense already recorded forthis employee’s 2003 grant will not be adjusted, rather, compensation expensefor the remaining unvested portion of the grant will be accrued in one-halfincrements ratably over the new vesting periods. Crown Media Holdings isadjusting compensation expense at the end of each reporting period based on thefair value of the common stock required to settle the RSUs at each reportingperiod end during the vesting period of the RSUs. Such compensation expense iscalculated using variable plan accounting.

 

The Companyrecorded $3.1 million and $3.4 million, respectively, of compensation expenseassociated with the RSUs during the three and nine months ended September 30,2003, which has been recorded as an accrued liability in the accompanyingconsolidated balance sheet and is included in selling, general andadministrative expense in the accompanying consolidated statement ofoperations. The Company recorded $2.5 million and $8.3 million of compensationexpense associated with the RSUs during the three and nine months endedSeptember 30, 2004, respectively, which has been recorded as an accruedliability in the accompanying consolidated balance sheet and is included inselling, general and administrative expense in the accompanying consolidatedstatement of operations. TheCompany settled the first one-third increment of the 2003 RSUs in June 2004 forapproximately $3.5 million in cash.

 

Inaddition, in May 2003, the Company’s Board immediately vested the stock optionsof all employees below the vice-president level who held options at that timeand granted them a right to receive a future cash payment of $1.00 for eachoutstanding option held by the employee. The immediate vesting of the employees’stock options created a new measurement date which required the Company torecord stock compensation expense, if any, for the excess of the Company’sstock price on the measurement date over the underlying stock options’ exerciseprice.  Since the price of the Company’sClass A common stock on the measurement date was less than the exercise priceof all of the stock options owned by the employees, no compensation expense wasrecorded under APB 25. However, the June 2004 cash payments totaling $344,386was contingent upon each respective employees’ continuous employment throughthat date. As a result, the Company was recording compensation expense fromJune 2003 through May 2004 as the compensation was earned. For the three andnine months ended September 30, 2003, $80,000 and $109,000, respectively, ofcompensation expense was recorded related to this obligation, which has beenincluded in accrued liabilities in the accompanying consolidated balance sheet.For the nine months ended September 30, 2004, $140,000 of compensation expensewas recorded related to this obligation, which has been included in accruedliabilities in the accompanying consolidated balance sheet. In June 2004,eligible employees received the $1.00 per option payment.

 

Had compensation expense for these plans been determinedconsistent with SFAS No. 123, Crown Media Holdings’ net loss and loss per sharewould have been increased to the following pro forma amounts for the three andnine months ended September 30, 2003 and 2004:

 

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**Pro Forma Effects**

**(unaudited)**

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

 
| ** **                                                     | ** ** | **Three  Months ended  September 30,** | ** ** | **Nine  Months ended   September 30,** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| ** **                                                     | ** ** | **2003**                               | ** ** | **2004**                               | ** ** | **2003** | ** ** | **2004** | ** ** |
| Net loss                                                       |       | $                                      | (72,717    | )                                      | $          | (105,763 | ) | $ | (168,804 | ) | $ | (187,826 | ) |
| Pro forma stock options  expense at  estimated fair value |       | (1,644                                 | )          | (660                                   | )          | (4,952 | ) | (1,983 | ) |
| Stock plan expense included in  net loss                       |       | —                                 |       | —                                 |       | 6 |   | — |   |
| Pro forma net loss                                             |       | $                                      | (74,361    | )                                      | $          | (106,423 | ) | $ | (173,750 | ) | $ | (189,809 | ) |
| Weighted average shares                                        |       | 104,473                                |       | 104,533                                |       | 104,468 |   | 104,533 |   |
| Pro forma net loss per share,  basic and diluted               |       | $                                      | (0.71      | )                                      | $          | (1.02 | ) | $ | (1.66 | ) | $ | (1.82 | ) |

 

Therewere no stock options granted during 2003 or during the three and nine monthsended September 30, 2003 and 2004.

 

***RetentionProgram***

 

TheCompany has established a retention program for approximately 175 employees whocould be affected if Crown Media Holdings’ international business issold.  Under the program, employees that remain with the Company throughthe earlier of the date on which a sale of the international business becomeseffective or December 31, 2004, are entitled to retention of approximately $7.4million. If the Company announces prior to December 31, 2004, that it hasdecided not to sell the international business, reduced retention payments ofapproximately $3.7 million will be payable within 30 days of that announcement.The Company recorded $2.2 million of expense for both the three and nine monthsended September 30, 2004, respectively, in regard to this retention program.

 

***Derivative Financial Instruments***

 

The Company follows the provisions of SFAS No. 133, *Accounting for Derivative Instruments and Hedging Activities,*as amended. The standard requires the recognition of all derivative instrumentson the balance sheet as either assets or liabilities measured at fair value.Changes in fair value are recognized immediately in earnings unless thederivatives qualify as hedges of future cash flows. The Company discontinueshedge accounting prospectively when it is determined that the derivative is nolonger effective in offsetting the cash flows of the hedged item, thederivative expires or is sold, terminated or exercised, or the derivative is nolonger designated as a hedging instrument. Changes in the fair value of thecontingent appreciation certificates included in the trust preferred securitieswere recognized immediately in earnings. The trust preferred securities were repurchased in August 2003 and thecost associated with the settlement of the contingent appreciation certificateshas been included in the loss on early extinguishment of debt in theaccompanying consolidated statements of operations.

 

***Use of Estimates***

 

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

 

TheCompany estimates and records the level of subscriber fees one month in advancebased upon the actual prior month’s subscriber levels. The Company’sadvertising revenue is heavily reliant upon third party ratings estimates todetermine the quantity of advertising delivered to viewers.

 

Whenmultiple films are sold under a single arrangement, in order to properlyrecognize revenue when each license fee commences, the Company must estimatethe relative fair value of each film and allocate the total contracted price tothe different films in the arrangement.

 

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The Company has established an allowance for doubtfulaccounts based upon historical charge-off experience. Periodically, managementanalyzes the attributes of the accounts which management has written-off duringthe period and adjusts the allowance percentages management applies to its agedreceivable balances.

 

Theinitial recoverability of subscriber acquisition fees is evaluated byprojecting the incremental subscriber fee and advertising revenue attributableto the incremental subscribers obtained through the distributionagreement.  This analysis includessignificant judgment and estimation by management in terms of the estimatedincremental advertising per subscriber.

 

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

 

Whenevents or circumstances indicate that the carrying amount of a long-lived assetor asset group may not be recoverable from its undiscounted cash flows, theCompany estimates such future cash flows and measures the impairment loss, if necessary, as the difference between thecarrying amount and fair value of the asset. Estimates of future cash flow and the assumptions used in the discountedcash flow model used by management to estimate fair value require significantjudgment by management.

 

***Concentration of Credit Risk***

 

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

 

***Fair Value***

 

Accounts payable and receivable, are reasonableestimates of their fair values because of their short-term nature. The interestrates on the bank credit facility and the line of credit with HC Crown arevariable and/or reset periodically, therefore, the fair value of this debt isnot significantly affected by fluctuations in interest rates. The carryingamount of the senior unsecured note to HC Crown at September 30, 2004, was$449.6 million, its fair value was $422.4 million and its unrealized gain was$27.2 million, assuming an interest rate of 11%. The company obligatedmandatorily redeemable preferred interest was revalued to its fair value as ofJuly 1, 2003, upon adoption of SFAS No. 150 *Accounting for CertainFinancial Instruments with Characteristics of both Liabilities and Equity*.The Company estimates the fair value of the company obligated mandatorilyredeemable preferred interest on an annual basis in November as it is notpracticable to perform the valuation more frequently. The Company employs adiscounted cash flows approach to value the company obligated mandatorilyredeemable preferred interest that involves a significant amount of time toperform. The valuation is dependent upon the future pre-tax income of CrownMedia United States since the Company is only obligated to make payments on theinstrument to the extent pre-tax income is generated by Crown Media UnitedStates.

 

***Recently Issued Accounting Pronouncements***

 

At arecent meeting, the FASB unanimously voted for proposed accounting standardsrelating to equity-based compensation to be effective for fiscal periodsbeginning after December 15, 2004 (January 1, 2005 for the Company).  Anexposure draft was released in the first quarter of 2004 and the final standardis expected to be issued in 2004.  The accounting standard is expected torequire all companies to utilize the fair value method of accounting forequity-based compensation in accordance with SFAS No. 123, “Accounting forStock-Based Compensation.” Companies can voluntarily adopt SFAS No. 123, usinga variety of adoption methods.  The Company is currently evaluating theimpact of the proposed accounting standards and the adoption alternatives

 

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provided under both thecurrent standards and the proposed standards.  Crown Media Holdingsdiscloses the pro forma impact of stock based compensation on its earnings inits notes to financial statements.

 

InMarch 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on EITFIssue No. 03-01, *The Meaning ofOther-Than-Temporary Impairment and Its Applications to Certain Investments*.EITF Issue No. 03-01 includes new guidance on evaluating and recordingimpairment losses on debt and equity investments, as well as new disclosurerequirements for investments that are considered to be temporarily impaired.The accounting guidance of EITF Issue No. 03-01 is effective for reportingperiods beginning after June 15, 2004, while the disclosure requirements fordebt and equity securities accounted for under SFAS No. 115, *Accounting for Certain Investments in Debt and EquitySecurities*, are effective for annual periods ending after December15, 2003. The Company believes that the adoption of EITF Issue No. 03-01 willnot have a material impact on its financial position or results of operations.

 

InDecember 2003, the Securities and Exchange Commission (“SEC”) issued StaffAccounting Bulletin (“SAB”) No. 104, “*RevenueRecognition”*, which supercedes SAB No. 101, *Revenue Recognition in Financial Statements.*SAB No. 104’s primary purpose is to rescind accounting guidance contained inSAB No. 101 related to multiple element revenue arrangements, superceded as aresult of the issuance of EITF Issue No. 00-21. Additionally, SAB No. 104rescinds the SEC’s Revenue Recognition in Financial Statements Frequently AskedQuestions and Answers (“FAQ”) issued with SAB No. 101 that had been codified inSEC Topic 13, *Revenue Recognition*.Selected portions of the FAQ have been incorporated into SAB No. 104. While thewording of SAB No. 104 has changed to reflect the issuance of EITF 00-21, therevenue recognition principles of SAB No. 101 remain largely unchanged by theissuance of SAB No. 104. EITF 00-21 was effective for revenue arrangementsentered into in fiscal periods beginning after June 15, 2003. There was noimpact to the Company’s consolidated financial statements related to SAB No.104 for the three and nine months ended September 30, 2004.

 

**3. Reorganization**

 

In October 2002, theCompany began reorganizing its operations in order to concentrate its effortson the Hallmark Channel in the U.S. and in its more successful internationalmarkets.  The Company completed decentralizingmany oversight and non-technical support functions formerly located in theCompany’s U.S.-based offices and transferred those responsibilities to regionalstaff.  In Latin America, the Companyentered into an agreement with a local distribution partner, Pramer S.C.A., whois now responsible for the day-to-day operations of the Hallmark Channel inthis region.  At the completion of thereorganization in April 2003, the Company’s workforce was reduced byapproximately 30% or 130 positions. Accordingly, the Company recorded areorganization charge of $28.8 million during the fourth quarter of 2002. Thischarge was comprised of a charge of $5.5 million for severance costs andcharges of $23.3 million related to exit costs for permanently abandoned satellite,transponder and facility leases.

 

The followingtable displays the activity and balances of the reorganization accrual accountfrom December 31, 2003, to September 30, 2004, which have been included inaccounts payable and accrued liabilities in the accompanying consolidatedbalance sheets.

 
| ** **                                 | ** ** | **Severance**      | ** ** | **Facilities** | ** ** | **Satellite and   Transponder** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|--------------------|------------|----------------|------------|---------------------------------|------------|-----------|------------|
| ** **                                 | ** ** | **(In thousands)** | ** ** |
| Balance at December 31, 2003               |       | $                  | 4          |           | $          | 1,523                           |       | $         | 13,511     |   | $ | 15,038 |   |
| Additions due to accretion                 |       | —             |       | —         |       | 48                              |       | 48        |       |
| Deductions due to adjustments to estimates |       | (4                 | )          | (126           | )          | (149                            | )          | (279      | )          |
| Deductions due to payments                 |       | —             |       | (278           | )          | (2,740                          | )          | (3,018    | )          |
| Balance at September 30, 2004              |       | $                  | —     |           | $          | 1,119                           |       | $         | 10,670     |   | $ | 11,789 |   |

 

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**4. Program license fees**

 

Program license fees are comprised of the following:

 
| ** **                           | ** ** | **As of   December 31,  2003** | ** ** | **As of   September 30,  2004** | ** ** |
|--------------------------------------|------------|--------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | ** **                     | ** ** | **(unaudited)**                 | ** ** |
| ** **                           | ** ** | **(In  thousands)**            | ** ** |
| Hallmark Entertainment  Distribution |       | $                              | 112,069    |                            | $          | 118,752 |   |
| NICC                                 |       | 1,885                          |       | 9,247                           |       |
| Other affiliates                     |       | 5,906                          |       | 5,906                           |       |
| Non-affiliates                       |       | 242,329                        |       | 268,521                         |       |
| Program license fees, at cost        |       | 362,189                        |       | 402,426                         |       |
| Accumulated amortization             |       | (115,696                       | )          | (162,681                        | )          |
| Program license fees, net            |       | $                              | 246,493    |                            | $          | 239,745 |   |
|                                      |            |                                |            |                                 |            |  |  |  |  |

 

Programming costs for thethree months ended September 30, 2003 and 2004, were $29.7 million and $32.7million, respectively. Programming costs for the nine months ended September30, 2003 and 2004, were $77.2 million and $93.6 million, respectively.Amortization of program license fees, included as a component of programmingcost in the accompanying consolidated statements of operations, was $29.3million and $32.7 million for the three months ended September 30, 2003 and2004. Amortization of program license fees, included as a component ofprogramming cost in the accompanying consolidated statements of operations, was$75.6 million and $93.6 million for the nine months ended September 30, 2003and 2004.

 

At December 31, 2003, andSeptember 30, 2004, $4.8 million and $4.6 million, respectively, of program licensefees were included in prepaid and other assets on the accompanying consolidatedbalance sheets since the airing windows had not begun but payment had beenmade.

 

License fees payable are comprised of the following:

 
| ** **                          | ** ** | **As of****   December 31,  2003** | ** ** | **As of   September 30,  2004** | ** ** |
|-------------------------------------|------------|-----------------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | ** **                              | ** ** | **(unaudited)**                 | ** ** |
| ** **                          | ** ** | **(In  thousands)**                     | ** ** |
| Hallmark Entertainment Distribution |       | $                                       | 90,609     |                            | $          | 108,233 |   |
| NICC                                |       | 291                                     |       | 1,403                           |       |
| Non-affiliates                      |       | 169,810                                 |       | 147,515                         |       |
| Total license fees payable          |       | 260,710                                 |       | 257,151                         |       |
| Less current maturities             |       | (118,391                                | )          | (183,358                        | )          |
| Long-term license fees payable      |       | $                                       | 142,319    |                            | $          | 73,793 |   |
|                                     |            |                                         |            |                                 |            |  |  |  |

 

**5. Credit Facility**

 

Inconnection with the completion of the purchase of the film assets in 2001,Crown Media Holdings entered into a credit agreement with a syndicate of banks,led by JP Morgan Chase Bank, under which the banks have extended to Crown MediaHoldings a five-year $320.0 million secured credit facility. The creditfacility includes a term loan of $100.0 million and a revolving line of creditof $220.0 million, up to $20.0 million of which can be letters of credit issuedat the request of Crown Media Holdings. At September 30, 2004, Crown MediaHoldings had outstanding borrowings of $310.0 million under the credit facilityand there were no letters of credit outstanding. As a result of an amendment tothe credit facility executed on October 28, 2004, the entire balance is due in2005 and, therefore, is classified as a current liability in the accompanyingconsolidated balance sheets. (Of the outstanding amount, $130.0 million is dueon the sale of the international operations and international film rights ifsuch an event occurs earlier than the maturity date.) This loan is guaranteedby Crown Media Holdings’ subsidiaries and is secured by all tangible andintangible property of Crown Media Holdings and its subsidiaries. The Companyis obligated to maintain certain financial debt covenants in conjunction withthe credit facility. As a result of the film asset impairment charge recordedin the third quarter 2004, the Company was not in compliance with the trailing12-month EBITDA (as defined) financial covenant at September 30, 2004.  The amendment to the credit facility 

 

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executed on October 28,2004, excluded the film asset impairment charge from the calculation oftrailing 12-month EBITDA.

 

Interest expense on borrowings under the credit facilityfor the three months ended September 30, 2003 and 2004, was $2.9 million and$3.5 million, respectively. Interest expense on borrowings under the creditfacility for each of the nine months ended September 30, 2003 and 2004, was$9.9 million.

 

**6. Related Party Transactions**

 

***Senior Unsecured Note***

 

InAugust 2003, the Company issued a senior unsecured note to HC Crown for $400.0million. A portion of the proceeds was used to repurchase the Company’soutstanding trust preferred securities, and the balance of the proceeds, afterexpenses, was used to reduce amounts outstanding under its bank creditfacility.

 

Thesenior unsecured note payable to HC Crown does not require interest orprincipal payments until August 2007. Instead, the principal amount of thesenior unsecured note accretes at 10.25% per annum, compounding semi-annually,to $596.6 million at August 5, 2007. From that date, interest at 10.25% per annum will be payablesemi-annually on the accreted value of the senior unsecured note to HCCrown.  The note matures onAugust 5, 2011, and is pre-payable by Crown Media Holdings at any timeafter August 5, 2004, without penalty. At December 31, 2003, $400.0 million ofprincipal and $17.1 million of accreted interest were included in the seniorunsecured note payable in the accompanying consolidated balance sheet. AtSeptember 30, 2004, $400.0 million of principal and $49.6 million of accruedinterest were included in the senior unsecured note payable in the accompanyingconsolidated balance sheet. The note purchase agreement for the seniorunsecured note contains certain covenants which restrict on the part of theCompany, among other matters, from the incurrence of any additionalindebtedness, the repurchase or other acquisitions of the Company’s stock,investments in other parties and the incurrence of liens on the Company’sassets.  As a fee for the issuance of thenotes, the Company paid $3.0 million to HC Crown, which is being amortized asadditional interest expense over the term of the note payable.

 

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

 

On December 14, 2001, theCompany executed a $75.0 million promissory note with HC Crown maturing on theearlier of six months from the termination of the credit facility or December21, 2007.  As discussed in note 8, thecredit facility termination date has been amended to September 1, 2005, and assuch, the line of credit becomes due and payable on February 2006.  This note replaced the promissory notepreviously issued to HC Crown dated September 28, 2001. This line of credit issubordinate to the credit facility. The rate of interest under this line ofcredit is equal to LIBOR plus three percent, payable quarterly. At bothDecember 31, 2003, and September 30, 2004, borrowings under the note were $75.0million. Accrued interest on the note of $2.7 million and $5.1 million as ofDecember 31, 2003, and September 30, 2004, respectively, is included ininterest payable to HC Crown on the accompanying consolidated balance sheets.

 

***Tax Sharing Agreement***

 

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 benefitedfrom past tax losses and will benefit from future federal tax losses, which maybe generated by Crown Media Holdings. Based on the Tax Sharing Agreement, Hallmark Cards has agreed to payCrown Media Holdings all of the benefits realized or realizable by HallmarkCards as a result of including Crown Media Holdings in its consolidated incometax return, 75% in cash on a quarterly basis and the balance when Crown MediaHoldings becomes a federal taxpayer. Under the Tax Sharing Agreement, at Hallmark Cards’ option, the balanceof the 25% in federal tax benefits may also be applied as an offset against anyamounts owed by Crown Media Holdings to any member of the Hallmark Cardsconsolidation group under any loan, line of credit or other payable, subject tolimitations under any loan indentures or contracts restricting such offsets. Asof September 30, 2004, Hallmark Cards has not exercised this option.

 

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TheCompany received $49.4 million under the Tax Sharing Agreement during 2003. TheCompany received $32.0 million and $39.5 million under the Tax SharingAgreement during the nine months ended September 30, 2003 and 2004,respectively. In October 2004, the Company received an additional $9.3 millionunder the Tax Sharing Agreement. These receipts have been recorded as an additionto paid-in capital in the accompanying consolidated balance sheet.

 

***Hallmark Entertainment Investments***

 

OnMarch 11, 2003, Hallmark Entertainment Holdings, Inc. (“HallmarkEntertainment Holdings”, a wholly-owned subsidiary of Hallmark Cards)contributed 100% of the Crown Media Holdings shares owned by it to HallmarkEntertainment Investments. Two of Crown Media Holdings’ investors, LibertyCrown, Inc., a subsidiary of Liberty Media, and JP Morgan, also contributed100% of their Crown Media Holdings shares to Hallmark EntertainmentInvestments, and VISN contributed 10% of its Crown Media Holdings shares toHallmark Entertainment Investments, all in return for shares in HallmarkEntertainment Investments. Hallmark Entertainment Holdings, now an owner of morethan 80% of Hallmark Entertainment Investments, has voting power over all ofthe Crown Media Holdings shares owned by Hallmark Entertainment Investments.

 

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

 

Since inception, Hallmark Entertainment has at times paidcertain costs on behalf of Crown Media Holdings. For the three and nine monthsended September 30, 2003, the Company paid $186,000 and $1.0 million toHallmark Entertainment as a reimbursement of such costs. No amounts werereimbursed to Hallmark Entertainment during the three and nine months endedSeptember 30, 2004. Hallmark Entertainment incurred $600,000 and $3.0 million,respectively, on Crown Media Holdings behalf for the three and nine monthsended September 30, 2004. Unreimbursed costs of $670,000 and $3.7 million areincluded in payable to affiliates in the accompanying consolidated balancesheets as of December 31, 2003, and September 30, 2004, respectively.

 

***Services Agreement with Hallmark Cards***

 

CrownMedia Holdings entered into an Intercompany Services Agreement with HallmarkCards, which was effective January 1, 2003, under which Hallmark Cards agreedfor a term of three years to provide Crown Media Holdings with tax, riskmanagement, health safety, environmental, insurance, legal, treasury and cashmanagement services and real estate consulting services.  Under the agreement, the Company agreed topay Hallmark Cards $515,000 per year for these services, plus out-of-pocketexpenses and third party fees, payable in arrears on the last business day ofeach quarter. At December 31, 2003 andSeptember 30, 2004, unpaid accrued service fees and unreimbursed expenses of$6.8 million and $8.4 million, respectively, have been included in payable toaffiliates in the accompanying consolidated balance sheets.

 

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

 

The Company entered into a film asset services agreementwith Hallmark Entertainment, under which Hallmark Entertainment provides CrownMedia Holdings with services related to the administration, distribution andother exploitation of the Company’s film assets. The services agreement expireson December 31, 2006, subject to cancellation by either party after thefirst or second year. In consideration forthe services provided by Hallmark Entertainment, Crown Media Holdings isobligated to pay a service fee of $1.5 million per year, payable in quarterlyinstallments of $375,000. Crown Media Holdings paid $375,000 to HallmarkEntertainment during both of the three months ended September 30, 2003 and2004. Crown Media Holdings paid $1.1 million to Hallmark Entertainment duringboth of the nine months ended September 30, 2003 and 2004. At both December 31,2003, and September 30, 2004, unpaid accrued service fees of $375,000 wereincluded in payable to affiliates in the accompanying consolidated balancesheet.

 

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***Trademark Agreement with Hallmark Cards***

 

CrownMedia United States, Crown Media International and Crown Entertainment havetrademark license agreements with Hallmark Cards and Hallmark Licensing, Inc.for use of the “Hallmark” mark for the versions of the Hallmark Channeldistributed both in the United States and internationally and for the HallmarkMovie Channel.  These trademark license agreementsexpire on September 1, 2005.

 

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

 

Crown Media International has a program licenseagreement with Hallmark Entertainment Distribution dated January 1, 2001. Theagreement expires on December 31, 2005, subject to a renewal through December31, 2010. Under the terms of the agreement, Crown Media International has theexclusive right to exhibit Hallmark Entertainment Distribution producedprogramming in the territories in which Crown Media International operatesduring three 18-month windows. Crown Media International also has the exclusiveright to exhibit programming in markets where it does not currently operate, ifit elects to distribute the channel in those markets, subject to any agreementbetween Hallmark Entertainment Distribution and a third party existing at thetime Crown Media International launches the channel in those markets. Inaddition, under the agreement, Hallmark Entertainment Distribution is generallyobligated to sell to Crown Media International all of the programming itproduces and Crown Media International is obligated to purchase up to 50programs produced per year during the term of the agreement.

 

Crown Media United States also licenses programming fordistribution in the United States from Hallmark Entertainment Distributionunder a separate program license agreement, dated January 1, 2001. Under thisprogram agreement, Crown Media United States licenses programs owned orcontrolled by Hallmark Entertainment Distribution, as well as all programmingproduced by or on behalf of Hallmark Entertainment Distribution for Crown MediaUnited States. The program agreement has a term of five years and isautomatically renewable for additional three-year periods, subject to rateadjustments, so long as Hallmark Entertainment Distribution or its affiliates,owns an interest of 35% or more of Crown Media Holdings.  If, at any time, Hallmark EntertainmentDistribution ceases to own a 35% interest in Crown Media Holdings, and if, atthat time, the remaining term of the program agreement is less than two years,then the remaining term of the program agreement will be extended to the datetwo years after the date on which Hallmark Entertainment Distribution ceased toown a 35% interest in Crown Media Holdings.

 

Ifeither Crown Media United States or Crown Media International sub-licenses anylicensed program to a third party, they must equally share with HallmarkEntertainment Distribution the excess, if any, of the sublicensing fee over theinitial program license fee paid by the Company.  The Company did not sub-license any licensedprograms to third parties during the three and nine months ended September 30,2003 and 2004.  Amounts due to HallmarkEntertainment Distribution as a result of sub-licensing agreements entered intoin other periods have been included in license fees payable to affiliates inthe accompanying balance sheets as noted below.

 

Programming costs relatedto the Hallmark program agreements were $7.1 million and $9.2 million,respectively, for the three months ended September 30, 2003 and 2004.Programming costs related to the Hallmark program agreements were $19.2 millionand $25.1 million, respectively, for the nine months ended September 30, 2003and 2004. As of December 31, 2003, and September 30, 2004, $90.6 million and$108.2 million, respectively, are included in license fees payable toaffiliates in the accompanying consolidated balance sheets.

 

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

 

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

 

Underthe company agreement, the members agreed that if during any year ending afterJanuary 1, 2005 and

 

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prior toDecember 31, 2009, Crown Media United States has net profits in excess of$10.0 million, and the preferred interest has not been redeemed, Crown MediaUnited States will redeem the preferred interest in an amount equal to thelesser of: (i) such excess net profits; (ii) $5.0 million; or (iii) the amountequal to the preferred liquidation preference on the date of redemption.  Crown Media United States may voluntarilyredeem the preferred interest at any time, however, it is obligated to do so onthe date of redemption (December 31, 2010). Due to the mandatory redemptionprovision of the preferred interest, on July 1, 2003, the preferred interestwas remeasured at fair value and reclassified to non-current liabilities in accordancewith the provisions of SFAS No. 150.

 

Underthe company agreement, Crown Media United States may be required to makecertain payments in regards to programming provisions to the NationalInterfaith Cable Coalition (“NICC”). Specifically, Crown Media United States may be required to pay licensefees to NICC or fund production costs consisting of: (i) a total of $5.3million per year, with CPI escalations, for two recurring programming blocksproduced by NICC; (ii) up to $10 million per year for an additional recurring “signature”series program block co-produced by NICC and Crown Media United States; (iii)up to $600,000 per “non-dramatic” holiday special produced by NICC; and (iv) upto $1.0 million per “dramatic” holiday special co-produced by NICC and HallmarkEntertainment. In addition, six monthsprior to the expiration of the agreement, Crown Media United States mustnegotiate in good faith with NICC regarding a continuation of this programmingand funding commitment. If agreement is not reached and Crown Media UnitedStates does not continue the NICC programming and funding commitments at thesame levels, NICC is entitled to compel Crown Media Holdings to buy all of NICC’sCrown Media Holdings shares at their then-current market value no later than 60days following the expiration of the amendment. Crown Media United States,however, can nullify this put by electing to continue the NICC programming andfunding commitments at the same levels.

 

Pursuant to additionalamendments effective January 1, 2002, and January 1, 2004, Crown Media UnitedStates agreed to advance NICC $3,000,000 in each of 2002, 2003 and 2004 to helpfund NICC’s cost of expanding its production operations to produce theaforementioned programming.  This advancewill be recovered from the license fees payable for this programming when suchprogramming is produced and accepted by Crown Media United States fordistribution on the channel. These expenses are included as components ofaffiliate programming costs in the accompanying consolidated statements ofoperations.

 

During the three monthsended September 30, 2003 and 2004, Crown Media United States paid NICC in theaggregate of $2.7 million and $653,000, respectively, related to the companyagreement. During the nine months ended September 30, 2003 and 2004, CrownMedia United States paid NICC in the aggregate of $7.7 million and $7.9million, respectively, related to the company agreement. As of December 31,2003, and September 30, 2004, $291,000 and $1.4 million, respectively, relatedto this arrangement are included in license fees payable to affiliates in theaccompanying consolidated balance sheets.

 

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**7. Operations in Different Geographic Areas**

 

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

 
| ** **                                | ** ** | **Revenue from  Unrelated  Entities** | ** ** | **Revenue from  Related  Entities** | ** ** | **Operating  Loss** | ** ** | **Identifiable  Assets** | ** ** |
|-------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|---------------------|------------|--------------------------|------------|
| ** **                                | ** ** | **(In millions)**                     | ** ** |
| Three months ended September 30, 2003:    |       |                                  |       |                                |       |                |       |                     |       |
| Domestic                                  |       | $                                     | 17.6       |                                | $          | 0.3                 |       | $                        | (25.6      | ) | $ | 674.1 |   |
| International                             |       | 20.5                                  |       | —                              |       | (7.9                | )          | 91.7                     |       |
| Film distribution                         |       | 12.6                                  |       | —                              |       | 0.2                 |       | 792.4                    |       |
| Consolidated total                        |       | $                                     | 50.7       |                                | $          | 0.3                 |       | $                        | (33.3      | ) | $ | 1,558.2 |   |
| Loss on extinguishment of debt            |       |                                  |       |                                |       | (39.8               | )          |                     |       |
| Interest expense                          |       |                                  |       |                                |       | (15.4               | )          |                     |       |
| Loss before income taxes                  |       |                                  |       |                                |       | $                   | (88.5      | )                        |       |   |
|                                      |       |                                  |       |                                |       |                |       |                     |       |
| Three months ended September 30, 2004:    |       |                                  |       |                                |       |                |       |                     |       |
| Domestic                                  |       | $                                     | 26.9       |                                | $          | 0.3                 |       | $                        | (21.9      | ) | $ | 667.9 |   |
| International                             |       | 23.1                                  |       | —                              |       | (4.3                | )          | 84.7                     |       |
| Film distribution                         |       | 5.5                                   |       | —                              |       | (61.9               | )          | 718.2                    |       |
| Consolidated total                        |       | $                                     | 55.5       |                                | $          | 0.3                 |       | $                        | (88.1      | ) | $ | 1,470.8 |   |
| Interest expense                          |       |                                  |       |                                |       | (16.8               | )          |                     |       |
| Loss before income taxes                  |       |                                  |       |                                |       | $                   | (104.9     | )                        |       |   |
|                                      |       |                                  |       |                                |       |                |       |                     |       |
| Nine months ended September 30, 2003:     |       |                                  |       |                                |       |                |       |                     |       |
| Domestic                                  |       | $                                     | 56.9       |                                | $          | 1.0                 |       | $                        | (63.6      | ) | $ | 674.1 |   |
| International                             |       | 60.5                                  |       | —                              |       | (17.6               | )          | 91.7                     |       |
| Film distribution                         |       | 20.0                                  |       | —                              |       | (8.6                | )          | 792.4                    |       |
| Consolidated total                        |       | $                                     | 137.4      |                                | $          | 1.0                 |       | $                        | (89.8      | ) | $ | 1,558.2 |   |
| Loss on extinguishment of debt            |       |                                  |       |                                |       | (39.8               | )          |                     |       |
| Guaranteed preferred beneficial accretion |       |                                  |       |                                |       | (23.2               | )          |                     |       |
| Interest expense                          |       |                                  |       |                                |       | (30.2               | )          |                     |       |
| Loss before income taxes                  |       |                                  |       |                                |       | $                   | (183.0     | )                        |       |   |
|                                      |       |                                  |       |                                |       |                |       |                     |       |
| Nine months ended September 30, 2004:     |       |                                  |       |                                |       |                |       |                     |       |
| Domestic                                  |       | $                                     | 81.6       |                                | $          | 1.0                 |       | $                        | (59.1      | ) | $ | 667.9 |   |
| International                             |       | 69.3                                  |       | —                              |       | (12.0               | )          | 84.7                     |       |
| Film distribution                         |       | 18.0                                  |       | —                              |       | (66.4               | )          | 718.2                    |       |
| Consolidated total                        |       | $                                     | 168.9      |                                | $          | 1.0                 |       | $                        | (137.5     | ) | $ | 1,470.8 |   |
| Interest expense                          |       |                                  |       |                                |       | (48.5               | )          |                     |       |
| Loss before income taxes                  |       |                                  |       |                                |       | $                   | (186.0     | )                        |       |   |

 

British Sky Broadcasting,which is domiciled in the United Kingdom and revenues from which are includedin the Company’s international segment, accounted for 8% and 15% of the Company’sconsolidated revenues for the three months ended September 30, 2003 and 2004,respectively. British Sky Broadcasting, accounted for 8% and 14% of the Company’sconsolidated revenues for the nine months ended September 30, 2003 and 2004,respectively. No other individual country, other than the United States and theUnited Kingdom, accounted for more than 10% of the Company’s consolidatedrevenues. No individual pay television distributor accounted for more than 10%of the Company’s consolidated subscribers for the three and nine months endedSeptember 30, 2003 and 2004.

 

**8. Subsequent Events**

 

On October 28, 2004, the Company enteredinto an amendment of its bank credit facility. The amendment modified certaincovenants with regard to current EBITDA and Net Worth thresholds and eliminatedthe debt to capitalization and leverage ratios. As amended, the term loan of$100.0 million is payable on the earlier of a “Foreign Asset Sale EffectiveDate” or September 1, 2005.  A ForeignAsset Sale Effective Date is generally the date on which the Company sells itsinternational business and international rights to its film library.  On a Foreign Asset Sale Effective Date, therevolving line of credit under the bank credit facility will be reduced from$220.0 million to $180.0 million and the line of credit will mature onSeptember 1, 2005.  The Agent bank hasthe ability to approve on behalf of the lending banks the final terms of anysale of the international business as described above, including thedocumentation for the transaction.  Inaddition, certain of the financial covenants, as revised, will be effectiveonly on a Foreign Asset Sale Effective Date, and proceeds of the sale arerequired to be used to pay down the credit facility so that the outstandingamount does not exceed $180.0 million and certain obligations due to Hallmarkaffiliates.

 

25

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

 

**Overview**

 

*CurrentChallenges*

 

*The Company faces many challenges in the current domestic andinternational marketplaces. The domestic cable industry is saturated withchannels striving to position themselves on lower analog tiers and on digitalplatforms of cable TV distributors. The Company has less leverage* in the marketplace in regard to channel line-uppositioning and advertising sales than many of our competitors since theyoperate multiple channels while we operate only one channel.Among other things, owners of multiplechannels are able to leverage demand for their more popular channels toconvince distributors and advertisers to distribute and advertise on their lesssuccessful channels. Our ratings and subscribers must continueto grow in future years in order to increase subscriber demand for our channeland our advertising revenues. The Company strives to obtain additionalsubscribers by renegotiating distribution agreements, and, as a result, mayface increased subscriber acquisition fee payments. The Company also attempts,and has succeeded, in improving its ratings by acquiring new programming andrevising its programming schedules to meet the demands of its viewers. A largeraudience share results in higher advertising rates, which, in turn, increasesrevenue. Domestically, we foresee in 2004 an increase in our domesticadvertising revenues due to an enhanced programming schedule and growingsubscriber counts.

 

In the United Kingdom and our Europe Middle Eastand Africa (“EMEA”) market, we have acquired programming, much of which has notbeen previously aired on cable television in the aforementioned markets. Weexpect this programming to attract additional viewers, resulting in increasedratings. In our Latin American and Asian markets, our primary focus is tomanage our investment, minimize our programming expenditures through the use ofour film assets, expand our subscriber base and thereby command increasedsubscriber fees and advertising revenue. We face challenges to overcoming thepolitical and economic problems in certain of our international markets.Management continuously evaluates our position in these countries. The Companycompleted the restructuring of its international segment during 2003 by decentralizingmany oversight and non-technical support functions formerly located in theCompany’s U.S.-based offices and transferring those responsibilities toregional staff. Certain operating expenses decreased because ofthis action, primarily the ongoing expense related to salaries and leasingtransponder space.

 

Our film assets provide us with a significant,additional source for revenue and cash flow. External demand for our filmlibrary assets improved during 2003, with the improvement of the economy and anincrease in incentives for our sales force. Our film assets have experienceddecreased sales in 2004 as explained below.

 

The primary financial and non-financial measuresanalyzed by management are Adjusted EBITDA (as defined below) and the metricsdriving each of our revenue lines such as: subscriber counts, advertisingrates, domestic ratings and ratings for certain international markets, anddemographics of our viewing audiences.

 

*International Business*

 

In April 2004, the Company announced that it isexploring strategic alternatives for its international operations and theinternational rights to its film library, including, but not necessarilylimited to, a sale or other corporate transaction in an effort to maximizeshareholder value.  The Company at thedate of this Report is negotiating a sale to a third party of its internationaloperations and the international rights to its film library. For informationregarding a possible sale of the international business, see “Potential Sale ofthe International Business” in Note 1 of the Notes to the UnauditedConsolidated Financial Statements in this Report.

 

The Company has established a retention program forapproximately 175 employees who could be affected if Crown Media Holdings’international business is sold.  Under the program, employees that remainwith the Company through the earlier of the date on which a sale of theinternational business becomes effective or 

 

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December 31, 2004, are entitled to retention of approximately $7.4million. If the Company announces prior to December 31, 2004, that it hasdecided not to sell the international business, reduced retention payments ofapproximately $3.7 million will be payable within 30 days of that announcement.

 

*Cash Flow*

 

Our management is striving to generate positive cashflows in 2004 and future years through the sale of advertising and ongoing costmanagement.  We will continue to monitorexpenses, and, potentially, reduce certain expenses in 2004 to meet our cashflow goals.  Our cash flow goals will besignificantly affected by a sale of our international operations andinternational film rights.

* *

*Significant uses of cash during the nine months ended September 30,2004, were for program acquisitions in primarily our domestic and UnitedKingdom markets. The Company also paid subscriber acquisition fees resultingfrom distribution agreements renegotiated in 2003 and prior years. Attainmentof certain subscriber levels will also cause an increase in subscriberacquisition fee payments in future years, but, as many of our more significantdistribution agreements expire in 2007, we do not foresee significantsubscriber acquisition fee payments until after 2007*.

 

*Writedown of Film Assets*

 

For the third quarter of 2004, the Company reviewedeach of its film assets for impairment as a result of the Company exploring thesale of its international operations and the international rights to its filmlibrary. The Company computed fair value of each film using the discounted cashflow model outlined above and also considered the indications of fair value forthe international rights to its film library as a group.  A non-cash impairment charge was recorded inthe third quarter 2004 for each film where the calculated fair value was lessthan its carrying value at September 30, 2004. The resulting impairmentcharge was $57.9 million. The Company concluded on November 11, 2004, thatthis non-cash impairment charge was required under generally acceptedaccounting principles to be recorded in the Company’s financial results for thethird quarter of 2004. Please see Note 2 of Notes to the Unaudited ConsolidatedFinancial Statements in this Report for additional information on thisimpairment charge.

 

**Revenue**

 

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

 

*Subscriber Fees*

 

Subscriber fees aregenerally payable to us on a per subscriber basis by pay television distributorsfor the right to carry our channels. In the United States, we pay certaintelevision distributors up-front subscriber acquisition fees to carry ourchannel. However, such payments are not common in the international cabletelevision markets. Subscriber acquisition fees that we pay are capitalized andamortized over the contractual term of the applicable distribution agreement asa reduction in subscriber fee revenue. If the amortization expense exceeds therevenue recognized on a per distributor basis, the excess amortization isincluded as a component of cost of services. At the time we sign a distributionagreement, we evaluate the recoverability of the costs we incur against theincremental revenue directly and indirectly associated with each agreement. 

 

Rates we receive persubscriber vary according to: 

 

•                                          thelevel of sophistication and degree of competition in the market; 

 

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

 

•                                          thepackaging arrangements for the channel; and 

 

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

 

In some circumstances,international distributors provide minimum revenue guarantees.

 

We are in continuousnegotiations with both our existing distributors and new distributors toincrease our subscriber base in order to enhance our advertising results. Inthe United States, we are often subject to requests by distributors to paysubscriber acquisition fees for additional subscribers or to waive or acceptlower subscriber fees if certain numbers of additional subscribers areprovided. In both domestic and international markets we also may help fund thedistributors’ efforts to market our channels or we may permit distributors tooffer limited promotional periods without payment of subscriber fees. As wecontinue our efforts to add subscribers, our domestic subscriber revenue willcontinue to be negatively affected by subscriber acquisition fee amortization,waiver of subscriber fees and bulk discounts resulting from the attainment ofcertain subscriber levels; however, we believe that as a result of thesemeasures, our subscriber counts will increase which in turn will allow us toattract additional advertisers and command higher advertising rates. 

 

We also expectinternational subscriber rates to decrease as we renew distribution agreements.These international rates are affected by the increasing competitive nature ofthe industry, the growth of digital cable, the shift in the industry in moredeveloped countries from subscriber fee revenue to advertising revenue,potential foreign currency fluctuations associated with global economies andthe potential economic turbulence in certain of our markets. Although weanticipate international subscriber rates to decrease, we expect subscribercounts to increase and, thereby, offset the negative effect the decreasedsubscriber rates will have on revenue. 

 

Our distributionagreement with a primary pay television distributor in Spain was amended on October 1,2003. Under the amendment, the distribution of our channel to that party willend on December 31, 2004. If a new agreement is not reached with thisdistributor, the Company may discontinue distribution of the channel in thisterritory in 2005. 

 

Our channel is usuallyoffered as one of a number of channels on either a basic tier or part of otherprogram packages and is not generally offered on a stand-alone basis. Thus,while a cable or satellite customer may subscribe and unsubscribe to the tiersand program packages in which our channel is placed, these customers do notsubscribe and unsubscribe to our channel alone. We are not provided withinformation from the distributors on their overall subscriber churn and in whatmanner their churn rates affect our subscriber counts; we instead are providedinformation on the total number of subscribers who receive the Hallmark Channel.

 

Our subscriber countdepends on the number of distributors carrying the Hallmark Channel and thesize of such distributors as well as the program tiers on which our channel iscarried by these distributors. From time to time, we experience decreases in thenumber of subscribers domestically and internationally as promotional periodsend or a distributor arrangement is amended or is terminated by us or thedistributor. Changes to distribution arrangements in 2004 have not beensignificant. Management analyzes the estimated effect each new or amendeddistribution agreement will have on revenues and costs. Based upon theseanalyses, management endeavors to achieve a fair combination of subscribercommitments and subscriber acquisition fees with each of our domesticdistributors.

 

*Advertising*

 

Advertising salesgenerally are made on the basis of a price per advertising spot or per unit ofaudience measurement (for example, a ratings point). Thus, our advertisingrevenues are heavily dependent on third parties ratings of the persons viewingour channel. Prices vary on a market-by-market basis. Rates differ amongmarkets depending on audience demographics. 

 

In markets where regularaudience measurements are available, our advertising rates are generallycalculated on the basis of an agreed upon price per unit of audiencemeasurement in return for a guaranteed commitment by the 

 

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advertiser. In these countries, we commit to provideadvertisers certain rating levels in connection with their advertising. Revenueis recorded net of estimated delivery shortfalls, which are usually settled byproviding the advertiser additional advertising time. In other lesssophisticated markets, our advertising rates are calculated on the basis ofcost per advertising spot or package of advertising spots, and the price variesby audience level expected (but not measured) during a particular time slot.This is the predominant arrangement in the countries outside the United Statesin which we sell advertising time. Advertising rates also vary by time of yeardue to seasonal changes in television viewership. 

 

*FilmLicensing*

 

Crown Media Distributiongenerates revenue from the film assets by granting licenses to exhibit thefilms to third parties. We are also using the films as programming for ourchannel. Customers for our film assets consist of other television channels,home video distributors and brokers who resell rights to our film assets invarious international markets. License fees for our film assets are generallynegotiated based upon the size of the potential audience who will be viewingthe programming.

 

**Cost of Services**

 

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

 

**Critical Accounting Estimates**

 

The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States requires Crown Media Holdings to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.Actual results could differ from those estimates.

 

For information regarding use ofestimates, accounting treatment and accounting policies concerning revenue,subscriber acquisition fees, program license fees, subtitling and dubbing, filmassets, long-lived assets impairment, goodwill and intangible assets, taxes onincome, stock-based compensation, and the 2002 reorganization, please see theNotes to Unaudited Consolidated Financial Statements.

 

The following discussionconcerns certain accounting estimates and assumptions that are considered to bematerial due to the levels of subjectivity and judgment necessary to accountfor uncertain matters and the susceptibility of such matters to changes.

 

***Revenue Recognition***

 

Subscriber fees from pay television distributors arerecognized as revenue when an agreement is executed, programming is provided,the price is determinable, and collectibility is reasonably assured. Weestimate and record the level of subscriber fees one month in advance basedupon the actual prior month’s subscriber levels. Historical results support ourmethod of estimating subscriber fee revenue as subscriber levels generallyincrease each month.

 

Advertising revenues are recognized as earned in theperiod in which the advertising is telecast and are generally billed monthly.If uncertainty as to the collectibility of this revenue exists, the revenue isrecognized on a cash basis. 

 

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Advertising revenue and expenses in barter transactions are recorded atthe fair value of the advertising to be provided. In certain markets, deliveryof advertising is determined based upon data received from third parties whomeasure the ratings of our channels. The ratings information drives ourcalculations of impressions delivered which in turn drives the amount ofrevenue we recognize from each advertising spot. Our advertising revenue istherefore heavily reliant upon these third party ratings estimates to determinethe quantity of advertising delivered to viewers.

 

Revenue from film asset licensing agreements isrecognized when an agreement is executed, the film is available for exhibitionby the licensee, the license fee is fixed or reasonably determinable,collectibility is reasonably assured and the cost of each film is known orreasonably determinable. When multiple films are sold under a singlearrangement, in order to properly recognize revenue when each license periodcommences, we must estimate the relative fair value of each film and allocatethe total contracted price to the different films in the arrangement. Ourestimation of relative fair value uses similar information as is used in ourannual third party valuation of our film assets. 

 

The Company records revenue fromcustomers in certain foreign countries only when the cash is received due tothe uncertainty regarding collection. 

 

***Allowance for Doubtful Accounts***

 

The Company has established anallowance for doubtful accounts based upon historical charge-offexperience.  Periodically, we analyze theattributes of the accounts which we have written-off during the period andadjust the allowance percentages we apply to our aged receivable balances.  As noted previously, for revenue generated incertain countries in which economic factors lead us to believe that collectibilityof these revenues is not reasonably assured, we recognize such revenue as it isreceived in cash.

 

***Subscriber Acquisition Fees***

 

Crown Media United Stateshas distribution agreements with every major cable distributor in the UnitedStates, some of which require the payment of subscriber acquisition fees. Theinitial recoverability of these subscriber acquisition fees is evaluated byprojecting the incremental subscriber fee and advertising revenue attributableto the incremental subscribers obtained through the distributionagreement.  This analysis includessignificant judgment and estimation by management in terms of the estimatedincremental advertising per subscriber.

 

***Film Assets***

 

In September 2001,the Company acquired certain film assets from Hallmark EntertainmentDistribution. The Company amortizes its film assets using theindividual-film-forecast-computation method over a maximum period of 10 yearsfrom the date of acquisition. The individual-film-forecast-computation methodamortizes such assets in the same ratio that current period actual revenuebears to estimated unrecognized ultimate revenues. The Company’s projections ofultimate revenue regarding sales of certain rights related to its film assetsto third parties and anticipated internal use of its film assets are based onthe history of each film and similar films, sales and marketing plans, andother factors, all of which require significant judgment by management. Inaccordance with SOP 00-02, the Company assesses the ultimate revenueprojections on a quarterly basis. 

 

The Company reviews therecoverability of each film in accordance with SOP 00-02 and on a quarterlybasis assesses whether events or circumstance have changed which indicate thatthe fair value of a film is lower than its unamortized cost or carrying value.If the carrying value of any individual film assets exceeds its fair value, thefilm asset is written-down to its fair value. A discounted cash flow model isused to estimate the fair value of the individual films. Future cash flows arebased on the terms of any existing contractual arrangements plus the projectedcash inflows from future license sales. The Company considers the followingfactors, among others, in estimating future cash inflows for each film:  (a) if previously released, the film’sperformance in historical markets, (*b*)the public’s perception of the film’s story, cast, director, or producer, (*c*) historical results of similar films, (*d*) historical results of the cast,director, or producer on prior films, and (*e*)running time of the film.  In estimating a film’s fair value, the Companyconsiders those cash outflows necessary to generate the film’s cashinflows.  Therefore, future exploitation and participation costs arefactored into the estimation of fair value. On an annual 

 

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basis, the Company isrequired by the covenants in its credit agreement to have an outside expertperform a valuation of the film library as a whole.

 

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

 

#### **HallmarkTransactions**

 

In2004 and in prior years, we entered into a number of significant transactionswith Hallmark Cards and its subsidiaries. These transactions concern, amongother things, programming, trademark licenses, administrative services, a lineof credit, a Tax Sharing Agreement and the issuance of a $400.0 millionsenior unsecured note. 

 

*Tax Sharing Agreement*

 

In March 2003, theCompany became a member of Hallmark Cards consolidated federal tax group andentered into a Tax Sharing Agreement with Hallmark Cards, which was amended atthe time the Company issued the senior unsecured note to HC Crown. We accountfor income taxes as if Crown Media Holdings were a separate taxpayer.Accordingly, Hallmark Cards’ ability to use our tax losses does not impact ourassessment of the need for a valuation allowance on deferred tax assets,including future tax losses. Any payments received from Hallmark Cards underthe Tax Sharing Agreement are recorded as an increase in paid-in capital.During 2003, the Company received $49.4 million under the Tax SharingAgreement. During the nine months ended September 30, 2004, the Companyreceived $39.5 million under the Tax Sharing Agreement. In October 2004,the Company received an additional $9.3 million under the Agreement. Forinformation regarding the Tax Sharing Agreement, please see Notes 2 and 6to the Notes to Unaudited Consolidated Financial Statements.

 

*Senior Unsecured Note*

 

On August 5, 2003, Crown Media Holdings repurchasedall of the outstanding trust preferred securities of Crown Media Trust andrelated contingent appreciation certificates issued by the Company. Thesecurities were repurchased for approximately $329.1 million. Funds for thisrepurchase were obtained from the proceeds from the issuance of a seniorunsecured note issued to HC Crown in the amount of $400.0 million. Afterrepayment of certain expenses for the issuance, including a fee of $3.0 millionto HC Crown, the Company used the balance of the proceeds of the note,approximating $67.3 million, to pay principal, interest and prepaymentpenalties on its bank revolving credit loans. For information regarding oursenior unsecured note, please see Note 6 to the Notes to UnauditedConsolidated Financial Statements. 

 

*NICC License Agreement*

 

For information regardingour amendment to our license agreement with NICC, please see Note 6 to theNotes to Unaudited Consolidated Financial Statements. 

 

*Pramer Agreement*

 

On January 30, 2003,Crown Media International entered into an agreement with Pramer S.C.A., awholly-owned subsidiary of Liberty Media International, under which Pramerprovides affiliate and advertising sales representation services, as well asprogramming, production and technical services in connection with thedistribution of the Hallmark Channel in Central and South America. Pramerreceives a 35% commission on advertising sales and a 20% commission onaffiliate sales and is reimbursed for its costs of providing production andtechnical services. The agreement with Pramer will terminate on December 31,2005, unless certain early termination rights arise and are exercised. 

 

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**Selected Historical Consolidated Financial Data ofCrown Media Holdings**

 

In the table below, we provideselected historical consolidated financial and other data of Crown MediaHoldings and its subsidiaries. The following selected consolidated statement ofoperations data for three and nine months ended September 30, 2003 and 2004,are derived from the unaudited financial statements of Crown Media Holdings andits subsidiaries. This data should be read together with the consolidatedfinancial statements and related notes included elsewhere in this Form 10-Q.

 
| ** **                                         | ** ** | ** **                                 | ** ** | ** **    | ** ** | **Percent  Change**                       | ** ** | ** **    | ** ** | ** ** | ** ** | **Percent  Change** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|---------------|------------|-------------------------------------------|------------|---------------|------------|------------|------------|---------------------|------------|
| ** **                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **2004  vs.** | ** ** | **Nine Months Ended  September 30,** | ** ** | **2004  vs.** | ** ** |
| ** **                                         | ** ** | **2003**                                   | ** ** | **2004**      | ** ** | **2003**                                  | ** ** | **2003**      | ** ** | **2004**   | ** ** | **2003**            | ** ** |
| Revenues:                                          |       |                                       |       |          |       |                                      |       |          |       |       |       |                |       |
| Subscriber fees                                    |       | $                                          | 17,543     |          | $          | 20,038                                    |       | 14            | %          | $          | 51,433     |                | $          | 60,190 |   | 17 | % |
| Advertising                                        |       | 20,815                                     |       | 30,031        |       | 44                                        | %          | 66,845        |       | 91,533     |       | 37                  | %          |
| Film asset license fees                            |       | 12,606                                     |       | 5,534         |       | -56                                       | %          | 20,010        |       | 17,968     |       | -10                 | %          |
| Other revenue                                      |       | 22                                         |       | 171           |       | 677                                       | %          | 79            |       | 256        |       | 224                 | %          |
| Total revenues                                     |       | 50,986                                     |       | 55,774        |       | 9                                         | %          | 138,367       |       | 169,947    |       | 23                  | %          |
| Cost of Services:                                  |       |                                       |       |          |       |                                      |       |          |       |       |       |                |       |
| Programming costs                                  |       | 29,727                                     |       | 32,746        |       | 10                                        | %          | 77,244        |       | 93,609     |       | 21                  | %          |
| Amortization of film  assets                       |       | 11,371                                     |       | 8,941         |       | -21                                       | %          | 24,957        |       | 24,407     |       | -2                  | %          |
| Impairment of film  assets                         |       | —                                     |       | 57,931        |       | 100                                       | %          | —        |       | 57,931     |       | 100                 | %          |
| Subscriber acquisition  fee amortization expense   |       | 6,468                                      |       | 7,010         |       | 8                                         | %          | 19,074        |       | 19,042     |       | 0                   | %          |
| Operating costs                                    |       | 12,921                                     |       | 12,459        |       | -4                                        | %          | 37,375        |       | 34,688     |       | -7                  | %          |
| Total cost of services                             |       | 60,487                                     |       | 119,087       |       | 97                                        | %          | 158,650       |       | 229,677    |       | 45                  | %          |
| Selling, general and  administrative expense       |       | 20,291                                     |       | 21,846        |       | 8                                         | %          | 51,812        |       | 60,906     |       | 18                  | %          |
| Marketing expense                                  |       | 3,474                                      |       | 2,899         |       | -17                                       | %          | 17,645        |       | 16,859     |       | -4                  | %          |
|                                               |       |                                       |       |          |       |                                      |       |          |       |       |       |                |       |
| Loss from operations                               |       | $                                          | (33,266    | )             | $          | (88,058                                   | )          | 165           | %          | $          | (89,740    | )                   | $          | (137,495 | ) | 53 | % |
|                                               |       |                                       |       |          |       |                                      |       |          |       |       |       |                |       |   |   |   |   |
| **Other  Data:**                                   |       |                                       |       |          |       |                                      |       |          |       |       |       |                |       |
| Net cash used in  operating activities             |       | $                                          | 31,182     |          | $          | 17,422                                    |       | -44           | %          | $          | 104,629    |                | $          | 44,096 |   | -58 | % |
| Capital expenditures                               |       | $                                          | 1,354      |          | $          | 19                                        |       | -99           | %          | $          | 3,135      |                | $          | 1,225 |   | -61 | % |
| Net cash provided by  financing activities         |       | $                                          | 27,364     |          | $          | 15,468                                    |       | -43           | %          | $          | 110,556    |                | $          | 48,308 |   | -56 | % |
| Adjusted EBITDA (1)                                |       | $                                          | (33,186    | )             | $          | (65,925                                   | )          | 99            | %          | $          | (53,124    | )                   | $          | (75,319 | ) | 42 | % |
| Total domestic day  household ratings (2)(4)       |       | 0.529                                      |       | 0.562         |       | 6                                         | %          | 0.489         |       | 0.588      |       | 20                  | %          |
| Total domestic  primetime household ratings (3)(4) |       | 0.715                                      |       | 0.862         |       | 21                                        | %          | 0.711         |       | 0.851      |       | 20                  | %          |
| Total subscribers at  period end:                  |       |                                       |       |          |       |                                      |       |          |       |       |       |                |       |
| Hallmark Channel –  International             |       | 56,556                                     |       | 60,653        |       | 7                                         | %          | 56,556        |       | 60,653     |       | 7                   | %          |
| Hallmark Channel – U.S.                       |       | 54,634                                     |       | 63,422        |       | 16                                        | %          | 54,634        |       | 63,422     |       | 16                  | %          |
| Total subscribers                                  |       | 111,190                                    |       | 124,075       |       | 12                                        | %          | 111,190       |       | 124,075    |       | 12                  | %          |

 

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(1) See reconciliation of Adjusted EBITDA below.

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

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

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

 

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Crown Media Holdings evaluates operating performancebased on several factors, including Adjusted EBITDA. Our measure of AdjustedEBITDA differs from the normal definition of EBITDA (earnings before interest,taxes, depreciation and amortization) used by most companies. We define AdjustedEBITDA as earnings before interest, taxes, depreciation, amortization,subscriber acquisition fee amortization and amortization of film assets. Webelieve Adjusted EBITDA is meaningful because it provides investors a means toevaluate the operating performance of our company on an ongoing basis usingcriteria that are used by other companies in our industry and investmentbankers and analysts who track our industry. We believe that Adjusted EBITDA isa meaningful measure because it represents a transparent view of our recurringoperating performance and allows our management and investors to readily viewoperating trends, perform analytical comparisons and benchmark our company tosimilar companies in our industry. Adjusted EBITDA is used by our management tomonitor segment operations and to determine the allocation of resources tosegments. Our credit facility also contains covenants that are based on anadjusted EBITDA measure. Consequently, management views Adjusted EBITDA as acritical measure of our operating performance to meet our debt covenants andmonitors this measure closely. We disclose Adjusted EBITDA so that ourinvestors can have some of the same information available to our management toevaluate their investment in our Company. We believe that Adjusted EBITDAprovides an indication of the Company’s ability to generate cash flows fromoperating activities since the majority of our non-cash expenses are excludedfrom our calculation of Adjusted EBITDA. A significant portion of the Company’scost structure relates to the amortization of film assets and subscriberacquisition costs, which are significant non-cash charges. The cash costs ofacquiring film assets and adding subscribers are essentially discretionaryexpenditures. The adjusted EBITDA calculation allows the Company to assess howmuch is available to pay debt service and gives a further indication of howmuch remains to fund discretionary expenditures such as the acquisition of filmassets or additional subscriber base. However, Adjusted EBITDA should beconsidered in addition to, not as a substitute for, historical operating incomeor loss, net loss, cash flow from operations and other measures of financialperformance reported in accordance with accounting principles generally acceptedin the United States.

 

Adjusted EBITDA differs significantly from cash flowsfrom operating activities reflected in the consolidated statement of cashflows. Cash flow from operating activities is net of interest and taxes paidand is a more comprehensive determination of periodic income on a cash basis,exclusive of non-cash items of income and expenses such as depreciation andamortization. In contrast, Adjusted EBITDA is derived from accrual basis incomeand is not reduced for cash invested in working capital. Consequently, AdjustedEBITDA is not affected by the timing of receivable collections or when accruedexpenses are paid. We are not aware of any uniform standards for determiningEBITDA or our Adjusted EBITDA and believe presentations of EBITDA may not becalculated consistently by different entities in the same or similarbusinesses. In the table below, we providea reconciliation of Adjusted EBITDA to net loss and to net cash used inoperating activities of Crown Media Holdings and its subsidiaries.

 
| ** **                                                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                   | ** ** | **2003**                                   | ** ** | **2004**                                  | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                                   | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss                                                                     |       | $                                          | (72,717    | )                                         | $          | (105,763 | ) | $ | (168,804 | ) | $ | (187,826 | ) |
| Amortization of film  assets                                                 |       | 11,371                                     |       | 8,941                                     |       | 24,957 |   | 24,407 |   |
| Subscriber acquisition  fee amortization expense                             |       | 8,460                                      |       | 9,843                                     |       | 23,968 |   | 27,324 |   |
| Depreciation and  amortization                                               |       | 3,733                                      |       | 3,349                                     |       | 11,175 |   | 10,445 |   |
| Guaranteed preferred                                                         |       |                                       |       |                                      |       |   |   |   |   |
| beneficial interest  expense                                                 |       | —                                     |       | —                                    |       | 23,218 |   | — |   |
| Interest expense and  accretion                                              |       | 15,374                                     |       | 16,801                                    |       | 30,230 |   | 48,483 |   |
| Income tax provision                                                         |       | 593                                        |       | 904                                       |       | 2,132 |   | 1,848 |   |
| Adjusted earnings  before interest, taxes, depreciation and amortization     |       | $                                          | (33,186    | )                                         | $          | (65,925 | ) | $ | (53,124 | ) | $ | (75,319 | ) |
|                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Loss on early  extinguishment of debt                                        |       | 39,812                                     |       | —                                    |       | 39,812 |   | — |   |
| Cumulative effect of  change in accounting principle                         |       | (16,328                                    | )          | —                                    |       | (16,328 | ) | — |   |
| Loss on impairment of  film assets                                           |       | —                                     |       | 57,931                                    |       | — |   | 57,931 |   |
| Restricted stock unit  and stock-based compensation                          |       | 3,044                                      |       | 2,511                                     |       | 3,367 |   | 8,319 |   |
| Programming, subtitling  and dubbing amortization                            |       | 29,505                                     |       | 34,045                                    |       | 77,764 |   | 97,497 |   |
| Provision for allowance  for doubtful account                                |       | 980                                        |       | 82                                        |       | 2,546 |   | 71 |   |
| Changes in operating  assets and liabilities:                                |       |                                       |       |                                      |       |   |   |   |   |
| Additions to program  license fees                                           |       | (112,016                                   | )          | (45,467                                   | )          | (177,829 | ) | (90,147 | ) |
| Additions to subscriber  acquisition fees                                    |       | (807                                       | )          | (9,781                                    | )          | (2,031 | ) | (23,100 | ) |
| Decrease in subscriber  acquisition fees payable                             |       | (9,231                                     | )          | (18,707                                   | )          | (32,255 | ) | (8,911 | ) |
| Interest paid                                                                |       | (4,906                                     | )          | (3,710                                    | )          | (15,022 | ) | (10,453 | ) |
| Income taxes paid                                                            |       | (593                                       | )          | (904                                      | )          | (2,132 | ) | (1,848 | ) |
| Changes in other  operating assets and liabilities, net of adjustments above |       | 72,544                                     |       | 32,503                                    |       | 70,603 |   | 1,864 |   |
| Net cash used in  operating activities                                       |       | $                                          | (31,182    | )                                         | $          | (17,422 | ) | $ | (104,629 | ) | $ | (44,096 | ) |

 

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### ***Results ofOperations***

 

#### *Three and Nine Months Ended September 30, 2004Compared to Three and Nine Months Ended September 30, 2003*

 

*Revenue. *

 

 Our revenue, which is primarily comprised ofsubscriber fees, advertising and film asset license fees, increased 9% and 23%for the three and nine months ended September 30, 2004. Our 14% and 17% increases in subscriber feerevenue for the three and nine months ended September 30, 2004, were theresult of the expiration of free carriage periods for certain of our domesticdistributors. Subscriber acquisition fee amortization recorded as a reductionof revenue was $2.8 million and $8.3 million for the three and nine monthsended September 30, 2004, and $2.0 million and $4.9 million for thecomparable periods in 2003. Although the number of subscribers to the HallmarkChannel increased as of September 30, 2004, compared to September 30,2003, subscriber revenue was also affected by a number of other, offsetting factors,including discounts for new subscribers, the waiver of subscriber fees and bulkdiscounts resulting from the attainment of certain subscriber levels and adecrease in subscriber rates for our international channel. Eighty-sevenpercent of subscriber fee revenue for each of the three and nine months ended September 30,2004, and 91% of subscriber fee revenue for each of the three and nine monthsended September 30, 2003, was earned internationally. Subscriber feerevenue was $2.6 million and $8.0 million for the domestic Hallmark Channel forthe three and nine months ended September 30, 2004, and $1.7 million and$4.7 million for the three and nine months ended September 30, 2003. 

 

The increase in advertisingrevenue reflects the following during 2004: the 12% growth in domestic andinternational subscribers; higher ratings in the United States; higheradvertising rates resulting from the increase in distribution and viewership;and expanded sales of advertising time primarily in the United States. Our domesticadvertising revenue increased to $24.6 million and $74.8 million for the threeand nine months ended September 30, 2004, compared to $16.3 million and$53.2 million for the three and nine months ended September 30, 2003.Additionally, the number of advertisers on our domestic channel rose from 300at September 30, 2003, to 380 at September 30, 2004. Ourinternational advertising revenue, primarily from the United Kingdom, increasedto $16.8 million for the nine months ended September 30, 2004, compared to$13.7 million for the nine months ended September 30, 2003. Amongthe 52 ad-supported cable channels in the United States market, the HallmarkChannel ranked10th in total day with a 0.6 householdrating for the third quarter of 2004 and15th for primetimewith a 0.9 household rating for the same quarter based on Nielsen ratings. 

 

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Revenue from the sale of our film assets totaled $5.5million and $18.0 million for the three and nine months ended September 30,2004, compared with $12.6 million and $20.0 million for the comparable periodsin 2003.  The decrease reflects a decrease in international sales, due inpart to softer market conditions and uncertainty surrounding the potential saleof the international business and international rights to the film assets.

 

*Cost ofservices. *Cost ofservices as a percent of revenue increased to 214% and 135% for the three andnine months ended September 30, 2004, as compared to 119% and 115% in theprior year’s periods. These increases were primarily due the changes inoperating expenses explained below. 

 

As a result of the Company’s analysis of its filmassets based upon current projections for sales and internal use, and basedupon outside indications of fair value, the Company recorded a non-cashimpairment charge of $57.9 million in the third quarter of 2004. Amortizationof film assets decreased 21% and 2% for the three and nine months ended September 30,2004, compared to the same periods in 2003 primarily because of a recalculationof the amortization from January 1, 2004, through September 30, 2004,as a result of the impairment analysis described above. Total programming costsfor the three and nine months ended September 30, 2004, increased 10% and21% due to the increased costs associatedwith the amortization of certain programming such as *MASH*, *Matlock*and *Little House on the Prairie,*for our domestic channel. 

 

Operatingcosts for the three months ended September 30, 2004, remained flat.Operating costs for the nine months ended September 30, 2004, decreased$2.7 million primarily due to a $2.5 million decrease in bad debt expense.  

 

*Selling,general and administrative expense.* Our general and administrative expenseincreased for the three months ended September 30, 2004 because of a $2.2million of retention program expense related to the proposed sale of theinternational business. For the nine month period, general and administrativeexpense was higher due to our retention program expense of $2.2 million, anincrease in salary expense of $1.2 million, and an increase in benefits expenseof $4.0 million. We commenced recording compensation expense for our RSUs in June 2003.

 

*Loss from Operations. *Losses from operations for the three and nine monthsended September 30, 2004, were $88.1 million and $137.5 million, whichwere comprised of a losses from operations of our domestic segment of $21.9million and $59.1 million, losses from operations of our international segmentof $4.3 million and $12.0 million, and losses from operations of our filmdistribution segment of $61.9 million and $66.4 million. The film distributionsegment losses include the impairment charge of $57.9 million. Losses fromoperations for the three and nine months ended September 30, 2003, were$33.3 million and $89.8 million, which were comprised of a losses fromoperations of our domestic segment of $25.6 million and $63.6 million, lossesfrom operations of our international segment of $7.9 million and $17.6 million,and income and a loss from operations of our film distribution segment of $0.2million and $8.6 million. 

 

*Guaranteedpreferred beneficial interest accretion. *This expense related to future obligations on ourdebentures issued on December 17, 2001, in connection with the trustpreferred securities of Crown Media Trust. The 2003 expense only includedguaranteed preferred beneficial interest accretion for a partial year due tothe repurchase of our preferred securities on August 5, 2003. 

 

*Interestexpense. *Interest expenseincreased for the three and nine months ended September 30, 2004, comparedto September 30, 2003, by $1.4 million and $18.3 million.  This increase was primarily due to intereston our $400.0 million senior unsecured note payable commencing August 5,2003, which amounted to $11.1 million and $32.5 million for the three and ninemonths ended September 30, 2004. The terms of our senior unsecured notepayable do not require any cash payment for interest or principal until August 2007.

 

## **Liquidity and Capital Resources**

 

Cash used in operatingactivities was $44.1 million and $104.6 million for the nine months ended September 30,2004 and 2003, respectively. Cash was used primarily to fund operatingexpenditures related to net losses of $187.8 million and $168.8 million for thenine months ended September 30, 2004 and 2003, respectively. The decreasein

 

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cash flow used in operations was primarily due tohigher domestic advertising revenue and resulting cash receipts. 

 

Cashused in investing activities was $1.0 million and $3.1 million for the ninemonths ended September 30, 2004 and 2003, respectively. Cash used ininvesting activities decreased primarily due to expenditures in our NetworkOperations Center to accommodate the launch of our domestic channel in thefirst quarter 2003 and our new domestic and international channel websitesbeing placed into service during that period. 

 

Cash provided by financingactivities was $48.3 million and $110.6 million for the nine months ended September 30,2004 and 2003, respectively. During the nine months ended September 30,2004 and 2003, we received proceeds of $39.5 million and $32.0 million,respectively, from our Tax Sharing Agreement with Hallmark Cards. We borrowed$70.0 million under our line of credit with HC Crown to meet our operatingdemands during the nine months ended September 30, 2003.

 

The following table aggregatesall of our contractual commitments as of September 30, 2004. 

 
| ** **                                                           | ** ** | **Scheduled Payments by Period** | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------|------------|
| **Contractual  Obligations**                                         | ** ** | **Total**                        | ** ** | **Less than  1 Year** | ** ** | **2-3 Years** | ** ** | **4-5  Years** | ** ** | **After 5  Years** | ** ** |
| ** **                                                           | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Credit Facility and  Interest Payable (a)                            |       | $                                | 310.5      |   | $ | 310.5 |   | $ | — |   | $ | — |   | $ | — |   |
| Company Obligated  Mandatorily Redeemable Preferred Interest         |       | 25.0                             |       |   |   | 7.6 |   | 10.0 |   | 7.4 |   |
| HC Crown Line of Credit                                              |       | 75.0                             |       |   |   | 75.0 |   | — |   |   |   |
| Senior Unsecured Note  to HC Crown, including accretion              |       | 596.6                            |       | — |   | — |   | — |   | 596.6 |   |
| Capital Lease  Obligations                                           |       | 25.5                             |       | 2.2 |   | 5.0 |   | 4.2 |   | 14.1 |   |
| Operating Leases                                                     |       | 51.4                             |       | 14.8 |   | 19.8 |   | 12.0 |   | 4.8 |   |
| Other Obligations                                                    |       |                             |       |   |   |   |   |   |   |   |   |
| Program license fees  payable to non-affiliates and NICC             |       | 148.9                            |       | 77.9 |   | 56.9 |   | 14.1 |   | — |   |
| Program license fees  payable to Hallmark Entertainment Distribution |       | 108.2                            |       | 105.4 |   | 2.8 |   | — |   | — |   |
| Program license fees  payable for future windows                     |       | 254.3                            |       | 145.2 |   | 65.7 |   | 23.0 |   | 20.4 |   |
| Subscriber acquisition  fees (b)                                     |       | 18.9                             |       | 18.0 |   | 0.9 |   | — |   | — |   |
| Deferred compensation  and interest                                  |       | 2.0                              |       | — |   | 2.0 |   | — |   | — |   |
| Payable to Hallmark  Entertainment Holdings (a)                      |       | 52.1                             |       | 52.1 |   | — |   | — |   | — |   |
| Payable to Hallmark  Entertainment (a)                               |       | 47.9                             |       | 47.9 |   | — |   | — |   | — |   |
| Total Contractual Cash  Obligations                                  |       | $                                | 1,716.3    |   | $ | 774.0 |   | $ | 235.7 |   | $ | 63.3 |   | $ | 643.3 |   |

 

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(a)           Due to the amendment to the creditagreement, which among other things, accelerated the maturity date to September 1,2005, these obligations are anticipated to be repaid or otherwise refinancedwithin less than one year.

 

(b)           Currentdomestic distribution agreements could significantly increase subscriberacquisition fees payable in the future by a maximum amount of $149.0 million,which would result if 42.0 million additional subscribers were provided withthe Hallmark Channel.

 

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*Potential Sale of the International Business*

 

In April 2004, the Company announced that it isexploring strategic alternatives for its international operations and theinternational rights to its film library, including, but not necessarilylimited to, a sale or other corporate transaction in an effort to maximizeshareholder value.  

 

The Company is in current negotiations for the sale ofits international operations and the international rights to its film library.However, the Company has not reached a final agreement regarding the terms ofany such sale. The Company cannot provide assurance that an agreement for anysuch sale will be executed or that such a sale will be executed or consummated.In addition, any sale would require the consent of existing lenders under thebank credit facility. The Company is required under its amended debt agreementsto use substantially all of the net proceeds from such a sale to pay down itscredit facility and certain of its obligations to affiliates.  Under the amendment to the credit facilityexecuted on October 28, 2004, the Company agreed (in the event of a saleof the international business) to a reduction in the maximum borrowings underthe facility from the current allowable borrowings of $320.0 million to $180.0million.

 

*Cash Flows*

 

As of September 30, 2004, the Company had $7.6 millionin cash and cash equivalents on hand and $10.0 million available under its bankcredit facility. The Company’s principal sources of funds are currently cashinflows from operations, cash on hand, periodic cash inflows expected under thetax sharing agreement with Hallmark Cards and amounts available for borrowingunder its bank credit facility. On October 28, 2004, the Company received anadditional tax sharing payment of $9.3 million.

 

The Company’s principal uses of funds during 2004 and2005 have been, and are expected to be, the payment of operating expenses,payments for licensing of programming and subscriber acquisition fees, andinterest payments under its bank credit facility. As part of the Company’sgrowth strategy, the Company expects to continue making investments inprogramming and distribution during 2004 and 2005. 

 

As of September 30, 2004, the Company believes thatcash inflows from its operations, cash on hand, remaining availability underits credit facility and payments anticipated under the tax sharing agreementwith Hallmark Cards, all of which are currently its principal sources of funds,will be sufficient to meet its liquidity needs through the amended maturitydate of its credit facility. As disclosed in note 8, subsequent to the end ofthe third quarter, the Company amended its credit facility which included anacceleration of the maturity and termination date of the facility from August2006 to September 1, 2005.  Thisrevision, along with agreements with certain affiliates of Hallmark Cards, hasresulted in approximately $470.0 million of obligations becoming due andpayable on September 1, 2005.  Of thisamount, $130.0 million of outstanding obligations will become due and payable,if earlier, upon the sale of the Company’s international operations andinternational film rights.

 

The Company is currently negotiating for the sale ofthe international operations which would provide cash resources to retire aportion of these obligations due and payable on September 1, 2005.  The Company intends to either extend orrefinance the credit facility prior to its maturity date. In addition, otherfinancing alternatives could include the issuance of additional equity or debtsecurities. There can be no assurance, however, that the credit facility can orwill be extended or refinanced or that additional funding will be available, ifat all, on terms acceptable to the Company. 

 

If the Company is unable to successfully complete thesale of the international business and restructure its obligations that becomedue in September 2005, the Company will not have sufficient available funds torepay such obligations.

 

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***Bank Credit Facility; Private Placement andHC Crown Line of Credit***

 

Ourbank credit facility, the HC Crown line of credit and the senior unsecured noteto HC Crown are described in detail in Item 7 of Management’s Discussion andAnalysis of Historical Financial Condition and Results of Operation in ourAnnual Report on Form 10-K for the year ended December 31, 2003, andearlier in this Report.  As a result ofthese agreements, we are subject to a number of affirmative and negativecovenants. As a result of the film asset impairment charge recorded in the thirdquarter 2004, the Company was not in compliance with the trailing 12-monthEBITDA (as defined) financial covenant at September 30, 2004.  On October 28, 2004, the Company enteredinto Amendment No. 7 to the agreement for its bank credit facility.  This Amendment No. 7 is attached as anexhibit to this Report and incorporated herein by reference.  Amendment No. 7 makes a number of significantchanges to the bank credit facility including changes to the financial covenants.Specifically, the amendment to the credit facility allows for the exclusion ofthe film asset impairment charge from the calculation of trailing 12-monthEBITDA.  Such amendment cures the Company’snon-compliance with this covenant at September 30, 2004.

 

As amended, the term loan of $100.0 million is payableon the earlier of a “Foreign Asset Sale Effective Date” or September 1,2005.  A Foreign Asset Sale EffectiveDate is generally the date on which the Company sells its internationaloperations and international rights to its film library.  On a Foreign Asset Sale Effective Date, therevolving line of credit under the bank credit facility will be reduced from$220.0 million to $180.0 million.  Theline of credit matures on September 1, 2005.  The lending banks must also approve the finalterms of any sale of the international business as described above.  In addition, effective only on a ForeignAsset Sale Effective Date, certain financial covenants in the bank creditfacility (regarding limitations on capital expenditures, required levels ofEBITDA at the end of each quarter and limitations on subscriber acquisitionfees as well as the deletion of required leverage and interest coverage ratios)are revised and proceeds of the sales are to be used to pay down the revolvingline of credit in a priority over other uses so that the outstanding amountunder the revolving line of credit does not exceed $180.0 million.

 

Under the Note Purchase Agreement for the seniorunsecured note to HC Crown, the Company and its subsidiaries are restricted from,among others, incurring additional indebtedness, repurchasing or otherwiseacquiring its own stock and making investments in other parties and incurringadditional liens.

 

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

 

The discussion set forth in this Form 10-Q containsstatements concerning potential future events. Such forward-looking statementsare based on assumptions by Crown Media Holdings management, as of the date ofthis Form 10-Q including assumptions about risks and uncertainties faced by CrownMedia Holdings. Readers can identify these forward-looking statements by theiruse of such verbs as “expects,” “anticipates,” “believes,” or similar verbs orconjugations of such verbs. If any of management’s assumptions prove incorrector should unanticipated circumstances arise, Crown Media Holdings’ actualresults, levels of activity, performance, or achievements could materiallydiffer from those anticipated by such forward-looking statements. Among thefactors that could cause actual results to differ materially are thosediscussed below in this Form 10-Q. Crown Media Holdings will not update anyforward-looking statements contained in this Form 10-Q to reflect future eventsor developments.

 

If wedo not successfully address the risks described below, our business, prospects,financial condition, results of operations or cash flow could be materiallyadversely affected. The trading price of our Class A common stock could declinebecause of any of these risks.

 

**Risks Relating to Our Business**

 

***Our business has incurred net losses sinceinception and may continue to incur losses.***

 

Both our international anddomestic channels have a history of net losses and we expect to continue toreport net losses for the foreseeable future. As of September 30, 2004, wehad an accumulated deficit of approximately $1.2 billion, total stockholders’equity of approximately $165.4 million, goodwill of approximately $314.0million, and film assets of $672.1 million.

 

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We cannot assure you that wewill achieve or sustain profitability. If we are not able to achieve or sustainprofitability, the trading price of our Class A common stock may fallsignificantly. To diminish our losses and become profitable, we will need tosubstantially increase our revenue, particularly advertising and licensingrevenue. This will require, among other things, increasing the distribution ofour channels, attracting more viewers to our channels, attracting moreadvertisers, and increasing our advertising rates. Risks associated with theseareas of our business are described below.

 

In addition, in order toaccomplish these goals, the management of Crown Media Holdings continues tobelieve that it is necessary to increase subscribers and enhance our programming,which results in increased subscriber acquisition fees and higher costs forprogramming. Over the last three years, these actions have resulted inincreased net losses for Crown Media Holdings.

 

***Our substantial indebtedness could adverselyaffect our financial health, and the restrictions imposed by the terms of ourdebt instruments may severely limit our ability to plan for or respond tochanges in our business.***

 

We have a substantial amount ofindebtedness. As of September 30, 2004, our total debt was $859.1 millionand we had $7.6 million of cash and cash equivalents. In addition, we mayborrow the remaining $10.0 million available borrowing under our bank creditfacility to cover the negative cash flow resulting from our current operations.Subject to restrictions under our debt agreements, we may also seek equity ordebt financing from time to time to cover our operating losses, to financeacquisitions or capital expenditures or for other purposes. 

 

As a result of our level of debtand the terms of our debt instruments:

 

• ourvulnerability to adverse general economic conditions is heightened;

 

• wewill be required to dedicate a portion of our cash flow from operations torepayment of debt, limiting the availability of cash for other purposes;

 

• weare and will continue to be limited by financial and other restrictivecovenants in our ability to borrow additional funds, consummate asset sales,enter into transactions with affiliates or conduct mergers and acquisitions;

 

• ourflexibility in planning for, or reacting to, changes in our business andindustry will be limited;

 

• we are sensitive to fluctuations in interestrates; and 

 

• ourability to obtain additional financing in the future for working capital,capital expenditures, acquisitions, general corporate purposes or otherpurposes may be impaired.

 

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

 

As a result of Amendment No. 7to our bank credit facility, approximately $470.0 million in obligations arecurrently due on September 1, 2005. The Company’s ability to meet these obligations by September 2005is dependent, in part, upon the successful sale of the international businessand the restructuring of the bank credit facility.

 

***We have increasing interest expense, whichmay impact our future operations.***

 

High levels of interest expense could have negative effects on ourfuture operations. Interest expense, which is net of interest income and includesamortization of debt issuance costs and interest expense on borrowings underour senior and demand notes and bank credit facility, increased substantiallyover the past year. The increase in interest

 

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expense in the past twelve months resulted from an increase in theaverage borrowings outstanding, due to cash generated from operations beinginsufficient to cover operating expenses and capital expenditures. Asubstantial portion of our cash flow from operations must be used to pay ourinterest expense and will not be available for other business purposes. Inaddition, we may need to incur additional indebtedness in the future. We cannotassure you that our business will generate sufficient cash flow or that futurefinancings will be available to provide sufficient proceeds to meet ourobligations or to service our total debt. 

 

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

 

Because we currently operate ata loss and may have a negative cash flow, any unanticipated significant expenseor any development that hampers our growth in revenue or decreases any of ourrevenue, would result in the need for additional external funds in order tocontinue operations. We have no arrangements for any external financings,whether debt or equity, and are not certain whether any such new externalfinancing would be available on acceptable terms. Any new debt financing wouldrequire the cooperation and agreement of existing lenders.

 

***Modification of any existing agreements withUnited States distributors could result in an increased obligation to paysubscriber acquisition fees.***

 

Several of the Crown MediaUnited States’ existing distribution agreements contain “most favored nations”clauses. These clauses typically provide that, in the event Crown Media UnitedStates enters into an agreement with another distributor on more favorableterms, these terms must be offered to the existing distributor, subject tocertain exceptions and conditions. Distribution agreements which we may enterinto in the future may also contain similar “most favored nation clauses.” Inthe past, Crown Media United States was asked to comply with such clauses andmodify its distribution agreements with certain distributors after enteringinto new distribution agreements.  Anyclaims under these clauses in the future could result in the payment of cash orthe issuance of stock by us to our distributors and would negatively affectsubscriber revenues; however, if our subscription base is increased as a resultof such modification, it could result in higher advertising revenue.

 

***If we are unable to obtain programming fromthird parties, we may be unable to increase our subscriber base.***

 

We compete with other paytelevision channel providers to acquire programming. If we fail to continue toobtain programming on reasonable terms for any reason, including as a result ofcompetition, we could be forced to incur additional costs to acquire suchprogramming or look for alternative programming, which may hinder the growth ofour subscriber base.

 

***If our programming declines in popularity,our subscriber fees and advertising revenue could fall and the additionalrevenue we expect as a result of the acquisition of film assets from HallmarkEntertainment Distribution may be lower than we anticipate.***

 

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

 

***We are currently dependent on HallmarkEntertainment to distribute and maximize licensing fees from the film assets.***

 

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Currently, we are dependent onHallmark Entertainment, a related party, to distribute and license our filmassets to third parties for us under a services agreement, which will expire onDecember 31, 2006. This arrangement reduces our control over the sales anddistribution of the film assets and might delay our realization of the fullrevenue stream from the film assets. We and Hallmark Entertainment each havethe right to terminate the service agreement on a yearly basis. If HallmarkEntertainment elects to terminate the agreement before we have established ourown distribution network, we may not be able to establish our own or obtainalternative distribution services of equivalent quality or on terms as favorableto us. Termination of this services agreement could hinder our ability, atleast in the short-term, to achieve the amount of additional revenueanticipated from these activities and could adversely affect the market priceof our Class A common stock.

 

We anticipate that in due coursewe will develop our own distribution/sales network and hire employees toperform the services currently performed by Hallmark Entertainment under theservice agreement. Our ability to do so is unproven and will require financial,operational and management resources. We may not be able to hire the number ofemployees, or employees who are sufficiently qualified, to perform theseservices, or do so in a cost efficient manner. If the cost to develop andmaintain this employee base is greater, or if this process takes longer thananticipated, it could have a negative impact on the revenue we anticipategenerating from the film assets.

 

***If we are unable to increase our advertisingrevenue, we may be unable to achieve profitability.***

 

Although it is expected over time that our advertisingrevenue will increase, if we fail to increase significantly our advertisingrevenue, we may be unable to achieve or sustain profitability or to expand ourbusiness.  A failure to increaseadvertising revenue may be a result of any or all of the following: (i) we have a limited history of marketing andselling advertising time, particularly internationally; (ii) we may be unableto identify, attract and retain experienced sales and marketing personnel withrelevant experience for our U.S. channel; (iii) our sales and marketingorganization may be unable to successfully compete against the significantlymore extensive and well-funded sales and marketing operations of our current orpotential competitors; (iv) the advancement of technologies such as DigitalVideo Recording may cause industry-wide changes concerning the frequency inwhich individuals are exposed to advertising on television; and/or (v) wewill not be able to increase our advertising sales rate-card or may be requiredto run additional advertising spots which affect the availability ofadvertising inventory for future sales.Success in increasing our advertising revenue also depends upon the number andcoverage of the distributors who carry our channels, our number of subscribers,and the viewership ratings for our programming. 

 

The international cableadvertising market is much less developed than in the United States, the UnitedKingdom and Central Europe. We believe that only certain international marketshave the potential for growth in advertising revenues and intend to emphasizethose markets but cannot assure success. 

 

***Hallmark Entertainment Investments controlsus and this control could create conflicts of interest or inhibit potentialchanges of control.***

 

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

 

***We could lose the right to use the name “Hallmark”because we have limited-duration trademark license agreements, which could harmour business.***

 

We license the name “Hallmark”from Hallmark Cards and Hallmark Licensing, Inc., for various uses, including

 

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in the name of our international and domesticchannels, and this license will expire on September 1, 2005. If HallmarkCards determines not to renew the trademark license agreements for any reason,including our failure to meet minimum programming thresholds dependent onprogramming provided by affiliates of Hallmark Cards or to comply with HallmarkCards’ programming standards, we would be forced to significantly revise ourbusiness plan and operations, and could experience a significant erosion of oursubscriber base and advertising revenue, particularly in the United States.

 

***If our third-party suppliers fail to provideus with network infrastructure services on a timely basis, our costs couldincrease and our growth could be hindered.***

 

We currently rely on thirdparties to supply key network infrastructure services, including uplink,playback, transmission and satellite services to certain of our markets, whichare available only from limited sources. We have occasionally experienceddelays and other problems in receiving communications equipment, services and facilitiesand may, in the future, be unable to obtain such services, equipment orfacilities on the scale and within the time frames required by us on terms wefind acceptable, or at all. If we are unable to obtain, or if we experience adelay in the delivery of, such services, we may be forced to incur significantunanticipated expenses to secure alternative third party suppliers or adjustour operations, which could hinder our growth and reduce our revenue andpotential profitability.

 

***If our Network Operations Center fails, itsoperations are disrupted, or sold, our costs could increase and our growthcould be hindered.***

 

We are currently using theNetwork Operations Center for the origination and playback of signals for theHallmark Channel both domestically and internationally. Like other single-pointfacilities, the Network Operations Center is subject to interruption from fire,tornadoes, lightning and other unexpected natural causes. Although we haveredundant systems in place, equipment failure, employee misconduct or outsideinterference could also disrupt the Network Operations Center’s services. Wecurrently do not have and are not planning a duplicate operations facility forthe international channels, but do have certain backup facilities for thedomestic channels. Any significant interruption at the Network OperationsCenter affecting the distribution of our channels could have an adverse effecton our operating results and financial condition.

 

We anticipate that a possible sale of our internationalbusiness would also include our Network Operations Center.  If such a sale is consummated, we would haveto negotiate the use of this facility with the purchaser of the facilityor arrange for these services from another party since we would no longercontrol these services.  Any significantinterruption of such services affecting the distribution of our channels couldhave an adverse effect on our operating results and financial condition.

 

****If our localdistribution partner for the Latin American region fails to perform, ouroperations could be disrupted and our business harmed.****

 

In the first quarter of 2003, we moved the majority ofour operations concerning the distribution of the Hallmark Channel in Mexico,Central and South America to a local distribution partner in Argentina, Pramer,primarily to substantially reduce our expenses for operations in this region.If Pramer is unable to adequately perform the functions of selling our channelto local operators, to gain sufficient advertising sales and to appropriatelymarket the channel, or, if Pramer’s services are significantly interruptedfor any reason, we may not improve our performance in Latin America.

 

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

 

Our success depends on theexpertise and continued service of our executive officers and key employees ofour subsidiaries. If we fail to attract, hire or retain the necessarypersonnel, or if we lose the services of our key executives, we may be unableto implement our business plan or keep pace with developing trends in ourindustry.

 

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***We are subject to the risks of doingbusiness outside the United States.***

 

Historically, a significantportion of our revenue has been generated from foreign operations. In order tomaintain or expand our presence in foreign markets, we have entered and may inthe future enter into strategic relationships with local operators in thosemarkets. Certain foreign laws, regulations and judicial procedures may not beas protective of programmer rights as those applicable in the United States. Inaddition, many foreign countries have currency and exchange laws regulating theinternational transfer of currencies. To the extent that significant currencyfluctuations result in materially higher costs to any of our foreign customers,those customers may be unable or unwilling to make the required payments. Wemay be subject to delays in access to courts and to the remedies local lawsimpose in order to collect our payments and recover our assets. We also mayexperience problems with collecting accounts due from foreign customers, whichwould adversely affect our revenue and income. Our growth and profitability mayalso suffer as a result of, among other matters, competitive pressures on videodelivery, labor stoppages, recessions and other political or economic eventsadversely affecting world or regional trading markets or affecting a particularcustomer.

 

***Our current and future operations inemerging markets may be harmed by the increased political and economic risksassociated with these markets.***

 

We currently broadcast inseveral foreign markets where market economies have only recently begun todevelop, and we may expand these operations in the future. If the governmentsin these markets adopt more restrictive economic policies, we may not be ableto continue operating, or to implement our expansion plans, in those markets.More generally, we are exposed to certain risks, many of which are beyond ourcontrol, inherent in operating in emerging market countries. These risksinclude changes in laws and policies affecting trade, investment and taxes(including laws and policies relating to the repatriation of funds and towithholding taxes), differing degrees of protection for intellectual propertyand the instability of emerging market economies, currencies, and governments.

 

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

 

As a result of our acquisitionsof all the common interests in Crown Media United States, we have generated asignificant amount of goodwill. We ceased the amortization of this acquiredgoodwill, and we are required to periodically review whether the value of ourgoodwill has been impaired. If we are required to write down our goodwill, ourresults of operations, stockholders’ equity or profitability could be materiallyadversely affected. 

 

We also have a film costrelating to the amortization of the purchase price for the film assets that weuse and license to others. This film cost is, and will continue to be, asignificant component of our cost of services each quarter.

 

***Our stock price may be volatile and coulddecline substantially.***

 

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

 

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

 

• material announcements by us or our competitors;

 

• governmental regulatory action; 

 

•technological innovations by competitors or competing technologies;

 

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

 

• changes in general market conditions or economictrends. 

 

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Additionally, of the approximately 73.9 million sharesof the Company’s outstanding Class A common stock, only 9.6 million shares(approximately 13%) are not held by affiliates of the Company.  This stock ownership structure may also be acause of volatility in the market price of the Company’s Class A common stock.

 

***Any non-compliance with theSarbanes-Oxley Act of 2002, and specifically section 404 of the Act, couldhave a negative impact on our stock price.***

 

Section 404 of the Sarbanes-Oxley Act of2002 requires that we establish and maintain an adequate internal controlstructure and procedures for financial reporting and assess on an on-goingbasis the design and operating effectiveness of our internal control structureand procedures for financial reporting. Although we believe that the ongoing review of our internal controlswill enable us to provide an assessment of our internal controls and ourexternal auditors to provide their audit opinion as of December 31, 2004as required by Section 404, we can give no assurance that these effortswill be completed on a timely and successful basis. Any inability to completeour process of assessing our internal controls will affect our auditors’ability to render their opinions.

 

**Risks Relating to Our Industry**

 

***The proposed change in television ratings inthe United States could reduce our channel revenue and our ability to achieveprofitability.***

 

Our domestic advertising revenues are partiallydependent on television ratings provided by Nielsen Media Research. Nielsen iscurrently modifying its ratings system by increasing its household samplesize.  Our ratings could either be positivelyor negatively affected by these changes, depending on the demographiccharacteristics of the households added to the Nielsen sample. 

 

***Competition could reduce our channel revenueand our ability to achieve profitability.***

 

We operate in the pay televisionbusiness, which is highly competitive. If we are unable to compete effectivelywith large diversified entertainment companies that have substantially greaterresources than we have, our operating margins and market share could bereduced, and the growth of our business inhibited. In particular, we competefor distribution with other pay television channels and, when distribution isobtained, for viewers and advertisers with pay television channels, broadcasttelevision networks, radio, the Internet and other media. We also compete, tovarying degrees, with other leisure-time activities such as movie theaters, theInternet, radio, print media, personal computers and other alternative sourcesof entertainment and information. Future technological developments may affectcompetition within this business.

 

A continuing trend towardsbusiness combinations and alliances in both the domestic and foreigncommunications industries may create significant new competitors for us orintensify existing competition. Many of these combined entities have more thanone channel and resources far greater than ours. These combined entities mayprovide bundled packages of programming, delivery and other services thatcompete directly with the products we offer. These entities may also offerservices sooner and at more competitive rates than we do. In addition, thesealliances may benefit from both localized content and the local politicalclimate.

 

We may need to reduce our pricesor license additional programming to remain competitive, and we may be unableto sustain future pricing levels as competition increases. Our failure toachieve or sustain market acceptance of our programming at desired pricinglevels could impair our ability to achieve profitability or positive cash flow,which would harm our business.

 

Distributors in the UnitedStates may attempt to increasingly pressure smaller pay TV channels in terms ofviewership, such as our domestic Hallmark Channel, to accept decreasing amountsfor subscriber fees, to pay higher subscriber acquisition fees or to allowcarriage of the channel without the payment of subscriber fees. Factors thatmay lead to this pressure include the number of competing pay TV channels, thelimited space available on services of distributors in the United States andthe desire of distributors to maintain or reduce costs. Any reduction insubscriber fees revenue now or in the future could have a material impact onour ability to achieve profitability and

 

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cash flow.

 

***New distribution technologies mayfundamentally change the way we distribute our channels and could significantlydecrease our revenue or require us to incur significant capital expenditures.***

 

Our future success will depend,in part, on our ability to anticipate and adapt to technological changes and tooffer, on a timely basis, services that meet customer demands and evolvingindustry standards. The pay television industry has been, and is likely tocontinue to be, subject to:

 

• rapidand significant technological change, including continuing developments intechnology which do not presently have widely accepted standards; and

 

•frequent introductions of new services and alternative technologies, includingnew technologies for providing video services.

 

For example, the advent ofdigital technology is likely to accelerate the convergence of broadcast,telecommunications, Internet and other media and could result in materialchanges in the economics, regulations, intellectual property usage andtechnical platforms on which our business relies, including lower retail ratesfor video services. These changes could fundamentally affect the scale, source,and volatility of our revenue streams, cost structures, and profitability, andmay require us to significantly change our operations.

 

We also rely in part on thirdparties for the development of, and access to, communications and networktechnology. As a result, we may be unable to obtain access to new technology ona timely basis or on satisfactory terms, which could harm our business andprospects.

 

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

 

***If we fail to comply with applicablegovernment regulations, our business could be harmed.***

 

If, as a provider of televisionchannels, we fail to comply with applicable present or future governmentregulations in any markets in which we operate, we could be prohibited fromoperating in those markets and could be subject to monetary fines, either ofwhich would increase our operating costs, reduce our revenue and limit ourability to achieve profitability. The scope of regulation to which we aresubject varies from country to country, although in many significant respects asimilar approach is taken to the regulation of broadcasting across all of themarkets in which we operate. Typically, broadcasting regulation in each of thecountries in which we operate requires that domestic broadcasters and platformproviders secure broadcasting licenses from the domestic broadcastingauthority. Additionally, many nations have broadcasting legislation andregulations, which set minimum standards regarding program content, andprescribe minimum standards for the content and scheduling of televisionadvertisements. Some countries require that a certain portion of programmingcarried by broadcasters be produced domestically.

 

Moreover, broadcastingregulations are generally subject to periodic and on-going governmental reviewand legislative initiatives, which may, in the future, affect the nature ofprogramming we are able to offer and the means by which it is distributed. Thetiming, scope or outcome of these reviews could be unfavorable to us, and anychanges to current broadcasting legislation or regulations could requireadjustments to our operations.

 

The Federal CommunicationsCommission or Congress may enact requirements that cable program services beoffered to subscribers on an “a la carte” basis, i.e. be made available forpurchase separately and not as part of a

 

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package of services. Such requirements couldresult in a reduction in the total number of subscribers to our domesticprogram services and adversely affect advertising revenue.

 

**Item 3****. *Quantitative and Qualitative Disclosures AboutMarket 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 there is an increase in interest rates. If market interest rates were toincrease immediately and uniformly by 10% from levels as of September 30,2004, the decline of the fair value of the fixed income portfolio would not bematerial.

 

As of September 30, 2004,our cash, cash equivalents and short-term investments had a fair value of $7.6million, which was invested in cash and short-term commercial paper. Theprimary purpose of these investing activities has been to preserve principaluntil the cash is required to fund operations. Consequently, the size of thisportfolio fluctuates significantly as cash is provided by and used in ourbusiness.

 

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 30,2004, 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, 2004, 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.

 

We have not used derivativefinancial instruments for speculative purposes. As of September 30, 2004,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 and foreign currency exchange rates. To reducethe volatility relating to these exposures, we may enter into variousderivative investment transactions in the near term pursuant to our investmentand risk management policies and procedures in areas such as hedging andcounterparty exposure practices. We have not and will not use derivatives forspeculative 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 unfavorable movementsin interest rates, foreign currency exchange rates or equity investment prices.

 

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

 

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

 

Our material interest bearingassets consisted of cash equivalents and short-term investments. The balance ofour interest bearing assets was $7.6 million, or less than 1% of total assets,as of September 30, 2004. Our material liabilities subject to interestrate risk consisted of a capital lease obligation, our bank credit facility,our line of credit with HC Crown and our note payable to HC Crown. The balanceof those liabilities was $848.3 million, or 65% of total liabilities, as of September 30,2004. Net interest expense for the three and nine months ended September 30,2004, was $16.8 million, 30%, of our total revenue and $48.5 million, 29% ofour total revenue. Our net interest expense of these liabilities is sensitiveto changes in the general level of interest rates, primarily U.S. and LIBORinterest rates. In this regard, changes in U.S. and LIBOR interest rates affectthe fair value of interest bearing

 

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liabilities.

 

***We are exposed to risks relating to foreigncurrency exchange rates and foreign economic conditions.***

 

Weevaluate our foreign currency exposure on a net basis. We receive subscriberfees and advertising revenue from countries throughout the world. Increasingly,however, expenses arising from our foreign facilities as well as non-U.S.denominated dollar expenses are offsetting these revenues. Generally, paymentsrequired under our agreements are denominated in U.S. dollars and, therefore,unaffected by foreign currency exchange rate fluctuations. We have someexposure to changes in exchange rates in Latin America, Europe, Asia, andAfrica. However, our exposure to foreign exchange rates primarily exists withthe British pound. When the U.S. dollar strengthens against the currencies in thesecountries, the U.S. dollar value of non-U.S. dollar denominated revenuedecreases; when the U.S. dollar weakens, the U.S. dollar value of non-U.S.dollar denominated revenue increases. Accordingly, changes in exchange rates,and in particular, a strengthening of the U.S. dollar, may adversely affect ourrevenue as expressed in U.S. dollars.

 

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

 

***Disclosure Controls andProcedures***

 

The Company, under thesupervision and with the participation of the Company’s management, includingits Chief Executive Officer and Chief Financial Officer, carried out anevaluation of the effectiveness of the design and operation of the Company’sdisclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934) as of September 30,2004.  Based upon this evaluation,the Company’s Chief Executive Officer and Chief Financial Officer concludedthat the Company’s disclosure controls and procedures are effective asof that date for purposes of recording, processing, summarizing andtimely reporting material information required to be disclosed in reports thatthe Company files under the Exchange Act.

 

***Changes in InternalControl Over Financial Reporting***

 

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

 

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**PART II.  OTHER INFORMATION**

 

**Item 6.  *Exhibits***

 

(a)

 

**INDEX TO EXHIBITS**

 
| **Exhibit Number** | ** ** | **Exhibit Title**                                                                                                                                                                                                          |
|--------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **         | ** ** | ** **                                                                                                                                                                                                                 |
| 3.1                |       | Amended and Restated  Certificate of Incorporation (previously filed as Exhibit 3.1 to our  Registration Statement on Form S-1/A (Amendment No. 2), Commission File No.  333-95573, and incorporated herein by reference). |
| 3.2                |       | Amendment to the Amended and  Restated Certificate of Incorporation (previously filed as Exhibit 3.2 to our  Quarterly Report on Form 10-Q filed on July 31, 2001 and incorporated  herein by reference).             |
| 3.3                |       | Amended and Restated By-Laws  (previously filed as Exhibit 3.2 to our Registration Statement on Form S-1/A  (Amendment No. 3), Commission File No. 333-95573, and incorporated herein by  reference).                      |
| 10.1               |       | Trademark License Extension Agreement, dated as of August 1,  2004, by and between Crown Media International, LLC and Hallmark Cards,  Incorporated.                                                                  |
| 10.2               |       | Trademark License Extension Agreement, dated as of August 1,  2004, by and between Crown Entertainment Limited and Hallmark Cards,  Incorporated.                                                                     |
| 10.3               |       | Amendment No. 7 dated October 28, 2004, to the  Credit, Security, Guaranty and Pledge Agreements with JP Morgan Chase Bank as  Administrative Agent and Issuing Bank.                                                 |
| 10.4*              |       | Letter Agreement dated July 2, 2004 between  Crown Media Holdings, Inc. and Jeff Henry.                                                                                                                               |
| 10.5               |       | Trademark License Extension Agreement, dated as of August 1,  2004, by and between Crown Media United States, LLC and Hallmark Cards,  Incorporated.                                                                  |
| 31.1               |       | Rule 13a-14(a) Certification executed by the Company’s  President and Chief Executive Officer.                                                                                                                        |
| 31.2               |       | Rule 13a-14(a) Certification executed by the Company’s  Executive Vice President and Chief Financial Officer.                                                                                                         |
| 32                 |       | Section 1350 Certifications.                                                                                                                                                                                          |

 

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* Management contract or compensating plan orarrangement.

 

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**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/  DAVID J. EVANS    |       |               | Director and Principal  |       | November 15, 2004 |   |
|       | David J. Evans                                          |       | Executive Officer  |                    |       |                   |
|       |                                                    |       |               |                    |       |                   |
|       | By:     /s/  WILLIAM J. ALIBER |       |               | Principal Financial and |       | November 15, 2004 |   |
|       | William J. Aliber                                       |       | Accounting Officer |                    |       |                   |
|            |                                                         |            |                    |                         |            |                        |  |  |

 

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**INDEX TO EXHIBITS**

 
| **Exhibit Number** | ** ** | **Exhibit Title**                                                                                                                                                                                                          |
|--------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **         | ** ** | ** **                                                                                                                                                                                                                 |
| 3.1                |       | Amended and Restated  Certificate of Incorporation (previously filed as Exhibit 3.1 to our  Registration Statement on Form S-1/A (Amendment No. 2), Commission File No.  333-95573, and incorporated herein by reference). |
| 3.2                |       | Amendment to the Amended and  Restated Certificate of Incorporation (previously filed as Exhibit 3.2 to our  Quarterly Report on Form 10-Q filed on July 31, 2001 and incorporated  herein by reference).             |
| 3.3                |       | Amended and Restated By-Laws  (previously filed as Exhibit 3.2 to our Registration Statement on Form S-1/A  (Amendment No. 3), Commission File No. 333-95573, and incorporated herein by  reference).                      |
| 10.1               |       | Trademark License Extension Agreement, dated as of August 1,  2004, by and between Crown Media International, LLC and Hallmark Cards,  Incorporated.                                                                  |
| 10.2               |       | Trademark License Extension Agreement, dated as of August 1,  2004, by and between Crown Entertainment Limited and Hallmark Cards,  Incorporated.                                                                     |
| 10.3               |       | Amendment No. 7 dated October 28, 2004, to the  Credit, Security, Guaranty and Pledge Agreements with JP Morgan Chase Bank as  Administrative Agent and Issuing Bank.                                                 |
| 10.4*              |       | Letter Agreement dated July 2, 2004 between  Crown Media Holdings, Inc. and Jeff Henry.                                                                                                                               |
| 10.5               |       | Trademark License Extension Agreement, dated as of August 1,  2004, by and between Crown Media United States, LLC and Hallmark Cards,  Incorporated.                                                                  |
| 31.1               |       | Rule 13a-14(a) Certification executed by the  Company’s President and Chief Executive Officer.                                                                                                                        |
| 31.2               |       | Rule 13a-14(a) Certification executed by the  Company’s Executive Vice President and Chief Financial Officer.                                                                                                         |
| 32                 |       | Section 1350 Certifications.                                                                                                                                                                                          |

 

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* Management contract or compensating plan orarrangement.

 

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