**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**Form 10-Q**

 

**(Mark One)**
| **ý**                                             | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13  OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|--------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|
|                                                   |       |                                                                                                |
| **For the quarterly period ended March 31, 2005** |
|                                                   |       |                                                                                                |
| **or**                                                 |
|                                                   |       |                                                                                                |
| **o**                                                  | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13  OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934** |

** **

**For the transition period from              to              .**

 

**Commission File Number: 000-30700**

 

**Crown MediaHoldings, Inc.**

(ExactName of Registrant as Specified in Its Charter)

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

 

**12700 Ventura Boulevard,**

**Suite 200**

**Studio City, California  91604**

(Addressof Principal Executive Offices and Zip Code)

 

**(818) 755-2400**

(Registrant’sTelephone Number, Including Area Code)

 

(FormerName, Former Address, and Former Fiscal Year,

ifChanged Since Last Report.)

 

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

 

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

 

As of May 31, 2005,the number of shares of Class A Common Stock, $.01 par value outstandingwas 73,869,641, and the number of shares of Class B Common Stock, $.01 parvalue, outstanding was 30,670,422.

 

 

----

 

**TABLE OF CONTENTS**

 
| **PART I**  | **Financial Information**                                                                                                                             |   |
|------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|             |                                                                                                                                                  |   |
| Item 1           | Financial Statements (Unaudited)                                                                                                                      |   |
|             | CROWN MEDIA HOLDINGS, INC. AND SUBSIDIARIES  Condensed Consolidated Balance Sheets – December 31, 2004 and March 31,  2005 (Unaudited) |   |
|             | Condensed Consolidated Statements of  Operations and Comprehensive Loss (Unaudited)  - Three Months Ended March 31, 2004 and 2005                |   |
|             | Condensed Consolidated Statements of Cash  Flows (Unaudited)  - Three Months Ended March 31, 2004 and 2005                                       |   |
|             | Notes to Unaudited Condensed Consolidated  Financial Statements                                                                                       |   |
|             |                                                                                                                                                  |   |
| Item 2           | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                                           |   |
|             |                                                                                                                                                  |   |
| Item 3           | Quantitative and Qualitative Disclosures  About Market Risk                                                                                           |   |
|             |                                                                                                                                                  |   |
| Item 4           | Controls and Procedures                                                                                                                               |   |
|             |                                                                                                                                                  |   |
| **PART II** | **Other Information**                                                                                                                                 |   |
|             |                                                                                                                                                  |   |
| Item 1           | Legal Proceedings                                                                                                                                     |   |
|             |                                                                                                                                                  |   |
| Item  6          | Exhibits                                                                                                                                              |   |
|             |                                                                                                                                                  |   |
| Signatures       |                                                                                                                                                  |   |

 

2

----

 

*Inthis Form 10-Q the terms “Crown Media Holdings” or the “Company,” refer toCrown Media Holdings, Inc.  and,unless the context requires otherwise, subsidiaries of Crown Media Holdingsthat operate or have operated our businesses, Crown Media United States, LLC (“CrownMedia United States”), Crown Media Distribution, LLC (“Crown Media Distribution”),and, until completion of the sale of our international business in April 2005,Crown Media International, LLC (“Crown Media International”) and CrownEntertainment Limited (“Crown Entertainment”). The term “common stock” refersto our Class A common stock and Class B common stock, unless thecontext requires otherwise.*

 

*The names Hallmark, Hallmark Entertainment and otherproduct or service names are trademarks or registered trademarks of theirowners.*

* *

**PART I. FINANCIAL INFORMATION**

 

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

 

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

**UNAUDITED CONDENSEDCONSOLIDATED BALANCE SHEETS**

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

 
| ** **                                                                                    | ** ** | **As of  December 31,  2004** | ** ** | **As of  March 31,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                    | ** ** | ** **                         | ** ** | ** **                      | ** ** |
| ASSETS                                                                                        |       |                               |       |                            |       |
|                                                                                          |       |                               |       |                            |       |
| Cash and cash equivalents                                                                     |       | $                                  | 12,102     |                            | $          | 14,746 |   |
| Accounts receivable, less allowance for doubtful accounts of $6,695  and $1,281, respectively |       | 75,459                             |       | 59,081                          |       |
| Program license fees — affiliates                                                        |       | 40,048                             |       | 29,785                          |       |
| Program license fees — non-affiliates                                                    |       | 78,823                             |       | 63,407                          |       |
| Subtitling and dubbing, net                                                                   |       | 1,143                              |       | —                          |       |
| Receivable from affiliate                                                                     |       | 16,644                             |       | 18,468                          |       |
| Prepaid and other assets                                                                      |       | 13,887                             |       | 7,174                           |       |
| Current assets held for sale                                                                  |       | —                             |       | 54,919                          |       |
| Total current assets                                                                          |       | 238,106                            |       | 247,580                         |       |
|                                                                                          |       |                               |       |                            |       |
| Accounts receivable                                                                           |       | 6,798                              |       | 7,616                           |       |
| Program license fees — affiliates                                                        |       | 59,987                             |       | 58,248                          |       |
| Program license fees — non-affiliates                                                    |       | 135,372                            |       | 160,536                         |       |
| Subtitling and dubbing                                                                        |       | 1,583                              |       | —                          |       |
| Film assets, net                                                                              |       | 599,013                            |       | 445,812                         |       |
| Subscriber acquisition fees, net                                                              |       | 120,013                            |       | 108,788                         |       |
| Property and equipment, net                                                                   |       | 32,829                             |       | 20,877                          |       |
| Goodwill                                                                                      |       | 314,033                            |       | 314,033                         |       |
| Prepaid and other assets                                                                      |       | 5,034                              |       | 3,466                           |       |
| Non-current assets held for sale                                                              |       | —                             |       | 168,064                         |       |
| Total assets                                                                                  |       | $                                  | 1,512,768  |                            | $          | 1,535,020 |   |

 

Seeaccompanying notes to unaudited condensed consolidated financial statements.

 

3

----

 

**CROWN MEDIA HOLDINGS, INC. ANDSUBSIDIARIES**

**UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS**

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

**(continued)**

 
| ** **                                                                                                                                                                 | ** ** | **As of  December 31,  2004** | ** ** | **As of  March 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                                                 | ** ** | ** **                         | ** ** | ** **                      | ** ** |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                  |       |                               |       |                            |       |
|                                                                                                                                                                       |       |                               |       |                            |       |
| LIABILITIES:                                                                                                                                                               |       |                               |       |                            |       |
| Accounts payable and accrued expenses                                                                                                                                      |       | $                                  | 40,228     |                            | $          | 24,171 |   |
| Liability for restricted stock units                                                                                                                                       |       | 13,649                             |       | 11,825                          |       |
| Subscriber acquisition fees payable                                                                                                                                        |       | 35,223                             |       | 33,465                          |       |
| License fees payable to affiliates                                                                                                                                         |       | —                             |       | 15,128                          |       |
| License fees payable to non-affiliates                                                                                                                                     |       | 79,815                             |       | 72,417                          |       |
| Payables to affiliates                                                                                                                                                     |       | 13,512                             |       | 14,125                          |       |
| Credit facility and interest payable                                                                                                                                       |       | 479                                |       | 376                             |       |
| Capital lease obligations                                                                                                                                                  |       | 2,276                              |       | 571                             |       |
| Deferred revenue                                                                                                                                                           |       | 612                                |       | 968                             |       |
| Current liabilities held for sale                                                                                                                                          |       | —                             |       | 23,433                          |       |
| Total current liabilities                                                                                                                                                  |       | 185,794                            |       | 196,479                         |       |
|                                                                                                                                                                       |       |                               |       |                            |       |
| Accrued expenses                                                                                                                                                           |       | 21,617                             |       | 14,036                          |       |
| Subscriber acquisition fees payable                                                                                                                                        |       | 678                                |       | —                          |       |
| License fees payable to affiliates                                                                                                                                         |       | 151,980                            |       | 151,980                         |       |
| License fees payable to non-affiliates                                                                                                                                     |       | 111,761                            |       | 140,845                         |       |
| Line of credit and interest payable to HC Crown                                                                                                                            |       | 81,067                             |       | 82,195                          |       |
| Payable to Hallmark Entertainment affiliates                                                                                                                               |       | 100,000                            |       | 100,000                         |       |
| Senior unsecured note to HC Crown, including accrued interest                                                                                                              |       | 460,930                            |       | 472,645                         |       |
| Credit facility                                                                                                                                                            |       | 310,000                            |       | 310,000                         |       |
| Capital lease obligations                                                                                                                                                  |       | 22,817                             |       | 16,635                          |       |
| Company obligated mandatorily redeemable preferred interest                                                                                                                |       | 11,488                             |       | 12,167                          |       |
| Non-current liabilities held for sale                                                                                                                                      |       | —                             |       | 13,397                          |       |
| Total liabilities                                                                                                                                                          |       | 1,458,132                          |       | 1,510,379                       |       |
| Commitments and contingencies                                                                                                                                              |       |                               |       |                            |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                 |       |                               |       |                            |       |
| Class A common stock, $.01 par value; 200,000,000 shares  authorized; 73,863,037 shares issued and outstanding as of December 31,  2004, and March 31, 2005 |       | 739                                |       | 739                             |       |
| Class B common stock, $.01 par value; 120,000,000 shares  authorized; 30,670,422 shares issued and outstanding as of December 31,  2004, and March 31, 2005 |       | 307                                |       | 307                             |       |
| Additional paid-in capital                                                                                                                                                 |       | 1,365,450                          |       | 1,386,857                       |       |
| Accumulated other comprehensive income                                                                                                                                     |       | 3,434                              |       | 2,939                           |       |
| Accumulated deficit                                                                                                                                                        |       | (1,315,294                         | )          | (1,366,201                      | )          |
| Total stockholders’ equity                                                                                                                                            |       | 54,636                             |       | 24,641                          |       |
| Total liabilities and stockholders’ equity                                                                                                                            |       | $                                  | 1,512,768  |                            | $          | 1,535,020 |   |

 

Seeaccompanying notes to unaudited condensed consolidated financial statements.

 

4

----

 

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

**UNAUDITED CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS AND**

**COMPREHENSIVE LOSS**

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

 
| ** **                                                                                      | ** ** | **Three  Months Ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                      | ** ** | **2004**                               | ** ** | **2005** | ** ** |
| ** **                                                                                      | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Revenue:                                                                                        |       |                                   |       |   |   |
| Subscriber fees                                                                                 |       | $                                      | 2,373      |   | $ | 4,610 |   |
| Advertising                                                                                     |       | 23,388                                 |       | 33,333 |   |
| Advertising by Hallmark Cards                                                                   |       | 350                                    |       | 543 |   |
| Film asset license fees                                                                         |       | 7,290                                  |       | 2,083 |   |
| Total revenue, net                                                                              |       | 33,401                                 |       | 40,569 |   |
| Cost of Services:                                                                               |       |                                   |       |   |   |
| Programming costs:                                                                              |       |                                   |       |   |   |
| Affiliates                                                                                      |       | 7,390                                  |       | 9,891 |   |
| Non-affiliates                                                                                  |       | 11,633                                 |       | 18,131 |   |
| Amortization of film assets                                                                     |       | 7,330                                  |       | 5,681 |   |
| Subscriber acquisition fee amortization expense                                                 |       | 5,941                                  |       | 9,508 |   |
| Other cost of services                                                                          |       | 3,925                                  |       | 1,796 |   |
| Total cost of services                                                                          |       | 36,219                                 |       | 45,007 |   |
| Selling, general and administrative expense                                                     |       | 11,251                                 |       | 12,152 |   |
| Marketing expense                                                                               |       | 4,121                                  |       | 9,830 |   |
| Depreciation and amortization expense                                                           |       | 1,684                                  |       | 1,350 |   |
| Loss from continuing operations before interest expense                                         |       | (19,874                                | )          | (27,770 | ) |
| Interest expense                                                                                |       | (14,218                                | )          | (16,896 | ) |
| Loss from continuing operations                                                                 |       | (34,092                                | )          | (44,666 | ) |
| Loss from discontinued operations                                                               |       | (7,384                                 | )          | (6,241 | ) |
| Net loss                                                                                        |       | $                                      | (41,476    | ) | $ | (50,907 | ) |
| Other comprehensive income (loss):                                                              |       |                                   |       |   |   |
| Foreign currency translation adjustment                                                         |       | 451                                    |       | (495 | ) |
| Comprehensive loss                                                                              |       | $                                      | (41,025    | ) | $ | (51,402 | ) |
| Weighted average number of Class A and Class B shares  outstanding, basic and diluted |       | 104,533                                |       | 104,533 |   |
| Loss from continuing operations, basic and diluted                                              |       | (0.33                                  | )          | (0.43 | ) |
| Loss from discontinued operations, basic and diluted                                            |       | (0.07                                  | )          | (0.06 | ) |
| Net loss per share, basic and diluted                                                           |       | $                                      | (0.40      | ) | $ | (0.49 | ) |

 

Seeaccompanying notes to unaudited condensed consolidated financial statements.

 

5

----

 

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

**UNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

 
| ** **                                                                   | ** ** | **Three  Months Ended March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                   | ** ** | **2004**                               | ** ** | **2005** | ** ** |
| ** **                                                                   | ** ** | ** **                             | ** ** | ** ** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                        | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Net loss                                                                     |       | $                                      | (41,476    | ) | $ | (50,907 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |       |                                   |       |   |   |
| Loss from discontinued operations                                            |       | 7,384                                  |       | 6,241 |   |
| Depreciation and amortization                                                |       | 37,068                                 |       | 48,511 |   |
| Accretion on company obligated mandatorily redeemable preferred  interest    |       | 537                                    |       | 679 |   |
| Provision for allowance for doubtful accounts (recoveries)                   |       | 1,031                                  |       | (946 | ) |
| Stock-based compensation                                                     |       | 2,339                                  |       | 2,412 |   |
| Changes in operating assets and liabilities:                                 |       |                                   |       |   |   |
| Increase in accounts receivable                                              |       | (4,483                                 | )          | (470 | ) |
| Additions to program license fees                                            |       | (17,368                                | )          | (66,003 | ) |
| Additions to subscriber acquisition fees                                     |       | (4,775                                 | )          | (1,493 | ) |
| (Increase) decrease in prepaids and other assets                             |       | (594                                   | )          | 1,148 |   |
| Increase (decrease) in accounts payable and accrued liabilities              |       | (14,459                                | )          | 23,370 |   |
| Increase in interest payable                                                 |       | 11,356                                 |       | 12,755 |   |
| Increase (decrease) in subscriber acquisition fees payable                   |       | 2,239                                  |       | (2,435 | ) |
| Increase in license fees payable to affiliates                               |       | 8,530                                  |       | 15,128 |   |
| Increase (decrease) in payables to affiliates                                |       | 3,514                                  |       | (1,211 | ) |
| Increase (decrease) in deferred revenue                                      |       | (27                                    | )          | 362 |   |
| Net cash used in continuing operating activities                             |       | (9,184                                 | )          | (12,859 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                        |       |                                   |       |   |   |
| Purchases of property and equipment                                          |       | (64                                    | )          | (248 | ) |
| Net cash used in investing activities                                        |       | (64                                    | )          | (248 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                        |       |                                   |       |   |   |
| Proceeds from tax sharing agreement with Hallmark Cards                      |       | 14,300                                 |       | 21,400 |   |
| Borrowings under the credit facility                                         |       | 10,000                                 |       | — |   |
| Principal payments under capital lease obligations                           |       | —                                 |       | (157 | ) |
| Net cash provided by financing activities                                    |       | 24,300                                 |       | 21,243 |   |
| NET CASH USED IN DISCONTINUED OPERATIONS                                     |       | (11,544                                | )          | (4,997 | ) |
| Effect of exchange rate changes on cash                                      |       | 460                                    |       | (495 | ) |
| Net increase in cash and cash equivalents                                    |       | 3,968                                  |       | 2,644 |   |
| Cash and cash equivalents, beginning of period                               |       | 4,306                                  |       | 12,102 |   |
| Cash and cash equivalents, end of period                                     |       | $                                      | 8,274      |   | $ | 14,746 |   |
| Supplemental disclosure of cash and non-cash activities:                     |       |                                   |       |   |   |
| Interest paid                                                                |       | $                                      | 3,514      |   | $ | 4,961 |   |
| Income taxes paid                                                            |       | $                                      | 475        |   | $ | 493 |   |

 

Seeaccompanying notes to unaudited condensed consolidated financial statements.

 

6

----

 

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

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**For the Three Months Ended March 31, 2004 and 2005**

 

**1. Business and Organization**

 

***Organization***

 

Crown MediaHoldings, Inc. (“Crown Media Holdings,” “Crown Media” or the “Company”),through its subsidiaries, owns and operates pay television channels(collectively the “Hallmark Channel” or the “channel”) dedicated to highquality, entertainment programming for adults and families, in the UnitedStates and, prior to the sale of its international business, in variouscountries throughout the world. Domestically, the Hallmark Channel is operatedand distributed by Crown Media United States, LLC (“Crown Media United States”).Significant investors in Crown Media Holdings include Hallmark EntertainmentInvestments Co. (“Hallmark Entertainment Investments”), a subsidiary ofHallmark Cards, Incorporated (“Hallmark Cards”), the National Interfaith CableCoalition, Inc. (“NICC”), and, indirectly through their investments inHallmark Entertainment Investments, Liberty Media Corporation (“Liberty Media”)and J.P. Morgan Partners (BHCA), L. P. (“J.P. Morgan”). The internationaloperations of the Hallmark Channel were operated in the United Kingdom, byCrown Entertainment Limited (“Crown Entertainment”) and elsewhere by CrownMedia International, LLC (“Crown Media International”). Crown MediaInternational commenced its operations outside the United States in 1995.

 

***Sale of the International Business***

 

The Company sold its international business to a groupof investors comprised of Equity Partners, 3i and U.K. executive David Elstein(collectively, the “buyer”) in a transaction that closed on April 26,2005. The sale included the international versions of the Hallmark Channeldistributed outside the United States, the international rights to over 580titles in the Crown Media film library, and the network broadcast facilitybased in Denver, Colorado.  The sale pricewas $242.0 million, subject to certain purchase price adjustments relating toreceivables acquired and working capital changes. Upon closing of thetransaction, the Company received cash proceeds of approximately $209.3million; such proceeds were net of approximately $12.7 million paid to thebuyer for future services to be provided by the buyer under a services contractand $20.0 million related to certain accounts receivable not acquired by thebuyer.  Within 45 days from the close ofthe transaction, the purchase price may be adjusted for certain minimum workingcapital considerations, guarantees and commitments, which we estimate willreduce the net cash proceeds by an additional $2.0 million in the aggregate.The Company agreed to pay the buyer approximately $24.1 million over a specifiednumber of years to cover the fair value amount of certain obligationstransferred with the international business. Proceeds from the transaction wereused by Crown Media Holdings to reduce outstanding indebtedness under its bankcredit facility and to pay transaction fees, restricted stock unit settlements,and employment contract terminations and severance for certain executives whowere involved in the Company’s international business and not retained by thebuyer.

 

Substantially all of the employees of theinternational business as well as the broadcast facility were retained by thebuyer.  Subsequent to the sale, theCompany has no continuing economic involvement with the operations of theinternational business.

 

Due to the delay in filing this quarterlyreport on Form 10-Q, the Company breached a report covenant of the bankcredit facility. The Company obtained a waiver for such covenant violation,subject to the filing of this interim report on Form 10-Q prior to June 30,2005.

 

***Liquidity***

 

As of March 31, 2005, the Company had$14.7 million in cash and cash equivalents on hand and $10.0 million availableunder its bank credit facility. As of March 31, 2005, the Company hadborrowed $310.0 million under its bank credit facility, which has a maturitydate of May 31, 2006. Upon the closing of the sale of the internationalbusiness on April 26, 2005, the Company used the net proceeds to repay$195.0 million of borrowings under its

 

7

----

 

bank credit facility and to pay $14.3 million for transaction fees,restricted stock unit settlements, and employment contract terminations andseverance for certain executives who were involved in the Company’sinternational business and not retained by the buyer. However, subsequent tothe close of the transaction, the Company borrowed $64.0 million under itscredit facility to pay subscriber acquisition fees and license fees payable toaffiliates. After these transactions were executed at May 31, 2005, theCompany had outstanding borrowings under the bank credit facility of $179.0million and had $41.0 million available under the bank credit facility. Fortymillion of the availability is subject to the approval of Hallmark Cards priorto the Company being able to draw such funds.

 

The Company’s principal sources of funds arecurrently cash on hand, periodic cash inflows expected under the tax sharingagreement with Hallmark Cards and amounts available for borrowing under itsbank credit facility.

 

In connection with the Company’s businessstrategy, the Company expects to continue making investments in programming anddistribution during 2005. If necessary, the Company may reduce some of thisanticipated spending in 2005. The Company’s principal uses of funds for theremainder of 2005 are expected to include the payment of operating expenses,licensing of programming, and interest under its bank credit facility.

 

The Company currently believes that cash onhand, remaining availability under its bank credit facility (drawings subject toapproval of Hallmark Cards) and payments anticipated under the tax sharingagreement with Hallmark Cards, all of which are currently its principal sourcesof funds, will be sufficient to fund the current level of operations and meetits liquidity needs through at least the maturity date of its credit facility.As noted above, Hallmark Cards is required to approve borrowings under our$220.0 million bank credit facility in excess of $180.0 million. Crown MediaHoldings has to date not requested Hallmark Cards to approve such drawing offunds; however, we anticipate that we will require such additional capacity andwill require approval of Hallmark Cards during 2005. There can be no assurancethat Hallmark Cards will approve such additional drawings and, if such drawingsare not approved, the Company will need alternative sources of funding or willneed to significantly curtail expenses.

 

The Company’s management anticipates that itwill either extend or refinance the credit facility prior to its maturity date.  In addition, other financing alternativescould include the issuance of additional equity or debt securities.  There can be no assurance that the creditfacility can or will be extended or refinanced or that additional funding willbe available, if at all, on terms acceptable to the Company.  In addition, any decline in the popularity ofthe Hallmark Channel, any significant future modifications to the Company’sdistribution agreements, an economic decline in the advertising market, anincrease in competition or other adverse operating conditions will impact theCompany’s ability to achieve its projected operating results.

 

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

 

***InterimFinancial Statements***

 

In the opinion of management, the accompanying condensed consolidatedbalance sheets and related interim consolidated statements of operations andcash flows, include all adjustments, consisting of normal recurring itemsnecessary for their fair presentation in conformity with accounting principlesgenerally accepted in the United States. Interim results are not necessarilyindicative of results for a full year. These consolidated financial statementsshould be read in conjunction with the audited consolidated financialstatements and the notes to those statements for the year ended December 31,2004, including the Company’s Annual Report on Form 10-K for the yearended December 31, 2004.

 

***Basis of Presentation***

 

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

 

In February 2005,the Company signed a definitive agreement to complete the sale of its internationalbusiness and, accordingly, classified the operating results of theinternational business as discontinued operations in the

 

8

----

 

accompanying statements of operations for allperiods presented and related assets and liabilities as held for sale in theaccompanying balance sheet as of March 31, 2005. The Company’sdiscontinued operations consisted of the international channel operations andthe international rights to the film library assets.

 

***Use of Estimates***

 

The Company’s condensed consolidatedfinancial statements are prepared in accordance with accounting principlesgenerally accepted in the United States of America (“GAAP”). These accountingprinciples require the Company to make certain estimates, judgments andassumptions. The Company believes that the estimates, judgments and assumptionsmade when accounting for items and matters such as customer retention patterns,allowance for bad debts, useful lives of assets, ultimate revenue used in the filmasset amortization calculations, asset valuations including cash flowprojections, recoverability of assets, income taxes, reserves and otherprovisions and contingencies are reasonable, based on information available atthe time they are made. These estimates, judgments and assumptions can affectthe reported amounts of assets and liabilities as of the date of theconsolidated financial statements, as well as the reported amounts of revenueand expenses during the periods presented. Actual results could differ fromthese estimates.

 

***Film Assets and Film Library Impairment***

 

The Company amortizes its film assets using theindividual-film-forecast-computation method over a maximum period of 9.25 yearsfrom the date of acquisition. The individual-film-forecast-computation methodamortizes such assets in the same ratio that current period actual revenuebears to estimated ultimate future revenues.

 

On a quarterlybasis, the Company assesses whether events or circumstances have changedindicating that the fair value of a film is lower than its unamortized cost orcarrying value. If the carrying value of any individual film asset exceeds itsfair value, the film asset is written-down to its estimated fair value. Adiscounted cash flow model, based on management’s anticipated ultimate futurerevenue of the film, is used to estimate the fair value of the individualfilms. The Company considers the following factors, among others, in estimatingultimate future revenue for each film:  *(a)* the film’s performance in historical markets, *(b)* the public’s perception of the film’s story, cast,director, or producer, *(c)* historicalresults of similar films, *(d)* historicalresults of the cast, director, or producer on prior films, and *(e)* running time of the film.  In estimating afilm’s fair value, the Company considers those cash outflows necessary togenerate the film’s cash inflows such as exploitation, residual andparticipation costs and taxes.

 

The Company reviews its estimates of ultimatefuture revenues and participation costs as of each reporting date to reflectcurrently available information. Estimated ultimate future revenues are basedon the history of each film and similar films, sales and marketing plans, andother factors, all of which require significant judgment and estimation bymanagement. Differences between expenses determined using the new estimates andany amounts previously expensed during that fiscal year are charged or creditedto the statement of operations in the period in which the estimates are revised.

 

For use of the film assets on the HallmarkChannel, the Company estimates the fair value of the internal usage based uponthe portion of the film’s ultimate revenues attributable to the term of thelicense window. The Company first calculates the amount of cost attributable tothe internal use using the individual-film-forecast-computation method and thenexpenses such amounts as the Company exhibits or exploits the film ratably overthe term of the license window.

 

***Cash and Cash Equivalents***

 

Cash and cash equivalents include highlyliquid investments with original maturities of three months or less thatare readily convertible into cash and are not subject to significant risk fromfluctuations in interest rates. As a result, the carrying amount of cash andcash equivalents approximates fair value.

 

9

----

 

***Allowance for Doubtful Accounts***

 

The allowancefor doubtful accounts is based upon the Company’s assessment of probable lossrelated to uncollectible accounts receivable. The Company uses a number of factors in determining the allowance,including, among other things, collection trends and current anticipatedeconomic conditions in each country in which the Company derives itsrevenue.  The Company’s bad debt expensewas $1.0 million for the three months ended March 31, 2004. The Company’sbad debt recovery was $946,000 for the three months ended March 31, 2005.

 

***Program License Fees***

 

Program licensefees are paid in connection with the acquisition of the rights to air programsacquired from others. Program rights are generally deferred and then amortizedon a straight-line basis over their contractual license periods or anticipatedusage. Crown Media Holdings periodically evaluates the realizability of thesecosts compared to the estimated future revenues associated with the programmingexpenses.

 

Estimates of netrealizable value for domestic program license fees are determined using futureestimated advertising revenues and anticipated patterns of programming usage ona day part basis as it pertains to programming licensed to the domesticchannel. Estimates of net realizable value for international program licensefees are determined using historical and future estimates of advertising andsubscriber revenues attributable to each territory.  These estimates of expected annual futureestimated revenues are compared to net book value of the program license feeassets to determine if the programming assets are realizable. Where thedomestic and/or international analysis indicates the costs are in excess of thenet realizable value, additional amortization is provided. No such additionalamortization was required as of the date of the Company’s last analysis.

 

***Subscriber Acquisition Fees***

 

Subscriber acquisition fees are generallyrequired to be paid to obtain carriage on domestic pay distributors systems.Under certain of these agreements with pay distributors, Crown Media UnitedStates is obligated to pay subscriber acquisition fees if defined subscriberlevels are met or in order to obtain additional carriage of the HallmarkChannel by those pay distributors. Such costs are accrued whenCrown Media United States receives notice from the distributors that they havemet the contractual penetration percentage or subscriber count.

 

Subscriberacquisition fees are amortized over the contractual life of the distributionagreements (ranging from 4 to 9 years) as a reduction of subscriber fee revenue. If the amortization expenseexceeds the revenue recognized on a per distributor basis, the excessamortization is included as a component of cost of services. Crown MediaHoldings assesses the recoverability of these costs periodically. It alsoassesses the recoverability when events such as changes in distributor relationshipsoccur or other indicators suggest impairment.

 

***Property and Equipment***

 

Property andequipment are stated at historical cost. Equipment under capital leases areinitially recorded at the present value of the minimum lease payments.

 

Depreciation onequipment is calculated using the straight-line method over the estimateduseful lives of the assets. Equipment held under capital leases and leaseholdimprovements are amortized straight-line over the shorter of the lease term orestimated useful life of the asset.

 

When propertyand equipment is sold or otherwise disposed of, the cost and relatedaccumulated depreciation or amortization are removed from the accounts and anyresulting gain or loss is included in income. The costs of normal maintenanceand repairs are charged to expense when incurred.

 

***Long-Lived Assets***

 

The Company reviews long-lived assets, otherthan goodwill and other intangible assets with indefinite lives, for impairmentwhenever facts and circumstances indicate that the carrying amounts of theassets may not be recoverable. An impairment loss is recognized if the carryingamount of the asset is not recoverable and exceeds its fair value.Recoverability of assets to be held and used is measured by comparing thecarrying amount of an asset to

 

10

----

 

the estimated undiscounted future net cash flows expected to begenerated by the asset. If the asset’s carrying value is not recoverable, animpairment charge is recognized for the amount by which the carrying amount ofthe asset exceeds its fair value. The Company determines fair values by using acombination of comparable market values and discounted cash flows, asappropriate.

 

Goodwill is reviewed for impairment annuallyor whenever an event occurs or circumstances change that indicates fair valuemight be below carrying value. Goodwill is carried at historical cost if theestimated fair value is greater than the carrying amounts. However, ifestimated fair value is less than the carrying amount, goodwill is reduced toestimated fair value through an impairment charge to the Company’s consolidatedstatements of operations.

 

***Revenue Recognition***

 

Subscriberrevenue from pay television distributors is recognized as revenue when anagreement is executed, programming is provided, the price is determinable, andcollectibility is reasonably assured. Subscriber fees from pay televisiondistributors are recorded net of amortization of subscriber acquisition costs.If the amortization expense exceeds the revenue recognized on a per distributorbasis, the excess amortization is included as a component of cost of services.

 

Advertising revenues are recognized as earnedin the period in which the advertising is telecast. Revenue is recognized ascommercial spots or long form programming are aired and as ratings guaranteesto advertisers are achieved. Advertising revenues are recorded net of agencycommissions. Agency commissions are calculated based on a statedpercentage applied to gross billing revenue for the Company’s broadcastingoperations. Customers remit the gross billing amount to the agency and theagency remits gross billings less their commission to the Company. Paymentsreceived in advance of being earned are recorded as deferred revenue.

 

Advertising revenueand expenses in barter transactions are recorded at the fair value of theadvertising to be provided. The fair value is determined based upon amountsreceived in cash for similar advertisements from buyers unrelated to the otherparty in the barter transaction. When the revenue does not meet therequirements of Emerging Issues Task Force (“EITF”) No. 99-17, *Accounting for Advertising Barter Transactions,* no revenueis recognized.

 

Revenue fromfilm asset licensing agreements is recognized in accordance with Statement ofPosition (“SOP”) 00-02,*Accounting byDistributors or Producers of Films*. Revenues are recognized when allof the following have occurred:  anagreement is executed, the film is available for exhibition by the licensee,the license fee is fixed or reasonably determinable, collectibility isreasonably assured and the cost of each film is known or reasonablydeterminable. Revenue from film asset licensing agreements containing multiplefilm titles is allocated among the various film titles based on their relativeestimated fair values. Payments received from licensees prior to theavailability of a film are recorded as deferred revenue. Fees payable withterms in excess of one year are discounted for revenue recognition purposes atthe customer’s estimated incremental borrowing rate in accordance withAccounting Principles Board (“APB’) Opinion No. 21, *Interest onReceivables and Payables.*

 

***Taxes on Income***

 

Pursuant to thetax sharing agreement entered into with Hallmark Cards in March 2003, theCompany’s results of operations for tax purposes became a part of the HallmarkCards consolidated federal tax return as of and subsequent to March 2003.  However, the Company continues to account forincome taxes on a separate return basis. Accordingly, the Company accounts forincome taxes using an asset and liability method which requires the recognitionof deferred tax assets and liabilities for the expected future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases and netoperating loss and tax credit carryforwards. Deferred tax assets andliabilities are measured using enacted tax rates expected to be applied totaxable income in the years in which those temporary differences are expectedto be recovered or settled. The Company reduces deferred tax assets by avaluation allowance if it is more likely than not that some portion or all ofthe deferred tax assets will not be realized. Any paymentsreceived from Hallmark Cards under the tax sharing agreement are recorded as anincrease in additional paid-in capital and any future utilization of deferredtax assets generated after March 2003 will be recorded as a reduction inpaid-in capital, to the extent payments

 

11

----

 

were previously received from Hallmark Cards for such benefits underthe tax sharing agreement.

 

***Stock-Based Compensation***

 

The Companyaccounts for its stock-based employee compensation plan using the intrinsicvalue method under the recognition and measurement principles of APB Opinion No. 25,*Accounting for Stock Issued to Employees,*and related Interpretations. Accordingly, compensation cost for stock optionsissued to employees is measured as the excess, if any, of the quoted marketprice of the Company’s stock at the date of the grant over the exercise priceof the underlying stock options. In December 2002, the FinancialAccounting Standards Board (“FASB”) issued Statement of Financial AccountingStandards (“SFAS”) No. 148, *Accountingfor Stock-Based Compensation – Transition and Disclosure – an amendment of SFASNo. 123.*SFAS No. 148 requires certain additionaldisclosures of the estimated fair value of stock-based compensation. Suchestimated fair value is determined through the use of the Black-Scholes optionpricing model. SFAS No. 123, *Accounting for Stock-BasedCompensation,* encourages, but does not require, companies to recordcompensation cost for stock-based employee compensation plans at fair value.

 

Had compensationexpense for these plans been determined consistent with SFAS No. 123,Crown Media Holdings’ net loss and loss per share would have been increased tothe following pro forma amounts for the three months ended March 31, 2004and 2005:

 

**Pro Forma Effects**

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

 
| ** **                                              | ** ** | **Three  Months Ended March 31,** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                              | ** ** | **2004**                               | ** ** | **2005** | ** ** |
|                                                    |       |                                   |       |   |   |
| Net loss                                                |       | $                                      | (41,476    | ) | $ | (50,907 | ) |
| Pro forma stock options expense at estimated fair value |       | (677                                   | )          | (168 | ) |
| Stock plan expense included in net loss                 |       | —                                 |       | 7 |   |
| Pro forma net loss                                      |       | $                                      | (42,153    | ) | $ | (51,068 | ) |
| Weighted average shares                                 |       | 104,533                                |       | 104,533 |   |
| Pro forma net loss per share, basic and diluted         |       | $                                      | (0.40      | ) | $ | (0.49 | ) |

 

***Net Loss per Share***

 

Basic net lossper share is computed by dividing the net loss for the period by the weightedaverage number of common shares outstanding during the period. Diluted net lossper share is computed based on the weighted average number of common shares andpotentially dilutive common shares outstanding. The calculation of diluted netloss per share excludes potential common shares if the effect would beantidilutive. Potential common shares consist of incremental common sharesissuable upon the exercise of stock options and restricted stock units.Approximately 1.6 million and 1.4 million stock options for the three monthsended March 31, 2004 and 2005, respectively, have been excluded from thecalculations of earnings per share because their effect would have beenantidilutive.

 

***Translation of Foreign Currency***

 

The balancesheets and statements of operations of certain Crown Media Holdings’ foreignsubsidiaries are measured using local currency as the functional currency.Revenues, expenses and cash flows of such subsidiaries are translated into UnitedStates dollars at the average exchange rates prevailing during the period.Assets and liabilities are translated at the rates of exchange at the balancesheet date. Translation gains and losses are deferred as a component ofaccumulated other comprehensive income (loss). Foreign currency transactiongains and losses recorded upon the remeasurement of financial assets andliabilities denominated in currencies other than the functional currency of thesubsidiary are included in determining net loss for the period.

 

***Concentration of Credit Risk***

 

Financialinstruments, which potentially subject Crown Media Holdings to a concentrationof credit risk, consist

 

12

----

 

primarily of cash, restricted cash, cash equivalents and accountsreceivable. Generally, Crown Media Holdings does not require collateral tosecure receivables. Crown Media Holdings has no significant off-balance sheetfinancial instruments with risk of accounting losses.

 

***Reclassifications***

 

Certain reclassificationshave been made to conform prior periods’ financial information to the currentpresentation.

 

***Recently Issued AccountingPronouncements***

 

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

 

In December 2004, the FASB issued SFAS No. 123 (revised 2004), *Share-Based Payment*. SFAS No. 123R replaced SFAS No. 123, *Accounting for Stock-Based Compensation*, and superseded Accounting Principles Board Opinion No. 25,  *Accounting for Stock Issued to Employees*.  SFAS No. 123R will require compensation cost related to share-based payment transactions to be recognized in the financial statements. As permitted by SFAS No. 123, Crown Media Holdings elected to follow the guidance of APB Opinion No. 25, which allowed companies to use the intrinsic value method of accounting to value their share-based payment transactions with employees.  Based on this method, Crown Media Holdings did not recognize compensation expense in its financial statements as the stock options granted had an exercise price equal to the fair market value of the underlying common stock on the date of the grant.  SFAS No. 123R allows measurement of the cost of share-based payment transactions to employees at the fair value of the award on the grant date and recognition of expense over the requisite service or vesting period. SFAS No. 123R allows implementation using a modified version of prospective application,  under which compensation expense for the unvested portion of previously granted awards and all new awards will be recognized on or after the date of adoption.  SFAS No. 123R also allows companies to adopt SFAS No. 123R by restating previously issued financial statements,  basing the amounts on the expense previously calculated and reported in their pro forma footnote disclosures required under SFAS No. 123. The provisions of SFAS No. 123R will be adopted by Crown Media Holdings using the modified prospective method beginning January 1, 2006.

 

In March 2005, the SEC staff issuedguidance on FASB Statement No. 123 (revised 2004), *Share-Based Payment,* SFAS No. 123R.Staff Accounting Bulletin (“SAB”) No. 107 was issued to assist preparersby simplifying some of the implementation challenges of SFAS No. 123Rwhile enhancing the information that investors receive.  SAB No. 107creates a framework that is premised on two overarching themes: (a) considerablejudgment will be required by preparers to successfully implement SFAS No. 123R,specifically when valuing employee stock options; and (b) reasonableindividuals, acting in good faith, may conclude differently on the fair valueof employee stock options. Key topics covered by SAB No. 107 include: (a) valuationmodels – SAB No. 107 reinforces the flexibility allowed by SFAS No. 123Rto choose an option-pricing model that meets the standard’s fair valuemeasurement

 

13

----

 

objective; (b) expected volatility – the SAB provides guidance onwhen it would be appropriate to rely exclusively on either historical orimplied volatility in estimating expected volatility; and (c) expectedterm – the new guidance includes examples and some simplified approaches todetermining the expected term under certain circumstances.  The Companywill apply the principles of SAB No. 107 in conjunction with its adoptionof SFAS No. 123R.

 

**3. Subscriber Acquisition Fees**

 

Subscriberacquisition fees are comprised of the following:

 
| ** **                           | ** ** | **As of December 31,  2004** | ** ** | **As of March 31,  2005** | ** ** |
|--------------------------------------|------------|-----------------------------------|------------|--------------------------------|------------|
| ** **                           | ** ** | **(In thousands)**                | ** ** |
| Subscriber acquisition fees, at cost |       | $                                 | 236,447    |                           | $          | 237,940 |   |
| Accumulated amortization             |       | (116,434                          | )          | (129,152                       | )          |
| Subscriber acquisition fees, net     |       | $                                 | 120,013    |                           | $          | 108,788 |   |

 

*Ofthe net balance at March 31, 2005, the Company expects $28.3 million willbe recognized as a reduction of subscriber fee revenue and $80.5 million willbe recognized as subscriber acquisition fee expense in future periods. TheCompany expects to amortize the net balance at March 31, 2005, as follows:*

* *
| **Period Ended March 31,** | ** ** | ** ** | ** ** |
|---------------------------------|------------|------------|------------|
| **(in thousands)**              | ** ** | ** ** | ** ** |
| 2005                            |       | $          | 33,692     |   |
| 2006                            |       | 36,902     |       |
| 2007                            |       | 35,377     |       |
| 2008                            |       | 948        |       |
| 2009                            |       | 935        |       |
| 2010                            |       | 233        |       |
| Thereafter                      |       | 701        |       |
| Total  amortization             |       | $          | 108,788    |   |

* *

*Asof December 31, 2004, and March 31, 2005, the consolidated balancesheets also reflect subscriber acquisition fees payable of $35.9 million and$33.5 million, respectively. For the three months ended March 31, 2004 and2005, Crown Media United States made cash payments of $2.5 million and $3.9million, respectively.*

* *

**4. Program License Fees**

 

Program licensefees are comprised of the following:

 
| ** **                                                      | ** ** | **As of December 31,  2004** | ** ** | **As of March 31,  2005** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------------------|------------|--------------------------------|------------|
| ** **                                                      | ** ** | **(In  thousands)**               | ** ** |
| Program license fees — Hallmark Entertainment Distribution |       | $                                 | 144,848    |                           | $          | 122,986 |   |
| Program license fees — NICC                                |       | 2,448                             |       | 8,876                          |       |
| Program license fees — other affiliates                    |       | 5,906                             |       | 6,644                          |       |
| Program license fees — non-affiliates                      |       | 329,021                           |       | 330,166                        |       |
| Program license fees, at cost                                   |       | 482,223                           |       | 468,672                        |       |
| Accumulated amortization                                        |       | (167,993                          | )          | (156,696                       | )          |
| Program license fees, net                                       |       | $                                 | 314,230    |                           | $          | 311,976 |   |

 

Programming costs for the three months ended March 31,2004 and 2005, were $19.0 million and $28.0 million, respectively. Amortizationof program license fees for continuing operations, which is included as acomponent of programming cost in the accompanying consolidated statements ofoperations, was $19.0 million and $28.0 million, respectively, for the threemonths ended March 31, 2004 and 2005.

 

At December 31, 2004, and March 31, 2005, $7.7 million and$2.7 million of program license fees were

 

14

----

 

included inprepaid and other assets on the accompanying condensed consolidated balancesheets as the Company had made payments, but the airing windows had notcommenced.

 

License feespayable are comprised of the following:

 
| ** **                                                      | ** ** | **As of December 31,  2004** | ** ** | **As of March 31,  2005** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------------------|------------|--------------------------------|------------|
| ** **                                                      | ** ** | **(In  thousands)**               | ** ** |
| License fees payable — Hallmark Entertainment Distribution |       | $                                 | 151,980    |                           | $          | 162,750 |   |
| License fees payable — NICC                                |       | —                            |       | 4,358                          |       |
| License fees payable — non-affiliates                      |       | 191,576                           |       | 213,262                        |       |
| Total license fees payable                                      |       | 343,556                           |       | 380,370                        |       |
| Less current maturities                                         |       | (79,815                           | )          | (87,545                        | )          |
| Long-term license fees payable                                  |       | $                                 | 263,741    |                           | $          | 292,825 |   |

 

**5. Property and Equipment**

 

Property andequipment are comprised of the following:

 
| ** **                        | ** ** | **As of December 31,  2004** | ** ** | **As of March 31,  2005** | ** ** | **Depreciable Life  (In years)** | ** ** |
|-----------------------------------|------------|-----------------------------------|------------|--------------------------------|------------|----------------------------------|------------|
| ** **                        | ** ** | **(In  thousands)**               | ** ** | ** **                     | ** ** |
| Technical equipment and computers |       | $                                 | 38,947     |                           | $          | 14,512                           |       | 3-5 |   |
| Leased assets                     |       | 30,615                            |       | 17,363                         |       | 8-15                             |       |
| Furniture, fixtures and equipment |       | 2,078                             |       | 1,219                          |       | 5                                |       |
| Leasehold improvements            |       | 10,402                            |       | 3,236                          |       | 3-7                              |       |
| Construction-in-progress          |       | 161                               |       | 172                            |       |                             |       |
| Property and equipment, at cost   |       | 82,203                            |       | 36,502                         |       |                             |       |
| Accumulated depreciation          |       | (49,374                           | )          | (15,625                        | )          |                             |       |
| Property and equipment, net       |       | $                                 | 32,829     |                           | $          | 20,877                           |       |   |   |

 

Depreciationexpense related to property and equipment was $924,000 and $900,000 for thethree months ended March 31, 2004 and 2005, respectively.

 

Software and other intangible assets of $3.2million and $2.6 million as of December 31, 2004, and March 31, 2005,respectively, have been included in prepaid and other assets in theaccompanying condensed consolidated balance sheets.

 

**6. Reorganization**

 

In October 2002,the Company reorganized its operations in order to concentrate its efforts onthe Hallmark Channel in the U.S.  Thefollowing table displays the activity and balances of the reorganizationaccrual account from December 31, 2003, to March 31, 2005, which isincluded in the current portion of accounts payable and accrued liabilities inthe accompanying condensed consolidated balance sheets.

 
| ** **                                   | ** ** | **Severance**      | ** ** | **Facilities** | ** ** | **Satellite and  Transponder** | ** ** | **Total** | ** ** |
|----------------------------------------------|------------|--------------------|------------|----------------|------------|--------------------------------|------------|-----------|------------|
| ** **                                   | ** ** | **(In thousands)** | ** ** |
|                                         |       |               |       |           |       |                           |       |      |       |
| Balance at December 31,  2003           |       | $                  | 4          |           | $          | 1,523                          |       | $         | 13,511     |   | $ | 15,038 |   |
|                                         |       |               |       |           |       |                           |       |      |       |
| Adjustments  due to change in estimates, net |       | (4                 | )          | (126           | )          | (301                           | )          | (431      | )          |
|                                         |       |               |       |           |       |                           |       |      |       |
| Payments                                     |       | —             |       | (337           | )          | (3,550                         | )          | (3,887    | )          |
| Balance at December 31,  2004           |       | —             |       | 1,060          |       | 9,660                          |       | 10,720    |       |
|                                         |       |               |       |           |       |                           |       |      |       |
| Payments                                     |       |               |       | (60            | )          | (528                           | )          | (588      | )          |
|                                         |       |               |       |           |       |                           |       |      |       |
| Discontinued  operations                     |       | —             |       | (1,000         | )          | (8,671                         | )          | (9,671    | )          |
|                                         |       |               |       |           |       |                           |       |      |       |
| Balance at  March 31, 2005              |       | $                  | —     |           | $          | —                         |       | $         | 461        |   | $ | 461 |   |

 

15

----

 

**7. Credit Facility**

 

The Company has a credit agreement with a syndicate ofbanks, led by JP Morgan Chase Bank, under which the banks extended to theCompany a secured credit facility in the original amount of up to $320.0million.  The Company and the lendingbanks entered into the facility in 2001 and have subsequently amended the termsof this facility, with the most recent amendment on March 1, 2005.  The facility is guaranteed by the Company’ssubsidiaries and is secured by all tangible and intangible property of CrownMedia Holdings and its subsidiaries.  Thebank credit facility encompassed a term loan of $100.0 million and a revolvingline of credit of $220.0 million, inclusive of up to $20.0 million of lettersof credit available to be issued at the Company’s request.  Upon the consummation of sale of theinternational business, the Company repaid and retired the $100.0 million termloan along with $95.0 million on the revolving line of credit under the creditfacility. The credit facility now consists of a revolving line of credit of$220.0 million, which includes up to $20.0 million of letters of credit.  In addition, following such closing, anyborrowings by the Company of amounts in excess of the $180.0 million under therevolving line of credit will require approval of Hallmark Cards.

 

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

 

As of March 1, 2005, we entered intoAmendment No. 8 to the agreement for our bank credit facility.  This amendment extended the maturity date to May 31,2006, as well as made a number of other significant changes to the bank creditfacility including elimination of certain financial covenants, changes to andwaivers of financial covenants concerning 2004 violations and the futurecompliance, and a reduction in the interest rates and commitment fees under thecredit facility.

 

Several changes to financial covenants in theAmendment No. 7 to the bank credit facility were not effective until theForeign Asset Sale Effective Date.  TheForeign Asset Sale Effective Date did not occur in 2004, which was one of thereasons that the Company needed waivers of its compliance with certainfinancial covenants in its bank credit facility.  Amendment No. 8 waived the Company’snon-compliance with the following financial covenants:  (1) capital expenditures in 2004; (2) cashprogram acquisition guaranties in 2004; (3) trailing 12-month EBITDA forthe quarter ended December 31, 2004; (4) cash payments to televisiondistributors for subscribers in 2004; (5) net worth at December 31,2004; (6) leverage ratio for the quarter ended December 31, 2004; and(7) interest coverage ratio for the 2004 year.  Amendment No. 8 also deleted the networth covenant; amended the limit on the Company’s cash program guarantees in2005; amended the quarterly EBITDA requirements for the remainder of the loanterm; and amended the limit of cash payments to television distributors forsubscribers, the minimum number of subscribers and the minimum gross subscriberrevenue.  Further, pursuant to Amendment No. 8,the limitation on Restricted Payments was amended to allow us to make certainpayments to Hallmark Cards or its affiliates.

 

At December 31, 2004, and March 31,2005, Crown Media Holdings had outstanding borrowings of $310.0 million underthe credit facility and there were no letters of credit outstanding. At March 31,2005, $310.0 million of the outstanding balance bore interest at the Eurodollarrate (3.85% at March 31, 2005). Interestexpense on borrowings under the credit facility for the three months ended March 31,2004 and 2005, was $3.1 million, and $3.9 million, respectively.

 

16

----

 

**8. Related Party Long-TermObligations**

 

***HallmarkLetter of Credit***

 

Pursuant to Amendment No. 8 to the bankcredit facility, Hallmark Cards has provided an irrevocable letter of creditissued to JP Morgan Chase Bank by Citibank, N.A. in the amount of $320.0million, as credit support for our obligations under the Company’s creditfacility.  The support letter of creditwas reduced to $220.0 million upon the consummation of the sale of the Company’sinternational business and the reduction of the aggregate outstanding creditexposure of its lenders to $220.0 million. Drawdowns under the letter of credit may be made for amounts due andpayable under the credit facility. Amounts in excess of $180.0 million requirethe concurrence of Hallmark Cards.  Anyproceeds received by JP Morgan Chase Bank from drawing under this supportletter of credit will not be applied to repay the Company’s obligations, butwill be used to purchase on the part of Hallmark Cards from the bank lenderssubordinated participations in our obligations under its bank credit facility,junior in payment to the bank lenders under the bank credit facility.  The support letter of credit automaticallyexpires on May 31, 2006. The Company pays to Hallmark Cards, ascompensation for the support letter of credit, the amounts resulting from the2% reduction in the interest rate and the 0.3% reduction in the commitment feepayable by the Company under the bank credit facility as provided in Amendment No. 8.

 

***SeniorUnsecured Note***

 

In August 2003, the Company issued asenior unsecured note to HC Crown for $400.0 million. A portion of the proceedswas used to repurchase the Company’s outstanding trust preferred securities,and the balance of the proceeds, after expenses, was used to reduce amountsoutstanding under its bank credit facility.

 

The senior unsecured note payable to HC Crown does notrequire cash payments until August 2007. Instead, the principal amount ofthe senior unsecured note accretes at 10.25% per annum, compoundingsemi-annually, to $596.6 million at August 5, 2007.  From that date, interest at 10.25% per annumwill be payable semi-annually on the accreted value of the senior unsecurednote to HC Crown.  The note matures on August 5,2011, and is pre-payable by Crown Media Holdings at any time after August 5,2004, without penalty. At December 31, 2004 and March 31, 2005,$460.9 million and $472.6 million, respectively, of principal and 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 was initiallycapitalized and is being amortized as additional interest expense over the termof the note payable.

 

***Line of Credit Payable to HCCrown***

 

On December 14, 2001, the Company executed a$75.0 million promissory note with HC Crown maturing on the earlier of sixmonths from the termination of the credit facility or December 21,2007.  This line of credit is subordinateto the bank credit facility. The rate of interest under this line of credit isequal to LIBOR plus three percent, payable quarterly. At both December 31,2004, and March 31, 2005, borrowings under the note were $75.0 million.Accrued interest on the note of $6.1 million, is included in interest payableto HC Crown and $7.2 million is included in line of credit and interest payableto HC Crown as of December 31, 2004, and March 31, 2005, respectivelyon the accompanying condensed consolidated balance sheets.

 

***HallmarkObligations***

 

In connection with Amendment No. 8, by a letterdated February 28, 2005, Hallmark Cards confirmed to the Company thatneither Hallmark Cards nor any of its wholly-owned subsidiaries would demandpayment from the Company on certain obligations outstanding as of December 31,2004, until May 31, 2006, at the earliest. Furthermore, the Company doesnot intend to pay the aforementioned liabilities before May 31, 2006.  Therefore, the Company has classified theseliabilities as non-current liabilities on the accompanying consolidated balancesheet.

 

**9. Related Party Transactions**

 

***Tax Sharing Agreement***

 

On March 11, 2003, Crown Media Holdingsbecame a member of Hallmark Cards consolidated federal tax group and enteredinto a federal tax sharing agreement with Hallmark Cards (the “tax sharingagreement”). Hallmark

 

17

----

 

Cards includes Crown Media Holdings in its consolidated federal incometax return.  Accordingly, Hallmark Cardshas benefited from past tax losses and will benefit from future federal taxlosses, which may be generated by Crown Media Holdings.  Based on the tax sharing agreement, HallmarkCards has agreed to pay Crown Media Holdings all of the benefits realized orrealizable by Hallmark Cards as a result of including Crown Media Holdings inits consolidated income tax return, 75% in cash on a quarterly basis and thebalance when Crown Media Holdings becomes a federal taxpayer.  Under the tax sharing agreement, at HallmarkCards’ option, the non-interest bearing balance of the 25% in federal taxbenefits may also be applied as an offset against any amounts owed by CrownMedia Holdings to any member of the Hallmark Cards consolidation group underany loan, line of credit or other payable, subject to limitations under anyloan indentures or contracts restricting such offsets. As of December 31,2004, Hallmark Cards has not exercised this option.

 

The Company received $14.3 million and $21.4million under the tax sharing agreement during the three months ended March 31,2004 and 2005, respectively. These receipts have been recorded as an additionto paid-in capital.

 

***Costs Incurred on Crown MediaHoldings’ Behalf***

 

Since inception,Hallmark Entertainment has at times paid certain costs on behalf of Crown MediaHoldings. Hallmark Entertainment incurred $530,000 and $408,000 of costs onCrown Media Holdings’ behalf for the three months ended March 31, 2004 and2005, respectively. Non-interest bearing unreimbursed costs of $4.5 million and$4.9 million are included in payable to affiliates in the accompanyingcondensed consolidated balance sheets as of December 31, 2004, and March 31,2005, respectively.

 

***Services Agreement withHallmark Cards***

 

Crown Media Holdings entered into anIntercompany Services Agreement with Hallmark Cards, effective January 1,2003, under which Hallmark Cards agreed for a term of three years to provideCrown Media Holdings with tax, risk management, health safety, environmental,insurance, legal, treasury and cash management services and real estateconsulting services.  Under theagreement, the Company agreed to pay Hallmark Cards $515,000 per year for theseservices, plus out-of-pocket expenses and third party fees, payable in arrearson the last business day of each quarter.For each of the three months ended March 31, 2004 and 2005, Crown MediaHoldings had accrued $129,000 under the agreement. At December 31, 2004,and March 31, 2005, non-interest bearing unpaid accrued service fees andunreimbursed expenses of $8.6 million and $8.8 million, respectively, wereincluded in payable to affiliates in the accompanying condensed consolidatedbalance sheets.

 

***Film Asset Services Agreementwith Hallmark Entertainment***

 

The Companyentered into a film asset services agreement with Hallmark Entertainment, underwhich Hallmark Entertainment provides Crown Media Holdings with servicesrelated to the administration, distribution and other exploitation of theCompany’s film assets. The services agreement expires on December 31,2006, subject to cancellation by either party after the first orsecond year. In consideration for theservices provided by Hallmark Entertainment, Crown Media Holdings is obligatedto pay a service fee of $1.5 million per year, payable in quarterlyinstallments of $375,000. At both December 31, 2004, and March 31,2005, non-interest bearing unpaid accrued service fees of $375,000 were includedin payable to affiliates in the accompanying condensed consolidated balancesheets.

 

***Trademark Agreement withHallmark Cards***

 

Crown Media United States has trademarklicense agreement with Hallmark Licensing, Inc. for use of the “Hallmark”mark for the versions of the Hallmark Channel distributed in the United Statesand for the Hallmark Movie Channel. Crown Media International and Crown Entertainment had trademark licenseagreements with Hallmark Cards for use of the “Hallmark” mark for the versionof the Hallmark Channel distributed internationally.  The trademark license agreements for theUnites States Hallmark Channel and the Movie Channel expire on September 1,2005. The Company is not required to pay any fees under the trademark licenseagreements.

 

18

----

 

***Program License Agreements withHallmark Entertainment Distribution***

 

Crown MediaUnited States licenses programming for distribution in the United States fromHallmark Entertainment Distribution under a program license agreement, dated January 1,2001. Under this program license agreement, Crown Media United States licensesprograms owned or controlled by Hallmark Entertainment Distribution, as well asall programming produced by or on behalf of Hallmark Entertainment Distributionfor Crown Media United States. The program agreement has a term of five yearsand is automatically renewable for additional three-year periods, subject torate adjustments, so long as Hallmark Entertainment Distribution or itsaffiliates, 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.

 

Crown MediaInternational had a program license agreement with Hallmark EntertainmentDistribution dated January 1, 2001. The agreement would have expired on December 31,2005, subject to a renewal through December 31, 2010. Under the terms ofthe agreement, Crown Media International had the exclusive right to exhibitHallmark Entertainment Distribution produced programming in the territories inwhich Crown Media International operated during three 18-month windows. CrownMedia International also had the exclusive right to exhibit programming in marketswhere it did not currently operate, if it elected to distribute the channel inthose markets, subject to any agreement between Hallmark EntertainmentDistribution and a third party existing at the time Crown Media Internationallaunches the channel in those markets. In addition, under the agreement,Hallmark Entertainment Distribution was generally obligated to sell to CrownMedia International all of the programming it produces and Crown MediaInternational was obligated to purchase up to 50 programs produced per yearduring the term of the agreement.

 

If Crown Media United States sub-licenses anylicensed program to a third party, it 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 licensedprogramming to third parties during the three months ended March 31, 2004and 2005.  Amounts due to HallmarkEntertainment Distribution as a result of these sub-licensing agreements havebeen included in license fees payable to affiliates in the accompanying balancesheets as noted below.

 

Programming costs related to the Hallmark programagreements were $4.6 million and $6.7 million, respectively, for the threemonths ended March 31, 2004 and 2005. As of December 31, 2004, and March 31,2005, $152.0 million and $162.8 million, respectively, are included in licensefees payable to affiliates in the accompanying condensed consolidated balancesheets. The Company obtained a letter from Hallmark Cards whereas HallmarkCards or its subsidiaries will not demand payment of these license fees priorto May 31, 2006.

 

**10. Company ObligatedMandatorily Redeemable Preferred Interest and NICC License Agreements**

 

VISNowns a $25.0 million company obligated mandatorily redeemable preferredinterest in Crown Media United States (the “preferred interest”) issued inconnection with an investment by Crown Media International in Crown MediaUnited States. On November 13, 1998, HEN Domestic Holdings, Inc., awholly-owned subsidiary of Crown Media International, Vision Group, VISN andHenson Cable Networks, Inc. signed an amended and restated companyagreement governing the operation of Crown Media United States, which agreementwas further amended on February 22, 2001 and January 1, 2002 (the “companyagreement”).

 

 Underthe company agreement, the members agreed that if during any year ending after January 1,2005 and prior to December 31, 2009, Crown Media United States has netprofits in excess of $10.0 million, and the preferred interest has not beenredeemed, Crown Media United States will redeem the preferred interest in anamount equal to the lesser of: (i) such excess net profits; (ii) $5.0million; or (iii) the amount equal to the preferred liquidation preferenceon the date of redemption.  Crown MediaUnited States may voluntarily redeem the preferred interest at any time,however, it is obligated to do so on the date of redemption (December 31,2010). Due to the mandatory redemption provision of the preferred interest, on July 1,2003, the preferred interest was remeasured at fair value

 

19

----

 

and reclassified to non-current liabilities in accordance with theprovisions of SFAS No. 150.

 

Under the company agreement, Crown MediaUnited States may be required to make certain payments in regards toprogramming provisions to the National Interfaith Cable Coalition (“NICC”).  Specifically, Crown Media United States maybe required to pay license fees to NICC or fund production costs consisting of:(i) a total of $5.3 million per year, with consumer price indexescalations, for two recurring programming blocks produced by NICC; (ii) upto $10 million per year for an additional recurring “signature” series programblock 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 United Statesdoes not continue the NICC programming and funding commitments at the samelevels, NICC is entitled to compel Crown Media Holdings to repurchase all ofNICC’s Crown Media Holdings shares at their then-current market value no laterthan 60 days following the expiration of the amendment. Crown Media UnitedStates, however, can nullify this put by electing to continue the NICCprogramming and funding commitments at the same levels.

 

Pursuantto additional amendments effective January 1, 2002, and January 1, 2004,Crown Media United States agreed to advance NICC $3,000,000 in each of 2002,2003 and 2004 to help fund NICC’s cost of expanding its production operationsto produce the aforementioned programming. This advance will be recovered from the license fees payable for thisprogramming when such programming is produced and accepted by Crown MediaUnited States for distribution on the channel. These expenses are included ascomponents of affiliate programming costs in the accompanying consolidatedstatements of operations.   See Note 14regarding NICC’s threatened litigation against the Company.

 

Duringthe three months ended March 31, 2004 and 2005, Crown Media United Statespaid NICC $3.5 million and $2.6 million, respectively, related to the companyagreement, as amended.

 

**11. Employee Incentives**

 

In April 2003, the Company’s Board of Directors approved actionsto provide additional incentives to encourage retention of its employees. CrownMedia Holdings’ then outstanding stock options held by employees had exerciseprices significantly above the current market value of its Class A commonstock.  The Company made an offer in May 2003to senior 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 atotal of 5,126,732 options exchanged for 2,050,693 RSUs. Each RSU, uponvesting, represents the right to receive one share of Class A common stockor the value of the share in cash at the time of vesting.  The determination of whether RSUs will besettled in cash or common stock is made by the Company’s Board of Directors.The RSUs vest over three years in one-third increments on the anniversary ofthe grant date each year.

 

Options for 279,254 shares of common stock owned by certain executivesand vice presidents that were not exchanged are subject to variable planaccounting in which compensation is remeasured at each reporting date until theoptions are exercised, expire unexercised or are forfeited.

 

In May 2004,the Company’s Board of Directors approved an additional grant to employees of1,065,000 RSUs. The Employment RSUs, which constitute 70% of the award grantedin 2004, vest in equal one-third installments over the next three years on theanniversary of the grant date each year. The Company is accruing expenserelated to the Employment RSUs ratably over each installment’s vesting period.The Performance RSUs, constituting 30% of the award granted in 2004, vest onthe 3rd anniversary of the grant date, provided that the price ofthe Crown common stock is $14 or higher on that date. The Company will begin toaccrue compensation expense for the Performance RSUs when it becomes probablethat the price of the Company’s stock will be $14 or more on the 3rdanniversary of the grant date.

 

20

----

 

The Company is recording compensation expense based on the fair valueof the common stock or cash equivalent required to settle the RSUs at eachreporting period end during the vesting period of the RSUs. Such compensationexpense is calculated using variable plan accounting.

 

TheCompany recorded $2.3 million and $2.4 million, of compensation expenseassociated with the RSUs during the three months ended March 31, 2004 and2005, respectively, which has been recorded as a liability for restricted stockunits in the accompanying consolidated balance sheet and is included inselling, general and administrative expense in the accompanying consolidatedstatement of operations. TheCompany settled certain RSUs during the three months ended March 31, 2005,for approximately $4.2 million in cash. Additionally, in conjunction with theclose of the international transaction, the Company immediately vested andsettled RSUs held by international employees in May 2005 for approximately$4.0 million in cash.

 

**12. Segment Reporting**

 

The Company’s continuing operations arecurrently organized into two principal divisions representing operatingsegments: domestic channel and film distribution. The Company evaluatesperformance and allocates resources based on the results of these segments. Thekey operating performance criteria used in this evaluation include revenue,segment income (loss) and total assets. The results of operations of our international channel operating segmentare not included in the segment reporting as they are classified separately asdiscontinued operations in the Company’s consolidated financial statements (seenote 13).

 

Thefollowing tables present the Company’s key performance measures (in thousands):

 

*March 31, 2004*

 
| ** **                             | ** ** | **Domestic** | ** ** | **Film  Distribution** | ** ** | **Adjustments** | ** ** | **Consolidated** | ** ** |
|----------------------------------------|------------|--------------|------------|------------------------|------------|-----------------|------------|------------------|------------|
|                                   |       |         |       |                   |       |            |       |             |       |
| Total  revenue                         |       | $            | 28,798     |                   | $          | 7,129           |       | $                | (2,526     | )(1) | $ | 33,401 |   |
|                                   |       |         |       |                   |       |            |       |             |       |
| Segment  income (loss)                 |       | $            | (4,389     | )                      | $          | 1,995           |       | $                | 161        | (2) | $ | (2,233 | ) |
|                                   |       |         |       |                   |       |            |       |             |       |   |   |   |   |
| Depreciation  and amortization expense |       | (1,308       | )          | 828                    |       | (1,204          | )(3)       | (1,684           | )          |
|                                   |       |         |       |                   |       |            |       |             |       |
| Amortization  of film assets           |       | —       |       | (7,330                 | )          | —          |       | (7,330           | )          |
|                                   |       |         |       |                   |       |            |       |             |       |
| Subscriber  acquisition fee expense    |       | (9,473       | )          | 846                    |       | —          |       | (8,627           | )          |
|                                   |       |         |       |                   |       |            |       |             |       |
| Interest  expense                      |       | (536         | )          | (17,205                | )          | 3,523           | (2)        | (14,218          | )          |
| Loss from  continuing operations       |       | $            | (15,706    | )                      | $          | (20,866         | )          | $                | 2,480      |   | $ | (34,092 | ) |
|                                   |       |         |       |                   |       |            |       |             |       |
| Total assets                           |       | $            | 656,367    |                   | $          | 561,533         |       | $                | 333,779    | (4) | $ | 1,551,679 |   |

 

*March 31, 2005*

 
| ** **                             | ** ** | **Domestic** | ** ** | **Film  Distribution** | ** ** | **Adjustments** | ** ** | **Consolidated** | ** ** |
|----------------------------------------|------------|--------------|------------|------------------------|------------|-----------------|------------|------------------|------------|
|                                   |       |         |       |                   |       |            |       |             |       |
| Total  revenue                         |       | $            | 41,695     |                   | $          | 1,921           |       | $                | (3,047     | )(1) | $ | 40,569 |   |
|                                   |       |         |       |                   |       |            |       |             |       |
| Segment  income (loss)                 |       | $            | (5,042     | )                      | $          | (2,853          | )          | $                | 163        | (2) | $ | (7,732 | ) |
|                                   |       |         |       |                   |       |            |       |             |       |   |   |   |   |
| Depreciation  and amortization expense |       | (4,337       | )          | 5,803                  |       | (3,105          | )(3)       | (1,639           | )          |
|                                   |       |         |       |                   |       |            |       |             |       |
| Amortization  of film assets           |       | —       |       | (5,681                 | )          | —          |       | (5,681           | )          |
|                                   |       |         |       |                   |       |            |       |             |       |
| Subscriber  acquisition fee expense    |       | (13,564      | )          | 846                    |       | —          |       | (12,718          | )          |
|                                   |       |         |       |                   |       |            |       |             |       |
| Interest  expense                      |       | (1,096       | )          | (18,504                | )          | 2,704           | (2)        | (16,896          | )          |
| Loss from  continuing operations       |       | $            | (24,039    | )                      | $          | (20,389         | )          | $                | (238       | ) | $ | (44,666 | ) |
|                                   |       |         |       |                   |       |            |       |             |       |
| Total assets                           |       | $            | 790,867    |                   | $          | 521,170         |       | $                | 222,983    | (4) | $ | 1,535,020 |   |

 

21

----

 

----

(1) Adjustment represents netting ofcertain subscriber acquisition fee expense against revenue not allocated todomestic segment and film asset license fees from international sources.

(2) Represents amounts not allocated tosegments that are reviewed by our chief operating decision maker.

(3) Represents programming amortizationexcluded from individual segment income (loss) calculations.

(4) Represents assets held for sale.

 

No individual pay television distributor accounted for more than 15% ofthe Company’s consolidated subscribers for the three months ended March 31,2004 and 2005.

 

**13.  Assets Held for Sale and DiscontinuedOperations**

 

On February 23, 2005, the Company signedan agreement for the sale of these assets and obtained other agreementsenabling the Company to then conduct the sale on an “as is” basis.  The sale closed on April 26, 2006.  The accompanying balance sheet as of March 31,2005, presents the international channel and film assets as “held for sale” pursuantto SFAS No. 144*Accounting for theImpairment or Disposal of Long-Lived Assets*.  Liabilities associated with these assets aresimilarly classified.  The accompanyingcondensed consolidated statements of operations and cash flows for each of thethree month periods ended March 31, 2004 and 2005 present the associatedresults of operations and cash flows of the international assets as “discontinuedoperations.”

 

The carrying amounts of the major classes ofassets and liabilities included in the disposal group are comprised of thefollowing:

 
| ** **                                | ** ** | **As of March 31, 2005** | ** ** |
|-------------------------------------------|------------|-------------------------------|------------|
| ** **                                | ** ** | **(In thousands)**            | ** ** |
|                                      |       |                          |       |
| Cash                                      |       | $                             | 112        |   |
| Accounts  receivable, net                 |       | 16,079                        |       |
| Program  license fees                     |       | 41,345                        |       |
| Prepaid and  other assets                 |       | 9,909                         |       |
| Property and  equipment, net              |       | 10,320                        |       |
| Film assets,  net                         |       | 145,218                       |       |
| Accounts  payable and accrued liabilities |       | (26,075                       | )          |
| License fees  payable                     |       | (10,755                       | )          |
|                                      |       |                          |       |   |
| Net assets  of disposal group             |       | $                             | 186,153    |   |

 

22

----

 

The net losses from discontinued operationsduring each of the three month periods ended March 31, 2004 and 2005,consisted of the following:

 
| ** **                         | ** ** | **As of March 31,** | ** ** |
|------------------------------------|------------|--------------------------|------------|
| ** **                         | ** ** | **2004**                 | ** ** | **2005** | ** ** |
| ** **                         | ** ** | **(In thousands)**       | ** ** |
| ** **                         | ** ** | ** **               | ** ** | ** ** | ** ** |
| Revenue                            |       | $                        | 24,933     |   | $ | 26,214 |   |
| Costs and  expenses                |       | (30,293                  | )          | (30,190 | ) |
| Interest  expense                  |       | (1,550                   | )          | (1,772 | ) |
| Income tax  provision              |       | (474                     | )          | (493 | ) |
| Loss from  discontinued operations |       | $                        | (7,384     | ) | $ | (6,241 | ) |

 

Effective February 23, 2005, the Companyceased depreciating and amortizing certain of the international assets held forsale.  Had the Company not ceased suchdepreciation and amortization, the loss for discontinued operations for thethree months ended March 31, 2005 would have included an additional$995,000 of depreciation and amortization expense and an additional $1.8million of amortization of film assets.

 

Assets held for sale as of March 31,2005, of $223.0 million were comprised of $77.8 million of assets previouslyincluded in our international segment and $145.2 million of assets previouslyincluded in our film distribution segment.

 

Interest expense includes an allocation ofinterest related to the Company’s bank credit facility that was required to bepaid as a result of the sale.  Theallocation was required by Emerging Issues Task Force (“EITF”) Issue No. 87-24,*Allocation of Interest to Discontinued Operations*.  Such interest expense amounted to $1.1million and $1.4 million for the three month periods ended March 31, 2004and 2005, respectively.  Upon receipt ofcash from the sale, the Company was required to repay and retire the $100.0million of the Company’s bank credit facility.

 

**14. Commitments andContingencies**

 

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

 

In May 2005, we received a letter from NationalInterfaith Cable Coalition, Inc. threatening litigation in regard to anAmendment dated February 22, 2001 to the Amended and Restated CompanyAgreement of Crown Media United States. The Amendment is described below under “Crown Media United StatesAmended and Restated Company Agreement” in Item 13, Certain Relationships andRelated Transactions.  The letter claimsthat, among other things, the Company and Hallmark Entertainment, Inc. havenot honored their commitments relating to the production and financing ofcertain NICC and “faith and values” programming for broadcast on the HallmarkChannel in the United States.   NICCalleges that we and HEI have materially breached the Amendment, causingsubstantial damages to NICC in an amount which exceeds$100.0 million.  The letter furtherindicates that NICC intends to file litigation for breaches of the Amendmentunless we agree, by June 1, 2005, to enter into a new, extended agreementwith NICC for the production, promotion and funding of programming.  We believe that the Company and HEI have notbreached the Amendment.  We cannot,however, predict at this time whether the letter will result in litigation, anamendment or other resolution. Accordingly, we have not provided for any amountof loss in these condensed financial statements for this matter.

 

23

----

 

**ITEM 2.**** *Management’s Discussion and Analysisof Financial Condition and Results of Operations***

 

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

 

**Description of Business and Overview**

 

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

 

CrownMedia Holdings owns and operates the Hallmark Channel and the Hallmark MovieChannel in the United States and, prior to the sale of its internationalbusiness, the Hallmark Channel in various countries throughout the world.  At the end of the first quarter, the HallmarkChannel was in 67.7 million homes in the United States and 60.1 million homesinternationally.  The Hallmark Channel inthe United States has been successful in increasing overall ratings.  During the first quarter of 2005, a newprogramming concept, Hallmark Channel Mystery Movies, was introduced.  This new programming concept premiered onFriday nights during the first quarter of 2005 and each of the movies averageda household coverage rating of 1.3, which was a nearly 60% increase from thesame period in the prior year.  Inaddition, the Hallmark Channel in the United States premiered a number of otheroriginal movies that also resulted in very strong ratings.  The success of our programming and ratingshad a positive impact on the demand on our advertising in the first quarter of2005.  As a result, our advertising salesincreased significantly during the first quarter of 2005 as compared to thefirst quarter of 2004.  Enhancedprogramming and increased ratings are also important tools to use to driveincreased distribution with cable operators.

 

On April 26,2005, the sale of our international business was completed.  Proceeds from the sale have been used to repayand retire $100.0 million of our bank credit facility and reduce theoutstanding balance on our $220.0 million revolving credit facility. Thecompletion of the sale of the international business has allowed Crown MediaHoldings to focus on the growth and success of the Hallmark Channel in theUnited States.

 

CrownMedia Holdings also owns a film library. The film library has approximately 640 titles.  Through its wholly owned subsidiary, CrownMedia Distribution, Crown Media Holdings distributes titles from the library ina variety of television media including broadcast, cable, Video-on-Demand andHigh Definition Television. In addition, the Company utilizes the film libraryfor programming content on the Hallmark Channels. The Company has increased itsinternal use of its film assets on the domestic channel in 2005 as compared to theprior year.

 

Alsoin the first quarter of 2005, Crown Media Holdings launched its second 24-hourlinear channel, Hallmark Movie Channel. The Hallmark Movie Channel will focus on movies and mini-series and willutilize content from our film library for programming.  The launch of the Hallmark Movie Channel isan opportunity for Crown Media Holdings to build a second programming asset,use this programming asset as a value added enhancement to increasedistribution of the Hallmark Channel, and further leverage the content in ourfilm library.

 

AsCrown Media Holdings and the Hallmark Channel continue to develop, the corefocus for the business remains unchanged. First, distribution must continue to expand. While recent ratingsperformance ranks the Hallmark Channel in the top ten of cable networks, interms of distribution, the Hallmark Channel is only in the top 40 cablenetworks. Increased distribution should improve not only our subscriberrevenue, but should also improve our advertising revenue. The combination ofour current ratings with increased distribution should also have a positiveimpact on advertising revenue. As noted above, increased distribution in and ofitself will enhance advertising sales simply because of the increased viewer universe.However, combining growing distribution with increasing ratings is more powerfulin terms of advertising revenue. As a result, the Hallmark Channel willcontinue

 

24

----

 

tofocus on enhancing the programming schedule through new series, additionaloriginal movies such as the recent Mystery Movies, and through uniquescheduling concepts.

 

Inaddition, we plan to focus on library sales. The Crown Media film library is alarge collection of award winning movies and mini-series. It is unique in thatit is such a large collection of family oriented films. We plan to use thelibrary on the Hallmark Channel, the Hallmark Movie Channel and for sales tothird parties.

 

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

 

TheHallmark Channel in the United States faces short-term and long-term challengeson the distribution front.  As notedabove, the near-term focus remains on growing the subscriber base.  One of the nine largest multiple serviceoperators has been our largest source of subscriber growth over the last 18months due to contractual monetary incentives, and we believe that we willcontinue to grow our subscriber base with this multiple systems operator in thefuture.  The long-term distributionchallenges will be renewing our distribution arrangements with the multiplesystem operators as they expire.  While theeconomics of the renewals is unknown and could have a significant impact on ourbusiness, we believe that the success of the Hallmark Channel in terms ofratings and the environment we have created with our programming schedule willenhance our renewal discussions. We also believe that our ability to offer tothe multiple systems operators a second channel, the Hallmark Movie Channel, isa value added component of the renewal equation.  The largest factors contributing to theeconomics of the distribution agreements are license fees and subscriberacquisition fees.

 

TheHallmark Channel continues to improve its ratings.  Three factors have contributed to the ratingsimprovements of the Channel: acquired series and movies, original productionsand marketing.  Acquired series rangingfrom *Little House* and *Perry Mason*to *Walker, Texas Ranger* and *M*A*S*H* have consistently delivered strong ratings acrossall day-parts.  Original productions areour most high profile programs and generate the channel’s highest ratings.  Original productions are significant inhelping our distribution and advertising sales teams sell the channel. Substantially,all of our original programming is provided by Hallmark Entertainment, asubsidiary of Hallmark Cards. The recent success of the Mystery Movies andother recent originals drives this point home.

 

Themarketing and promotion strategy is another essential part of the ratingsequation.  Marketing and promotion areresponsible for attracting viewers to our big events as well as buildingawareness of the channel in general.

 

Tocontinue the ratings growth and enhance the demographics of our viewers, theHallmark Channel must continue to invest in programming and marketing.  For the Hallmark Channel to continue toincrease its attractiveness to distributors and advertisers, it has to increasethe ratings, but also attract a younger more upscale audience, which isgenerally more attractive to advertisers.

 

Strongdistribution and ratings growth delivering to larger audiences has made itpossible for the advertising sales to grow rapidly over the last fewyears.  To advertisers, the HallmarkChannel offers a strong brand, positive environment and family friendly programmingwith a successful growth pattern.  Thesecharacteristics have enabled the channel to sell to advertisers in the packagedgoods and pharmaceutical industries.  Thenext step for the Hallmark Channel will be to deliver the younger more upscaleaudience needed to attract advertisers from the attractive financial servicesand automotive industries.

 

**International Business**

 

The Company sold its international business to a groupof investors comprised of Equity Partners, 3i and U.K. executive David Elstein (collectively, the “buyer”) in a transaction thatclosed on April 26, 2005. The sale included the international versions ofthe Hallmark Channel distributed outside the United States, the internationalrights to over 580 titles in the Crown Media film library, and the networkbroadcast facility based in Denver, Colorado. The sale price was $242.0 million, subject to certain purchase priceadjustments relating to receivables acquired and working capital changes. Upon closingof the transaction, the Company received cash proceeds of approximately $209.3million; such proceeds were net of approximately $12.7 million paid to thebuyer for future services to be provided by the buyer under a services contractand $20.0 million related to certain accounts receivable not acquired

 

25

----

 

by the buyer. Within 45 days from the close of the transaction, the purchase price maybe adjusted for certain minimum working capital considerations, guarantees andcommitments, which we estimate will reduce the net cash proceeds by approximatelyan additional $2.0 million in the aggregate. The Company agreed to pay thebuyer approximately $24.1 million over a specified number of years to cover thefair value amount of certain obligations transferred with the internationalbusiness. Proceeds from the transaction were used by Crown Media Holdings toreduce outstanding indebtedness under its bank credit facility and to paytransaction fees, restricted stock unit settlements, and employment contract terminationsand severance for certain executives who were involved in the Company’sinternational business and not retained by the buyer.

 

Substantiallyall of the employees of the international business as well as the broadcastfacility were retained by the buyer. Subsequent to the sale, the Company has no continuing economicinvolvement with the operations of the international business.

 

The international business is classified in thefinancial statements at March 31, 2005 and for the three months ended March 31,2004 and 2005, as assets held for sale and discontinued operations,respectively.

 

**Revenuefrom Continuing Operations**

 

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

* *

*Subscriber Fees*

 

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

 

Rateswe receive per subscriber vary according to:

 

•                                          the level of sophistication and degree of competition in themarket;

 

•                                          the relative position in the market of the distributor andthe popularity of the channel;

 

•                                          the packaging arrangements for the channel; and

 

•                                          other commercial terms and length of the contract term.

 

We arein continuous negotiations with our existing distributors to increase oursubscriber base in order to enhance our advertising results. We are oftensubject to requests by distributors to pay subscriber acquisition fees foradditional subscribers or to waive or accept lower subscriber fees if certainnumbers of additional subscribers are provided. We also may help fund thedistributors’ efforts to market our channels or we may permit distributors tooffer limited promotional periods without payment of subscriber fees. As wecontinue our efforts to add subscribers, our 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.

 

Ourchannel is usually offered as one of a number of channels on either a basictier or part of other program packages and is not generally offered on a stand-alonebasis. Thus, while a cable or satellite customer may subscribe and unsubscribeto the tiers and program packages in which our channel is placed, thesecustomers do not subscribe and unsubscribe to our channel alone.  We are not provided with information from thedistributors on their overall

 

26

----

 

subscriberchurn and in what manner their churn rates affect our subscriber counts;instead, we are provided information on the total number of subscribers whoreceive the Hallmark Channel.

 

Oursubscriber count depends on the number of distributors carrying the HallmarkChannel and the size of such distributors as well as the program tiers on whichour channel is carried by these distributors. From time to time, we experiencedecreases in the number of subscribers as promotional periods end, or as adistributor arrangement is amended or terminated by us or the distributor.Changes to distribution arrangements in the first quarter of 2005 have not beensignificant. Management analyzes the estimated effect each new or amendeddistribution agreement will have on revenues and costs. Based upon theseanalyses, management endeavors to achieve a fair combination of subscribercommitments and subscriber acquisition fees with each of our domesticdistributors.

 

#### A*dvertising*

 

Advertisingsales generally are made on the basis of a price per advertising spot or perunit of audience measurement (for example, a ratings point). Thus, ouradvertising revenues are heavily dependent on the viewershipof our channel. Prices vary on a market-by-market basis. Rates differ amongmarkets depending on audience demographics.

 

In theU.S., our advertising rates are generally calculated on the basis of an agreedupon price per unit of audience measurement in return for a guaranteedcommitment by the advertiser. We commit to provide advertisers certain ratinglevels in connection with their advertising. Revenue is recorded net ofestimated delivery shortfalls, which are usually settled by providing theadvertiser additional advertising time. Advertising rates also vary by time ofyear due to seasonal changes in television viewership.

 

*Film Asset License Fees*

 

Crown Media Distributiongenerates revenue from the film assets by granting licenses to exhibit thefilms to third parties in the United States We are also using the films asprogramming for our channel and the Movie Channel. Customers for our filmassets consist of other television channels, home video distributors andbrokers who resell rights to our film assets. License fees for our film assetsare generally negotiated based upon the size of the potential audience who willbe viewing the programming.

 

**Costof Services**

 

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

 

**CriticalAccounting Policies, Judgments and Estimates**

 

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

 

For further information regarding our criticalaccounting policies, judgments and estimates, please see the Notes to Unaudited Consolidated Financial Statements contained inthis Report and “Critical Accounting Policies, Judgments and Estimates”beginning on page 32 of the Company’s Annual Report on Form 10-K forthe year ended December 31, 2004, filed with the SEC.

 

27

----

 

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

 

In 2005 and in prioryears, we entered into a number of significant transactions with Hallmark Cardsand its subsidiaries. These transactions include, among other things,programming, trademark licenses, administrative services, a line of credit, a taxsharing agreement and the issuance of a $400.0 million senior unsecurednote. For information regarding such transactions and transactions with otherrelated parties, please see “Effects of Transactions with Related and CertainOther Parties” beginning on page 34 of the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2004, filed with the SEC.

 

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

##  

In the table below, we provide selected historicalconsolidated financial and other data of Crown Media Holdings and itssubsidiaries. The following selected consolidated statement of operations datafor three months ended March 31, 2004 and 2005, 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.

 
| ** **                                               | ** ** | ** **               | ** ** | ** **   | ** ** | **Percentage Change** | ** ** |
|----------------------------------------------------------|------------|--------------------------|------------|--------------|------------|-----------------------|------------|
| ** **                                               | ** ** | **As of March 31,** | ** ** | **2005 vs.** | ** ** |
| ** **                                               | ** ** | **2004**                 | ** ** | **2005**     | ** ** | **2004**              | ** ** |
| Revenues:                                                |       |                     |       |         |       |                  |       |
| Subscriber fees                                          |       | $                        | 2,373      |         | $          | 4,610                 |       | 94 | % |
| Advertising                                              |       | 23,738                   |       | 33,876       |       | 43                    | %          |
| Film asset license fees                                  |       | 7,290                    |       | 2,083        |       | -71                   | %          |
| Total revenues                                           |       | 33,401                   |       | 40,569       |       | 21                    | %          |
| Cost of Services:                                        |       |                     |       |         |       |                  |       |
| Programming costs                                        |       | 19,023                   |       | 28,022       |       | 47                    | %          |
| Amortization of film assets                              |       | 7,330                    |       | 5,681        |       | -22                   | %          |
| Subscriber acquisition fee amortization                  |       | 5,941                    |       | 9,508        |       | 60                    | %          |
| Operating costs                                          |       | 3,925                    |       | 1,796        |       | -54                   | %          |
| Total cost of services                                   |       | 36,219                   |       | 45,007       |       | 24                    | %          |
| Selling, general and administrative expense              |       | 12,935                   |       | 13,502       |       | 4                     | %          |
| Marketing expense                                        |       | 4,121                    |       | 9,830        |       | 139                   | %          |
| Loss from continuing operations before interest  expense |       | (19,874                  | )          | (27,770      | )          | 40                    | %          |
| Interest expense                                         |       | (14,218                  | )          | (16,896      | )          | 19                    | %          |
| Loss from continuing operations                          |       | (34,092                  | )          | (44,666      | )          | 31                    | %          |
| Loss from discontinued operations                        |       | (7,384                   | )          | (6,241       | )          | -15                   | %          |
| Net Loss                                                 |       | $                        | (41,476    | )            | $          | (50,907               | )          | 23 | % |
|                                                     |       |                     |       |         |       |                  |       |
| **Other Data:**                                          |       |                     |       |         |       |                  |       |
| Net cash used in operating activities                    |       | $                        | (9,184     | )            | $          | (12,859               | )          | 40 | % |
| Capital expenditures                                     |       | $                        | (64        | )            | $          | (248                  | )          | 288 | % |
| Net cash provided by financing activities                |       | $                        | 24,300     |         | $          | 21,243                |       | -13 | % |
| Net cash used in discontinued operations                 |       | $                        | (11,544    | )            | $          | (4,997                | )          | -57 | % |
| Total domestic day household ratings (1)(3)              |       | 0.640                    |       | 0.705        |       | 10                    | %          |
| Total domestic primetime household ratings (2)(3)        |       | 0.882                    |       | 0.962        |       | 9                     | %          |
|                                                     |       |                     |       |         |       |                  |       |
| Total subscribers at period end:                         |       |                     |       |         |       |                  |       |
| Hallmark Channel – International                    |       | 57,254                   |       | 60,132       |       | 5                     | %          |
| Hallmark Channel – U.S.                             |       | 57,586                   |       | 67,716       |       | 18                    | %          |
| Total subscribers                                        |       | 114,840                  |       | 127,848      |       | 11                    | %          |

 

28

----

 

----

(1)  Total day isthe time period measured from the time each day the broadcast of commerciallysponsored programming commences to the time such commercially sponsoredprogramming ends.

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

(3)  These Nielsenratings are for the time period January 1 through March 31.

 

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

 

#### *ThreeMonths Ended March 31, 2004 Compared to Three Months Ended March 31,2005*

####  

*Revenue.*

 

 Our revenue from continuing operations, whichis comprised of subscriber fees, advertising and film asset license fees,increased 21% for the three months ended March 31, 2005. Our 94% increase in subscriber fee revenue forthe three months ended March 31, 2005, was a result of the expiration offree carriage periods for certain of our domestic distributors. Many of thedistribution deals we have require us to provide a period of free carriage tothe cable operator. Subscriber acquisition fee expense recorded as a reductionof revenue was $3.2 million for the three months ended March 31, 2005, and$2.7 million for the comparable period in 2004. Subscribers have increased as aresult of previously amended distribution agreements in the United States,which provided for incentives for growth in distribution. The ability toincrease our subscriber base is important both in terms of growing oursubscriber revenue and our advertising sales. Our enhanced programming schedule andincreased ratings are important tools for increases in our subscriber universe.

 

The increase in advertising revenue to $33.9 million forthe three months ended March 31, 2005, compared to $23.7 million for thethree months ended March 31, 2004, reflects the following during 2005: the18% growth in domestic subscribers; an increase in household day ratings of 10%in the United States; and an increase in advertising rates of approximately 10%.As we continue to grow distribution and ratings, we are able to attractadditional advertisers to our domestic Channel, which generally puts upwardpressure on advertising rates. The number of our advertisers increased from 300at March 31, 2004, to 425 at March 31, 2005. Generally, as we have expandedour domestic subscribers and provided higher rated programming, our advertisingrevenues have increased. The three factors noted above, subscriber universe,ratings and advertising rates are the three critical drivers of advertisingsales. We anticipate growth across each of these factors to continue.

 

Among the 52 ad-supportedcable channels in the United States market, the Hallmark Channel ranked 9thin total day with a 0.705 household rating for the first quarter of 2005 and 15thfor primetime with a 0.962 household rating for the same quarter based onNielsen ratings. This ratings performance is significant, particularly becausethe Hallmark Channel is not a fully distributed network. Most of the channelsthat rate above the Hallmark Channel have higher levels of distribution.

 

Revenuefrom the sale of our film assets totaled $2.1 million for the three months endedMarch 31, 2005, compared with $7.3 million for the comparableperiod in 2004.  During the first quarter of 2004, the Company signed alarge sale agreement with one customer, which did not occur during the firstquarter of 2005. Generally, our library sales are condensed in the second halfof the year as this coincides with our customers scheduling of the upcomingprogramming schedules.

 

*Cost of services. *Cost of services as apercent of revenue increased to 111% in 2005, as compared to 108% in 2004. Thisincrease was primarily due to the changes in operating expenses explainedbelow.

 

Totalprogramming costs for the three months ended March 31, 2005, increased 47%due to our focus on retaining higher qualityseries programming such as *M*A*S*H*, *JudgingAmy,*and *J.A.G*.and the related amortization. Inaddition, the Hallmark Channel introduced the Mystery Movies in the firstquarter of 2005. The

 

29

----

 

seriesand new original Mystery Movies have been important to the Hallmark Channel indriving our ratings. In addition, the new programming schedule has beenimportant in terms of driving increased distribution. The decrease inamortization of film assets was primarily due to a decrease in the internal useof the library assets for the three months ended March 31, 2005,substantially offset by the reduction in third party licenses of library assets.During the fourth quarter of 2004, we commenced the utilization of more moviesand mini-series from our library on the domestic channel.

 

As noted above, theCompany amended distribution agreements with multiple system operators in priorperiods. Generally, our distribution agreements require the Company to paysubscriber acquisition fees to distributors for additional subscribers. Oursubscribers increased from 57.6 million at March 31, 2004, to 67.7 millionat March 31, 2005, and the Company incurred approximately $41.8 million ofsubscriber acquisition fees primarily for such additional subscribers. TheCompany amortizes these costs over the remaining life of the distributionagreement, which has resulted in a 60% increase in our subscriber acquisitionfee amortization expense for the period ended March 31, 2005, as comparedto the prior year period.

 

*Selling,general and administrative expense.*** Our selling, generaland administrative expense increased 4% primarily due to an increase inconsulting expense and audit fees associated with our requirements underSarbanes-Oxley.

 

*Marketingexpense.** *Our marketing expense increased139% primarily due to the first quarter 2005 Mystery Movie marketing campaignfor the Hallmark Channel. In order to build upon the success of our 2004Holiday promotion and assist with sales in our upfront season by driving upratings, the Company has run the Mystery Movie promotion commencing in 2005. Theprior year’s marketing activity was significantly less as there were not asmany tent pole programming events in the first quarter of 2004.

 

*Interestexpense.** *Interest expense increased for thethree months ended March 31, 2005, compared to March 31, 2004, by$2.7 million.  This increase wasprimarily due to interest on our $400.0 million senior unsecured note payablecommencing August 5, 2003, which involves interest paid on compoundedamounts and was $11.7 million for the quarter ended March 31, 2005, and$10.6 million for the quarter ended March 31, 2004.

 

*Lossfrom Continuing Operations.** *Loss from operationsfor the three months ended March 31, 2005, was $44.7 million. Loss from continuingoperations for the three months ended March 31, 2004, was $34.1 million. Ourloss from continuing operations increased primarily due to (1) $5.7million increase in marketing expenses to continue to drive ratings (2) increasesin loss generated from library sales and internal use of $3.6 million primarilydue to incremental internal use of the film library product on the HallmarkChannels (3) increase in selling, general and administrative expense of approximately$1.0 million (4) and an increase in interest expense of $2.7 million due torelatively higher borrowings during the first quarter of 2005 as compared tothe prior year period. These increases are partially offset by subscriber andadvertising revenue increasing greater than programming costs.

 

*Lossfrom Discontinued Operations.** *Lossfrom discontinued operations for the three months ended March 31, 2005,was $6.2 million. Loss from discontinued operations for the three months ended March 31,2004, was $7.4 million. Loss from discontinued operations was less for thethree months ended March 31, 2005, as compared to the comparable periodfor 2004, because revenues were $1.2 million greater for the three months endedMarch 31, 2005, while expenses remained relatively level for both periods.

 

## **Liquidityand Capital Resources**

 

Cash used in operating activities from continuingoperations was $9.2 million and $12.9 million for the three months ended March 31,2004 and 2005, respectively, while the loss from continuing operations increasedin the first quarter of 2005 by $10.6 million, substantially all of the increasedloss was attributable to non-cash depreciation and amortization.

 

Cash used in investingactivities was $64,000 and $248,000 for the three months ended March 31,2004 and 2005, respectively.  This increaseis due to a increase in capital expenditures during2005 primarily for technical equipment and computers.

 

30

----

 

Cash provided by financing activities was $24.3 millionand $21.2 million for the three months ended March 31, 2004 and 2005, respectively. During the quarters ending March 31, 2004and 2005, we received proceeds of $14.3 million and $21.4 million,respectively, from our tax sharing agreement with Hallmark Cards. We borrowed $10.0million under our credit facility to meet our operating demands during thefirst quarter of 2004.

 

Cash used in discontinued operations was $11.5 millionand $5.0 million for the three months ended March 31, 2004 and 2005,respectively.  Cash was used primarily tofund operating expenditures related to losses from discontinued operations of $7.4million and $6.2 million for the three months ended March 2004 and 2005,respectively. The significant decrease in cash used by discontinued operationsis primarily due to a significant reduction of international payables in thefirst quarter of 2004. In the first quarter of 2005, the Company did not retirethe same level of liabilities. This change in liability movements, coupled withmanagement’s incremental focus on collections of accounts receivable in 2005,resulted in the $6.5 million reduction in cash utilization by the internationaloperations.

 

The following table aggregates all of our contractualcommitments as of March 31, 2005.

 
| ** **                                                           | ** ** | **Scheduled Payments by Period** | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------|------------|
| **Contractual Obligations**                                          | ** ** | **Total**                        | ** ** | **Less than 1  Year** | ** ** | **2-3  Years** | ** ** | **4-5  Years** | ** ** | **After 5 Years** | ** ** |
| Credit Facility and Interest Payable (a)                             |       | $                                | 310.4      |   | $ | 100.4 |   | $ | 210.0 |   | $ | — |   | $ | — |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Company Obligated Mandatorily  Redeemable Preferred Interest         |       | 25.0                             |       | 2.6 |   | 10.0 |   | 10.0 |   | 2.4 |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| HC Crown Line of Credit                                              |       | 82.2                             |       | 7.2 |   | 75.0 |   | — |   |   |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Senior Unsecured Note to HC Crown, including  accretion              |       | 596.6                            |       | — |   | — |   | — |   | 596.6 |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Capital Lease Obligations                                            |       | 22.8                             |       | 2.5 |   | 5.0 |   | 1.6 |   | 13.7 |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Operating Leases                                                     |       | 45.0                             |       | 12.6 |   | 19.1 |   | 10.5 |   | 2.8 |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Other Obligations                                                    |       |                             |       |   |   |   |   |   |   |   |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Program license fees payable to non-affiliates and NICC              |       | 228.4                            |       | 87.5 |   | 90.2 |   | 39.2 |   | 11.5 |   |
| Program license fees payable to Hallmark  Entertainment Distribution |       | 162.8                            |       | — |   | 162.8 |   | — |   | — |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Program license fees payable for future windows                      |       | 154.8                            |       | 94.5 |   | 28.6 |   | 19.3 |   | 12.4 |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Subscriber acquisition fees (b)                                      |       | 33.5                             |       | 33.5 |   | — |   | — |   | — |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Deferred compensation and interest                                   |       | 2.1                              |       | — |   | 2.1 |   | — |   | — |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Payable to Hallmark Entertainment affiliates                         |       | 100.0                            |       | — |   | 100.0 |   | — |   | — |   |
|                                                                 |       |                             |       |   |   |   |   |   |   |   |   |
| Total Contractual Cash Obligations                                   |       | $                                | 1,763.6    |   | $ | 340.8 |   | $ | 702.8 |   | $ | 80.6 |   | $ | 639.4 |   |

 

----

(a) The credit agreement was amended in March 2005, to among other things, change the maturity date to May 31, 2006.

TheCompany repaid and retired its $100.0 million term loan and repaid $95.0million under its revolving credit facility with proceeds from the sale of itsinternational business.

 

(b) Current domestic distribution agreements could significantly increasesubscriber acquisition fees payable in the future by a

maximum amount of $33.4 million, which would result if 32.3 million additionalsubscribers were provided with the Hallmark Channel.

 

31

----

 

*Cash Flows*

 

As of March 31,2005, the Company had $14.7 million in cash and cash equivalents on hand and$10.0 million available under its bank credit facility. As of March 31,2005, the Company had borrowed $310.0 million under its bank credit facility,which has a maturity date of May 31, 2006. Upon the closing of the sale ofthe international business on April 26, 2005, the Company used theproceeds to repay $195.0 million of borrowings under its bank credit facilityand to pay $14.3 million for transaction fees, restricted stock unitsettlements, and employment contract terminations and severance for certainexecutives who were involved in the Company’s international business and notretained by the buyer. However, subsequent to the close of the transaction, theCompany had borrowed $64.0 million under its bank credit facility to paysubscriber acquisition fees and license fees payable to affiliates. After thesetransactions were executed at May 31, 2005, the Company had outstandingborrowings under the bank credit facility of $179.0 million and had $41.0million available under the bank credit facility. Forty million of theavailability is subject to the approval of Hallmark Cards prior to the Companybeing able to draw such funds. In addition, as of May 31, 2005, theCompany had $24.6 million of cash and cash equivalents.

 

On March 1,2005, we entered into Amendment No. 8 to the agreement for our bank creditfacility.  This amendment extended thematurity date to May 31, 2006, as well as made a number of othersignificant changes to the bank credit facility including elimination ofcertain financial covenants, changes to and waivers of other financialcovenants concerning 2004 and the future, and a reduction in the interest ratesand commitment fees under the credit facility.

 

Due tothe delay in filing this quarterly report on Form 10-Q, the Companybreached a reporting covenant of the bank credit facility. The Company obtaineda waiver for such covenant violation, subject to the filing of this interimreport on Form 10-Q prior to June 30, 2005.

 

Inconnection with the Company’s business strategy, the Company expects to continuemaking investments in programming and distribution during 2005. If necessary,the Company may reduce some of this anticipated spending in 2005. The Company’sprincipal uses of funds during 2005 are expected to include the payment ofoperating expenses, licensing of programming, subscriber acquisition fees, andinterest under its bank credit facility.

 

TheCompany currently believes that cash on hand, remaining availability under itsbank credit facility (drawings subject to approval of Hallmark Cards) andpayments anticipated under the tax sharing agreement with Hallmark Cards, allof which are currently its principal sources of funds, will be sufficient tofund the current level of operations and meet its liquidity needs through atleast the maturity date of its credit facility. As noted above, Hallmark Cardsis required to approve borrowings under our $220.0 million bank credit facilityin excess of $180.0 million. Crown Media Holdings has to date not requestedHallmark Cards to approve such drawing of funds; however, we anticipate that wewill require such additional capacity and will require approval of HallmarkCards during 2005. There can be no assurance that Hallmark Cards will approvesuch additional drawings and, if such drawings are not approved, the Companywill need alternative sources of funding or to significantly curtail expenses.

 

TheCompany’s management anticipates that it will either extend or refinance thecredit facility prior to its maturity date. In addition, other financing alternatives could include the issuance ofadditional equity or debt securities. There can be no assurance that the credit facility can or will beextended or refinanced or that additional funding will be available, if at all,on terms acceptable to the Company.  Inaddition, any decline in the popularity of the Hallmark Channel, anysignificant future modifications to the Company’s distribution agreements, aneconomic decline in the advertising market, an increase in competition or otheradverse operating conditions will impact the Company’s ability to achieve itsprojected operating results.

 

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

 

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

 

32

----

 

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

##  

Thediscussion set forth in this Form 10-Q contains statements concerningpotential future events. Such forward-looking statements are based onassumptions by Crown Media Holdings management, as of the date of this Form 10-Qincluding assumptions about risks and uncertainties faced by Crown MediaHoldings. Readers can identify these forward-looking statements by their use ofsuch verbs as “expects,” “anticipates,” “believes,” or similar verbs orconjugations of such verbs. If any of management’s assumptions prove incorrector should unanticipated circumstances arise, Crown Media Holdings’ actualresults, levels of activity, performance, or achievements could materiallydiffer from those anticipated by such forward-looking statements. Among thefactors that could cause actual results to differ materially are thosediscussed below in this Form 10-Q. Crown Media Holdings will not updateany forward-looking statements contained in this Form 10-Q to reflectfuture events or developments.

 

If we do not successfullyaddress the risks described below, our business, prospects, financialcondition, results of operations or cash flow could be materially adverselyaffected. 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 since inception and may continueto incur losses.***

 

Both our international and domestic channels have ahistory of net losses and we expect to continue to report net losses for theforeseeable future. As of March 31, 2005, we had an accumulated deficit ofapproximately $1.4 billion, total stockholders’ equity of approximately $24.6million, goodwill of approximately $314.0 million, and film assets of $445.8million.

 

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

 

In addition, in order to accomplish these goals, themanagement of Crown Media Holdings continues to believe that it is necessary toincrease subscribers and enhance our programming, which results in increasedsubscriber acquisition fees and higher costs for programming. Over the lastfour years, these actions have contributed to increased net losses for CrownMedia Holdings.

 

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

 

We have a substantial amount of indebtedness. As of March 31,2005, our total debt was $894.6 million and we had $14.7 million of cash andcash equivalents. In addition, we may borrow the remaining $10.0 millionavailable borrowing under our bank credit facility to cover the negative cashflow resulting from our current operations. Subject to restrictions under ourdebt agreements, we may also seek equity or debt financing from time to time tocover our operating losses, to finance acquisitions or capital expenditures orfor other purposes.

 

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

 

• our vulnerability toadverse general economic conditions is heightened;

 

• we will be required todedicate a portion of our cash flow from operations to repayment of debt,limiting the availability of cash for other purposes;

 

• we are and willcontinue to be limited by financial and other restrictive covenants in ourability to borrow additional funds, consummate asset sales, enter intotransactions with affiliates or conduct mergers and

 

33

----

 

acquisitions;

 

• our flexibility inplanning for, or reacting to, changes in our business and industry will belimited;

 

• we are sensitive tofluctuations in interest rates; and

 

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

 

Our ability to meet our debt and other obligations andto reduce our total debt depends on our future operating performances and oneconomic, financial, competitive and other factors. There can be no assurancethat our leverage and such restrictions will not materially and adverselyaffect our ability to finance our future operations or capital needs or toengage in other business activities.

 

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

 

High levels ofinterest expense could have negative effects on our future 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 expense in the past twelvemonths resulted from an increase in the average borrowings outstanding, due tocash generated from operations being insufficient to cover operating expensesand capital expenditures. A substantial portion of our cash flow fromoperations must be used to pay our interest expense and will not be availablefor other business purposes. In addition, we may need to incur additionalindebtedness in the future. We cannot assure you that our business willgenerate sufficient cash flow or that future financings will be available toprovide sufficient proceeds to meet our obligations or to service our totaldebt.

 

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

 

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

 

***Modification of any existing agreements with United States distributorscould result in an increased obligation to pay subscriber acquisition fees.***

 

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

 

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

 

We compete with other pay television channel providersto acquire programming. If we fail to continue to obtain programming onreasonable terms for any reason, including as a result of competition, we couldbe forced to incur additional costs to acquire such programming or look foralternative programming, which may hinder the growth of our subscriber base.

 

34

----

 

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

 

Our success depends partly upon unpredictable andvolatile factors beyond our control, such as viewer preferences, competingprogramming and the availability of other entertainment activities. We may notbe able to anticipate and react effectively to shifts in tastes and interestsin our markets. In particular, our ability to react effectively may be limitedby our obligation to license programming from Hallmark EntertainmentDistribution, which has standards and contractual commitments to other partiesthat limit the types of programming that it will provide to us. Our competitorsmay have 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 our Class A common stock.

 

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

 

Currently, we are dependent on Hallmark Entertainment, arelated party, to distribute and license our film assets to third parties forus under a services agreement, which will expire on December 31, 2006.This arrangement reduces our control over the sales and distribution of thefilm assets and might delay our realization of the full revenue stream from thefilm assets. We and Hallmark Entertainment each have the right to terminate theservice agreement on a yearly basis. If Hallmark Entertainment elects toterminate the agreement before we have established our own distributionnetwork, we may not be able to establish our own or obtain alternativedistribution services of equivalent quality or on terms as favorable to us.Termination of this services agreement could hinder our ability, at least inthe short-term, to achieve the amount of additional revenue anticipated fromthese activities and could adversely affect the market price of our Class Acommon stock.

 

We may in due course develop our own distribution/salesnetwork and hire employees to perform the services currently performed byHallmark Entertainment under the service agreement. Ourability to do so is unproven and will require financial, operational andmanagement resources. We may not be able to hire the number 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 advertising revenue, we may be unableto achieve profitability.***

 

Althoughit is expected over time that our advertising revenue will increase, if we failto increase significantly our advertising revenue, we may be unable to achieveor sustain profitability or to expand our business.  A failure to increase advertising revenue maybe a result of any or all of the following: (i) we have a limited history of marketing andselling advertising time; (ii) we may be unable to identify, attract andretain experienced sales and marketing personnel with relevant experience forour U.S. channel; (iii) our sales and marketing organization may be unableto successfully compete against the significantly more extensive andwell-funded sales and marketing operations of our current or potentialcompetitors; (iv) the advancement of technologies such as Digital VideoRecording may cause industry-wide changes concerning the frequency in whichindividuals 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 of advertisinginventory for future sales. Success inincreasing our advertising revenue also depends upon the number and coverage ofthe distributors who carry our channels, our number of subscribers, and the viewership ratings for our programming.

 

35

----

 

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

 

Hallmark Entertainment Investments controls all of ouroutstanding shares of Class B common stock and owns shares of our Class Acommon stock, representing in the aggregate approximately 95.8% of theoutstanding voting power on all matters submitted to our stockholders. HallmarkEntertainment Holdings, a subsidiary of Hallmark Cards, controls the voting ofall our shares held by Hallmark Entertainment Investments. Hallmark Entertainment Investments’ control coulddiscourage others from initiating potential merger, takeover or other change ofcontrol transactions that may otherwise be beneficial to our business orholders of Class A common stock. As a result, the market price of our Class A common stock could suffer, and our business could suffer.Hallmark Entertainment Investments’ control relationship with us also couldgive rise to conflicts of interest in certain situations.

 

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

 

Wecurrently acquire library programming, new productions and first-runpresentations pursuant to our program license agreement with HallmarkEntertainment Distribution.  However, Hallmark Entertainment Distributionis not required to deliver a specific minimum number of programs.  Wecould be forced to develop and produce or acquire alternative programming if weno longer receive as many programs from Hallmark Entertainment Distribution aswe have in prior years and, without adequate notice, this could negativelyimpact our ability to effectively program our Channels.

 

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

 

We license the name “Hallmark” from Hallmark Licensing, Inc.,a subsidiary of Hallmark Cards, for various uses, including the name of ourdomestic channel and the Hallmark Movie Channel. This license will expire on September 1,2005. If Hallmark Cards determines not to renew the trademark licenseagreements for any reason, including our failure to meet minimum programmingthresholds dependent on programming provided by affiliates of Hallmark Cards orto comply with Hallmark Cards’ programming standards, we would be forced tosignificantly revise our business plan and operations, and could experience asignificant erosion of our subscriber base and advertising revenue.

 

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

 

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

 

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

 

We are currently using the Network Operations Center forthe origination and playback of signals for the Hallmark Channel. Like othersingle-point facilities, the Network Operations Center is subject tointerruption from fire, tornadoes, lightning and other unexpected naturalcauses. Although we have redundant systems in place, equipment failure,employee misconduct or outside interference could also disrupt the NetworkOperations Center’s services. We have certain backup facilities. Anysignificant interruption at the Network Operations Center affecting thedistribution of our channels could have an adverse effect on our operatingresults and financial condition.

 

As part of the completion of the sale of ourinternational business, the buyer of the business acquired the NetworkOperations Center, but we continue to use the Network Operations Center for thedistribution ofour domestic channel pursuant to a service agreement, and we depend upon thebuyer in providing these services for our domestic Channel. Any significantinterruption of such services affecting the distribution of our channels couldhave

 

36

----

 

an adverse effect on our operating results and financialcondition.

 

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

 

Our success depends on the expertise and continued serviceof our executive officers and key employees of our subsidiaries. If we fail toattract, hire or retain the necessary personnel, or if we lose the services ofour key executives, we may be unable to implement our business plan or keeppace with developing trends in our industry.

 

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

 

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

 

We also have film costs relating to the amortization ofthe purchase price for the film assets that we use and license to others. Thesefilm costs are, and will continue to be, a significant component of our cost ofservices each quarter.

 

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

 

The stock market has, from time to time, experiencedextreme price and volume fluctuations. Many factors may cause the market pricefor our Class A common stock to decline,including:

 

• our operating resultsfailing to meet the expectations of securities analysts or investors in anyquarter;

 

• material announcementsby us or our competitors;

 

• governmental regulatoryaction;

 

• technologicalinnovations by competitors or competing technologies;

 

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

 

• changes in generalmarket conditions or economic trends.

 

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

 

**Risks Relating to Our Industry**

 

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

 

Our domestic advertisingrevenues are partially dependent on television ratings provided by NielsenMedia Research. Nielsen is currently modifying its ratings system by increasingits household sample size and plans to institute other changes in its audiencemeasurement systems.  Our ratings couldeither be positively or negatively affected by these changes, depending on thedemographic characteristics of the households added to the Nielsen sample andthe natures of the changes in the measurement systems.

 

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

 

We operate in the pay television business, which ishighly competitive. If we are unable to compete effectively

 

37

----

 

with large diversified entertainment companies that have substantiallygreater resources 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, electronic games and other alternative sources ofentertainment and information. Future technological developments may affectcompetition within this business.

 

A continuing trend towards business combinations andalliances in the communications industries may create significant new competitorsfor us or intensify existing competition. Many of these combined entities havemore than one channel and resources far greater than ours. These combinedentities may provide bundled packages of programming, delivery and otherservices that compete directly with the products we offer. These entities mayalso offer services sooner and at more competitive rates than we do. Inaddition, these alliances may benefit from both localized content and the localpolitical climate.

 

We may need to reduce our prices or license additionalprogramming to remain competitive, and we may be unable to sustain futurepricing levels as competition increases. Our failure to achieve or sustainmarket acceptance of our programming at desired pricing levels could impair ourability to achieve profitability or positive cash flow, which would harm ourbusiness.

 

Distributors in the United States may attempt topressure pay TV channels with lower viewership, suchas our domestic Hallmark Channel, to accept decreasing amounts for subscriberfees, to pay higher subscriber acquisition fees or to allow carriage of thechannel without the payment of subscriber fees. Factors that may lead to thispressure include the number of competing pay TV channels, the limited spaceavailable on services of distributors in the United States and the desire ofdistributors to maintain or reduce costs. Any reduction in subscriber feesrevenue now or in the future could have a material impact on our ability toachieve profitability and cash flow.

 

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

 

Our future success will depend, in part, on our abilityto anticipate and adapt to technological changes and to offer, on a timelybasis, services that meet customer demands and evolving industry standards. Thepay television industry has been, and is likely to continue to be, subject to:

 

• rapid and significanttechnological change, including continuing developments in technology which donot presently have widely accepted standards; and

 

• frequent introductionsof new services and alternative technologies, including new technologies forproviding video services.

 

For example, the advent of digital technology is likelyto accelerate the convergence of broadcast, telecommunications, Internet andother media and could result in material changes in the economics, regulations,intellectual property usage and technical platforms on which our businessrelies, including lower retail rates for video services. These changes couldfundamentally affect the scale, source, and volatility of our revenue streams,cost structures, and profitability, and may require us to significantly change ouroperations.

 

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

 

Moreover, the increased capacity of digital distributionplatforms, including the introduction of digital terrestrial television, mayreduce the competition for the right to carry channels and allow development ofextra services at low incremental cost. These lower incremental costs couldlower barriers to entry for competing channels, and place pressure on ouroperating margins and market position. In addition, a greater number ofchannels would likely increase competition among channels for viewers andadvertisers, which could affect our ability to attract

 

38

----

 

advertising and new distribution at desired pricing levels, and could thereforehinder or prevent the growth of our subscriber base.

 

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

 

If, as a provider of television channels, we fail tocomply with applicable present or future government regulations in the UnitedStates, we could be prohibited from operating and could be subject to monetaryfines, either of which would increase our operating costs, reduce our revenueand limit our ability to achieve profitability.

 

Moreover, broadcasting regulations are generally subjectto periodic and on-going governmental review and legislative initiatives, whichmay, in the future, affect the nature of programming we are able to offer andthe means by which it is distributed. The timing, scope or outcome of thesereviews could be unfavorable to us, and any changes tocurrent broadcasting legislation or regulations could require adjustments toour operations.

 

The Federal Communications Commission or Congress mayenact requirements that cable program services be offered to subscribers on an “ala carte” basis, i.e. be made available for purchase separately and not as partof a package of services. Such requirements could result in a reduction in thetotal number of subscribers to our domestic program services and adverselyaffect advertising revenue.

 

### **Available Information**

 

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

 

**Additionally, we will make available,free of charge upon request, a copy of our Code of Business Conduct and Ethics,which is applicable to all of our employees, including our senior financialofficers. Requests for a copy of this code should be addressed to Director ofReporting and Compliance at 6430 South Fiddlers Green Circle, Suite 225,Greenwood Village, Colorado 80111.**

 

**Item 3.**** *Quantitative and Qualitative Disclosures About Market Risk***

 

We only invest in instruments that meet high credit andquality standards, as specified in our investment policy guidelines. Theseinstruments, like all fixed income instruments, are subject to interest rate risk.The fixed income portfolio will decline in value if there is an increase ininterest rates. If market interest rates were to increase immediately anduniformly by 10% from levels as of March 31, 2005, the decline of the fairvalue of the fixed income portfolio would not be material.

 

As of March 31, 2005, our cash, cash equivalentsand short-term investments had a fair value of $14.7 million, which wereinvested in cash and short-term commercial paper. The primary purpose of theseinvesting activities has been to preserve principal until the cash is requiredto fund operations. Consequently, the size of this portfolio fluctuatessignificantly as cash is provided by and used in our business.

 

The value of certain investments in this portfolio canbe impacted by the risk of adverse changes in securities and economic marketsand interest rate fluctuations. At March 31, 2005, all of our investmentsin this category were in fixed rate instruments or money market type accounts.A decrease in interest rates has the effect of reducing our future annualinterest income from this portfolio, since funds would be reinvested at lowerrates as the instruments mature. Over time, any net percentage decrease in ourinterest rates could be reflected in a corresponding net percentage decrease inour interest income. For the three months ended March 31, 2005, the impactof interest rate fluctuations, changed business prospects and all other factorsdid not have a material impact on the fair value of this portfolio, or on our incomederived from this portfolio.

 

39

----

 

We have not used derivative financial instruments forspeculative purposes. As of March 31, 2005, we are not hedged or otherwiseprotected against risks associated with any of our investing or financingactivities.

 

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

 

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

 

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

 

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

 

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

 

Our material interest bearing assets consisted of cashequivalents and short-term investments. The balance of our interest bearingassets was $14.7 million, or less than 1% of total assets, as of March 31,2005. Our material liabilities subject to interest rate risk consisted ofcapital lease obligations, our bank credit facility, our line of credit with HCCrown and our note payable to HC Crown. The balance of those liabilities was $882.4million, or 58% of total liabilities, as of March 31, 2005. Net interestexpense for the three months ended March 31, 2005, was $16.9 million, 42%,of our total revenue. Our net interest expense of these liabilities issensitive to changes in the general level of interest rates, primarily U.S. andLIBOR interest rates. In this regard, changes in U.S. and LIBOR interest ratesaffect the fair value of interest bearing liabilities.

 

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

 

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

 

The Company, under the supervision and with theparticipation of the Company’s management, including its Chief ExecutiveOfficer and Chief Financial Officer, carried out an evaluation of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934) as of March 31, 2005.  Based upon this evaluation,the Company’s Chief Executive Officer and Chief Financial Officer concludedthat the Company’s disclosure controls and procedures were not effectiveas of that date for purposes of recording, processing, summarizing andtimely reporting material information required to be disclosed in reports thatthe Company files under the Exchange Act.

 

***b.  Changes******in Internal Control overFinancial Reporting***

 

There were no changes in the Company’s internal control over financial reporting that occurred during the quarter ended March 31, 2005, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

**c.  *Remediation******Steps***

 

In thesecond quarter of 2005, the Company commenced the implementation of thefollowing remediation steps to address the material weaknesses outlined in ourAnnual Report on Form 10-K:

 

•       TheCompany engaged consultants to assist with the first quarter 2005 accountingfor complex non-recurring transactions and to review calculations, includingcalculations imbedded in spreadsheets. The Company also

 

40

----

 

plansto retain consulting services to serve as contemporaneous, technical resourcesto review, evaluate and provide guidance on the most appropriate accountingtreatment for complex, non-recurring transactions.

 

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

 

**PART II.****  OTHER INFORMATION**

 

**Item 1.****  *Legal Proceedings***

 

In May 2005, wereceived a letter from National Interfaith Cable Coalition, Inc.threatening litigation in regard to an Amendment dated February 22, 2001to the Amended and Restated Company Agreement of Crown Media UnitedStates.  The Amendment is described belowin Note 11 to the Notes to Unaudited ConsolidatedFinancial Statements.  The letter claimsthat, among other things, the Company and Hallmark Entertainment, Inc.have not honored their commitments relating to the production and financing ofcertain NICC and “faith and values” programming forbroadcast on the Hallmark Channel in the United States.   NICC alleges thatwe and HEI have materially breached the Amendment,causing substantial damages to NICC in an amountwhich exceeds $100.0 million.  Theletter further indicates that NICC intends to file litigationfor breaches of the Amendment unless we agree, by June 1, 2005, to enterinto a new, extended agreement with NICC for theproduction, promotion and funding of programming.  There was no such agreement on June 1,2005. We believe that the Company and HEI are incompliance with the Amendment.  Wecannot, however, predict at this time whether the letter will result inlitigation, an amendment or other resolution. Accordingly, we have not providedfor any amount of loss in our condensed consolidated financial statements forthis matter.

 

**Item 6.****  *Exhibits***

 

(a)

 

**INDEX TO EXHIBITS**

 
| **Exhibit Number** | ** ** | **Exhibit Title**                                                                                                                                                                                                                                                                                                                                                                          |   |
|-------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| 2.1                     |       | Purchase and Sale Agreement, dated as of February 23, 2005, by and  among CM Intermediary, LLC, Bagbridge Limited and,  solely with respect to Section 10.14 of the Agreement, Crown Media  Holdings, Inc. (previously filed as Exhibit 2.1 to our Current  Report on Form 8-K, filed on February 23, 2005 and incorporated  herein by reference).                |   |
| 2.2                     |       | Asset Purchase and Sale Agreement, dated as of February 23, 2005,  by and among Crown Media Distribution, LLC, Bagbridge  Limited and, solely with respect to Section 10.14 of the Agreement,  Crown Media Holdings, Inc. (previously filed as Exhibit 2.2 to our  Current Report on Form 8-K, filed on February 23, 2005 and  incorporated herein by reference). |   |
| 3.1                     |       | Amended and Restated Certificate of Incorporation (previously filed as Exhibit 3.1  to our Registration Statement on Form S-1/A (Amendment No. 2),  Commission File No. 333-95573, and incorporated herein by reference).                                                                                                                                                   |   |
| 3.2                     |       | Amendment to the Amended and Restated Certificate of Incorporation  (previously filed as Exhibit 3.2 to our Quarterly Report on Form 10-Q  filed on July 31, 2001 and incorporated herein by reference).                                                                                                                                                                         |   |
| 3.3                     |       | Amended and Restated By-Laws (previously filed as Exhibit 3.2 to  our Registration Statement on Form S-1/A (Amendment No. 3),  Commission File No. 333-95573, and incorporated herein by reference).                                                                                                                                                                        |   |
| 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.                                                                                                                                                                                                                                                                                                                                                              |   |

 

41

----

 

----

*Management contract or compensating plan or arrangement.

 

42

----

 

**SIGNATURES**

 

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

 

CROWN MEDIA HOLDINGS, INC.

 
| ** ** | **Signature**  | ** **            | **Title**         | ** **              | **Date** | ** **         |
|------------|----------------|-----------------------|-------------------|-------------------------|----------|--------------------|
|       |           |                  |              |                    |     |
|       | By:            | /s/ DAVID J. EVANS    |              | Director and Principal  |     | June 13, 2005 |   |
|       | David J. Evans |                  | Executive Officer |                    |     |               |
|       |           |                  |              |                    |     |
|       | By:            | /s/ WILLIAM J. ALIBER |              | Principal Financial and |     | June 13, 2005 |   |
|       |           | William J. Aliber     |              | Accounting Officer      |     |               |   |

 

43

----

 

**INDEX TO EXHIBITS**

 
| **Exhibit Number** | ** ** | **Exhibit Title**                                                                                                                                                                                                                                                                                                                                                                          |   |
|-------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| 2.1                     |       | Purchase and Sale Agreement, dated as of February 23, 2005, by and  among CM Intermediary, LLC, Bagbridge Limited and,  solely with respect to Section 10.14 of the Agreement, Crown Media  Holdings, Inc. (previously filed as Exhibit 2.1 to our Current  Report on Form 8-K, filed on February 23, 2005 and incorporated  herein by reference).                |   |
| 2.2                     |       | Asset Purchase and Sale Agreement, dated as of February 23, 2005,  by and among Crown Media Distribution, LLC, Bagbridge  Limited and, solely with respect to Section 10.14 of the Agreement,  Crown Media Holdings, Inc. (previously filed as Exhibit 2.2 to our Current  Report on Form 8-K, filed on February 23, 2005 and incorporated  herein by reference). |   |
| 3.1                     |       | Amended and Restated Certificate of Incorporation (previously filed as Exhibit 3.1  to our Registration Statement on Form S-1/A (Amendment No. 2),  Commission File No. 333-95573, and incorporated herein by reference).                                                                                                                                                   |   |
| 3.2                     |       | Amendment to the Amended and Restated Certificate of Incorporation  (previously filed as Exhibit 3.2 to our Quarterly Report on Form 10-Q  filed on July 31, 2001 and incorporated herein by reference).                                                                                                                                                                         |   |
| 3.3                     |       | Amended and Restated By-Laws (previously filed as Exhibit 3.2 to  our Registration Statement on Form S-1/A (Amendment No. 3),  Commission File No. 333-95573, and incorporated herein by reference).                                                                                                                                                                        |   |
| 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.                                                                                                                                                                                                                                                                                                                                                              |   |

 

----

*Management contract or compensating plan or arrangement.

 

44

----