**UNITED STATES SECURITIES ANDEXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**Form 10-Q**

 

**(Mark One)**

| **ý**                                                                                                                                                                                                                                                                                                                                          | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                |       |                                                                                                |
| **For the quarterly period ended  June 30, 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 Media Holdings, Inc.**

(Exact Name of Registrant as Specified in ItsCharter)

 
| **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**

(Address of Principal Executive Offices and ZipCode)

 

**(818) 755-2400**

(Registrant’s Telephone Number, Including AreaCode)

 

 

(Former Name, Former Address, and Former FiscalYear,

if Changed Since Last Report.)

 

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

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inExchange Act Rule 12b-2).  Yes  ý     No  o

 

As of August 5, 2005,the number of shares of Class A Common Stock, $.01 par value outstandingwas 73,938,337, and the number of shares of Class B Common Stock, $.01 parvalue, outstanding was 30,670,422.

 

 

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**TABLE OF CONTENTS**

 
| **PART I**  | **Financial Information**                                                                                                                     |   |
|------------------|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|
|             |                                                                                                                                          |   |
| Item 1           | Financial  Statements (Unaudited)                                                                                                             |   |
|             | CROWN MEDIA  HOLDINGS, INC. AND SUBSIDIARIES                                                                                                  |   |
|             | Condensed  Consolidated Balance Sheets – December 31, 2004 and June 30, 2005  (Unaudited)                                      |   |
|             | Condensed  Consolidated Statements of Operations and Comprehensive Loss (Unaudited)  - Three and Six Months Ended June 30, 2004 and 2005 |   |
|             | Condensed  Consolidated Statements of Cash Flows (Unaudited)  - Six Months Ended June 30, 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

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*In this Form 10-Q the terms “CrownMedia Holdings” or the “Company,” refer to Crown Media Holdings, Inc.  and, unless the context requires otherwise,subsidiaries of Crown Media Holdings that operate or have operated ourbusinesses, Crown Media United States, LLC (“Crown Media United States”), CrownMedia Distribution, LLC (“Crown Media Distribution”), and, until completion ofthe sale of our international business in April 2005, Crown MediaInternational, LLC (“Crown Media International”) and Crown EntertainmentLimited (“Crown Entertainment”). The term “common stock” refers to our Class Acommon stock and Class B common stock, unless the context requiresotherwise.*

 

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

* *

**PART I. FINANCIAL INFORMATION**

** **

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

 

**CROWN MEDIA HOLDINGS, INC. ANDSUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED BALANCE SHEETS**

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

 
| ** **                                                                                    | ** ** | **As of**             | ** ** | **As of**         | ** ** |
|-----------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                                                                    | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
| ** **                                                                                    | ** ** | **2004**              | ** ** | **2005**          | ** ** |
| ** **                                                                                    | ** ** | ** **            | ** ** | ** **        | ** ** |
| ASSETS                                                                                        |       |                  |       |              |       |
|                                                                                          |       |                  |       |              |       |
| Cash and cash equivalents                                                                     |       | $                     | 12,102     |              | $          | 5,570 |   |
| Accounts receivable, less allowance for doubtful accounts of $6,695 and  $3,345, respectively |       | 75,459                |       | 57,946            |       |
| Program license fees — affiliates                                                        |       | 40,048                |       | 29,621            |       |
| Program license fees — non-affiliates                                                    |       | 78,823                |       | 61,305            |       |
| Subtitling and dubbing, net                                                                   |       | 1,143                 |       | —            |       |
| Receivable from affiliate                                                                     |       | 16,644                |       | 22,017            |       |
| Receivable from buyer of international business                                               |       | —                |       | 2,542             |       |
| Prepaid and other assets                                                                      |       | 13,887                |       | 9,466             |       |
| Total current assets                                                                          |       | 238,106               |       | 188,467           |       |
|                                                                                          |       |                  |       |              |       |
| Accounts receivable                                                                           |       | 6,798                 |       | 8,756             |       |
| Program license fees — affiliates                                                        |       | 59,987                |       | 60,864            |       |
| Program license fees — non-affiliates                                                    |       | 135,372               |       | 144,920           |       |
| Subtitling and dubbing                                                                        |       | 1,583                 |       | —            |       |
| Film assets, net                                                                              |       | 599,013               |       | 438,250           |       |
| Subscriber acquisition fees, net                                                              |       | 120,013               |       | 99,651            |       |
| Property and equipment, net                                                                   |       | 32,829                |       | 20,301            |       |
| Goodwill                                                                                      |       | 314,033               |       | 314,033           |       |
| Prepaid and other assets                                                                      |       | 5,034                 |       | 13,556            |       |
| Total assets                                                                                  |       | $                     | 1,512,768  |              | $          | 1,288,798 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

3

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**CROWN MEDIA HOLDINGS, INC. ANDSUBSIDIARIES**

**UNAUDITED CONDENSED CONSOLIDATEDBALANCE SHEETS**

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

 
| ** **                                                                                                                                                                                                    | ** ** | **As of**             | ** ** | **As of**         | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                                                                                                                                                                                    | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
| ** **                                                                                                                                                                                                    | ** ** | **2004**              | ** ** | **2005**          | ** ** |
| ** **                                                                                                                                                                                                    | ** ** | ** **            | ** ** | ** **        | ** ** |
| LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                                                           |       |                  |       |              |       |
|                                                                                                                                                                                                          |       |                  |       |              |       |
| LIABILITIES:                                                                                                                                                                                                  |       |                  |       |              |       |
| Accounts payable and accrued expenses                                                                                                                                                                         |       | $                     | 40,228     |              | $          | 24,801 |   |
| Liability for restricted stock units                                                                                                                                                                          |       | 13,649                |       | 6,833             |       |
| Subscriber acquisition fees payable                                                                                                                                                                           |       | 35,223                |       | 10,622            |       |
| License fees payable to affiliates                                                                                                                                                                            |       | —                |       | 2,905             |       |
| License fees payable to non-affiliates                                                                                                                                                                        |       | 79,815                |       | 66,875            |       |
| Payables to affiliates                                                                                                                                                                                        |       | 13,512                |       | 15,551            |       |
| Payables to buyer of international business                                                                                                                                                                   |       | —                |       | 8,673             |       |
| Credit facility and interest payable                                                                                                                                                                          |       | 479                   |       | 179,162           |       |
| Capital lease obligations                                                                                                                                                                                     |       | 2,276                 |       | 585               |       |
| Deferred revenue                                                                                                                                                                                              |       | 612                   |       | 1,160             |       |
| Deferred credit from technical services agreement                                                                                                                                                             |       | —                |       | 1,020             |       |
| Total current liabilities                                                                                                                                                                                     |       | 185,794               |       | 318,187           |       |
|                                                                                                                                                                                                          |       |                  |       |              |       |
| Accrued expenses                                                                                                                                                                                              |       | 21,617                |       | 25,178            |       |
| Subscriber acquisition fees payable                                                                                                                                                                           |       | 678                   |       | —            |       |
| License fees payable to affiliates                                                                                                                                                                            |       | 151,980               |       | 138,261           |       |
| License fees payable to non-affiliates                                                                                                                                                                        |       | 111,761               |       | 127,936           |       |
| Line of credit and interest payable to HC Crown                                                                                                                                                               |       | 81,067                |       | 83,449            |       |
| Payable to Hallmark Entertainment affiliates                                                                                                                                                                  |       | 100,000               |       | 100,000           |       |
| Payable to buyer of international business                                                                                                                                                                    |       | —                |       | 10,100            |       |
| Senior unsecured note to HC Crown, including accrued interest                                                                                                                                                 |       | 460,930               |       | 484,553           |       |
| Credit facility                                                                                                                                                                                               |       | 310,000               |       | —            |       |
| Capital lease obligations                                                                                                                                                                                     |       | 22,817                |       | 16,484            |       |
| Company obligated mandatorily redeemable preferred interest                                                                                                                                                   |       | 11,488                |       | 12,846            |       |
| Deferred credit from technical services agreement                                                                                                                                                             |       | —                |       | 5,709             |       |
| Total liabilities                                                                                                                                                                                             |       | 1,458,132             |       | 1,322,703         |       |
| Commitments and contingencies (note 15)                                                                                                                                                                       |       |                  |       |              |       |
| STOCKHOLDERS’ EQUITY (DEFICIT):                                                                                                                                                                          |       |                  |       |              |       |
| Class A common stock, $.01 par value; 200,000,000 shares  authorized; 73,863,037 shares and 73,936,925 shares issued and outstanding as  of December 31, 2004, and June 30, 2005, respectively |       | 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  June 30, 2005                                     |       | 307                   |       | 307               |       |
| Additional paid-in capital                                                                                                                                                                                    |       | 1,365,450             |       | 1,387,505         |       |
| Accumulated other comprehensive income                                                                                                                                                                        |       | 3,434                 |       | —            |       |
| Accumulated deficit                                                                                                                                                                                           |       | (1,315,294            | )          | (1,422,456        | )          |
| Total stockholders’ equity (deficit)                                                                                                                                                                     |       | 54,636                |       | (33,905           | )          |
| Total liabilities and stockholders’ equity (deficit)                                                                                                                                                     |       | $                     | 1,512,768  |              | $          | 1,288,798 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

4

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**CROWN MEDIA HOLDINGS, INC. ANDSUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS**

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

 
| ** **                                                                                      | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                      | ** ** | **2004**                              | ** ** | **2005**                           | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                                                                      | ** ** | ** **                            | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                                                                                        |       |                                  |       |                               |       |   |   |   |   |
| Subscriber fees                                                                                 |       | $                                     | 2,971      |                               | $          | 4,193 |   | $ | 5,344 |   | $ | 8,803 |   |
| Advertising                                                                                     |       | 26,013                                |       | 37,635                             |       | 49,401 |   | 70,968 |   |
| Advertising by Hallmark Cards                                                                   |       | 444                                   |       | 482                                |       | 794 |   | 1,025 |   |
| Film asset license fees                                                                         |       | 963                                   |       | 3,169                              |       | 8,253 |   | 5,252 |   |
| Other revenue                                                                                   |       | —                                |       | 213                                |       | — |   | 213 |   |
| Total revenue, net                                                                              |       | 30,391                                |       | 45,692                             |       | 63,792 |   | 86,261 |   |
| Cost of Services:                                                                               |       |                                  |       |                               |       |   |   |   |   |
| Programming costs:                                                                              |       |                                  |       |                               |       |   |   |   |   |
| Affiliates                                                                                      |       | 7,845                                 |       | 10,202                             |       | 15,235 |   | 20,093 |   |
| Non-affiliates                                                                                  |       | 12,208                                |       | 18,211                             |       | 23,841 |   | 36,342 |   |
| Amortization of film assets                                                                     |       | 1,347                                 |       | 13,664                             |       | 8,677 |   | 19,345 |   |
| Subscriber acquisition fee amortization expense                                                 |       | 6,091                                 |       | 8,695                              |       | 12,032 |   | 18,203 |   |
| Other cost of services                                                                          |       | 248                                   |       | 4,730                              |       | 4,173 |   | 6,526 |   |
| Total cost of services                                                                          |       | 27,739                                |       | 55,502                             |       | 63,958 |   | 100,509 |   |
| Selling, general and administrative expense                                                     |       | 11,856                                |       | 14,619                             |       | 23,107 |   | 26,771 |   |
| Marketing expense                                                                               |       | 6,215                                 |       | 7,420                              |       | 10,336 |   | 17,250 |   |
| Depreciation and amortization expense                                                           |       | 1,627                                 |       | 1,182                              |       | 3,311 |   | 2,532 |   |
| Loss from continuing operations before interest expense and income tax  provision               |       | (17,046                               | )          | (33,031                            | )          | (36,920 | ) | (60,801 | ) |
| Interest expense                                                                                |       | (14,393                               | )          | (17,444                            | )          | (28,611 | ) | (34,340 | ) |
| Loss from continuing operations before income tax provision                                     |       | (31,439                               | )          | (50,475                            | )          | (65,531 | ) | (95,141 | ) |
| Income tax provision                                                                            |       | —                                |       | (6                                 | )          | — |   | (6 | ) |
| Loss from continuing operations                                                                 |       | (31,439                               | )          | (50,481                            | )          | (65,531 | ) | (95,147 | ) |
| Loss from discontinued operations, net of tax                                                   |       | (9,148                                | )          | (4,425                             | )          | (16,532 | ) | (10,666 | ) |
| Loss from sale of discontinued operations, net of tax                                           |       | —                                |       | (1,349                             | )          | — |   | (1,349 | ) |
| Net loss                                                                                        |       | $                                     | (40,587    | )                                  | $          | (56,255 | ) | $ | (82,063 | ) | $ | (107,162 | ) |
| Other comprehensive income (loss):                                                              |       |                                  |       |                               |       |   |   |   |   |
| Foreign currency translation adjustment                                                         |       | 30                                    |       | (2,939                             | )          | 481 |   | (3,434 | ) |
| Comprehensive loss                                                                              |       | $                                     | (40,557    | )                                  | $          | (59,194 | ) | $ | (81,582 | ) | $ | (110,596 | ) |
| Weighted average number of Class A and Class B shares  outstanding, basic and diluted |       | 104,533                               |       | 104,551                            |       | 104,533 |   | 104,542 |   |
| Loss from continuing operations, basic and diluted                                              |       | (0.30                                 | )          | (0.48                              | )          | (0.63 | ) | (0.91 | ) |
| Loss from discontinued operations, basic and diluted                                            |       | (0.09                                 | )          | (0.06                              | )          | (0.16 | ) | (0.12 | ) |
| Net loss per share, basic and diluted                                                           |       | $                                     | (0.39      | )                                  | $          | (0.54 | ) | $ | (0.79 | ) | $ | (1.03 | ) |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

5

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**CROWN MEDIA HOLDINGS, INC. ANDSUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

 
| ** **                                                                       | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                       | ** ** | **2004**                           | ** ** | **2005** | ** ** |
| ** **                                                                       | ** ** | ** **                         | ** ** | ** ** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                            | ** ** | ** **                         | ** ** | ** ** | ** ** |
| Net loss                                                                         |       | $                                  | (82,063    | ) | $ | (107,162 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities:     |       |                               |       |   |   |
| Loss from discontinued operations                                                |       | 16,532                             |       | 10,666 |   |
| Loss from sale of discontinued operations                                        |       | —                             |       | 1,349 |   |
| Depreciation and amortization                                                    |       | 69,351                             |       | 103,934 |   |
| Accretion on company obligated mandatorily redeemable preferred  interest        |       | 1,073                              |       | 1,358 |   |
| Provision for allowance for doubtful accounts (recoveries)                       |       | (1,014                             | )          | 1,117 |   |
| Stock-based compensation                                                         |       | 5,811                              |       | 5,243 |   |
| Changes in operating assets and liabilities:                                     |       |                               |       |   |   |
| (Increase) decrease in accounts receivable                                       |       | (6,348                             | )          | (2,539 | ) |
| Increase in receivable from buyer of international business                      |       | —                             |       | (1,042 | ) |
| Additions to program license fees                                                |       | (27,915                            | )          | (85,229 | ) |
| Additions to subscriber acquisition fees                                         |       | (13,319                            | )          | (4,426 | ) |
| Increase in prepaids and other assets                                            |       | (2,883                             | )          | (12,385 | ) |
| Increase (decrease) in accounts payable and accrued liabilities                  |       | (23,392                            | )          | 3,966 |   |
| Increase in interest payable                                                     |       | 22,948                             |       | 26,210 |   |
| Increase (decrease) in subscriber acquisition fees payable                       |       | 9,796                              |       | (25,278 | ) |
| Increase (decrease) in license fees payable to affiliates                        |       | 14,259                             |       | (10,814 | ) |
| Increase (decrease) in payables to affiliates                                    |       | 1,378                              |       | (3,333 | ) |
| Increase in deferred revenue                                                     |       | 103                                |       | 554 |   |
| Net cash used in continuing operating activities                                 |       | (15,683                            | )          | (97,811 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                            |       |                               |       |   |   |
| Purchases of property and equipment                                              |       | (683                               | )          | (558 | ) |
| Payments to buyer of international business                                      |       | —                             |       | (5,843 | ) |
| Proceeds from disposition of international business, net of funds  transfer fees |       | —                             |       | 221,979 |   |
| Net cash provided by (used in) investing activities                              |       | (683                               | )          | 215,578 |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                            |       |                               |       |   |   |
| Proceeds from issuance of common stock upon exercise of stock options            |       | —                             |       | 643 |   |
| Proceeds from tax sharing agreement with Hallmark Cards                          |       | 23,600                             |       | 21,400 |   |
| Borrowings under the credit facility                                             |       | 10,000                             |       | 64,000 |   |
| Principal payments on the credit facility                                        |       | —                             |       | (195,000 | ) |
| Principal payments on capital lease obligations                                  |       | —                             |       | (295 | ) |
| Net cash provided by (used in) financing activities                              |       | 33,600                             |       | (109,252 | ) |
| NET CASH USED IN DISCONTINUED OPERATIONS                                         |       | (12,509                            | )          | (14,758 | ) |
| Effect of exchange rate changes on cash                                          |       | 479                                |       | (289 | ) |
| Net increase (decrease) in cash and cash equivalents                             |       | 5,204                              |       | (6,532 | ) |
| Cash and cash equivalents, beginning of period                                   |       | 4,306                              |       | 12,102 |   |
| Cash and cash equivalents, end of period                                         |       | $                                  | 9,510      |   | $ | 5,570 |   |
| Supplemental disclosure of certain cash and non-cash activities:                 |       |                               |       |   |   |
| Interest paid                                                                    |       | $                                  | 6,743      |   | $ | 8,295 |   |
| Income taxes paid                                                                |       | $                                  | 944        |   | $ | 846 |   |
| Payable to buyer of international business                                       |       | $                                  | —     |   | $ | 24,616 |   |
| Prepayment on technical services agreement                                       |       | $                                  | —     |   | $ | 12,643 |   |
| Deferred credit from technical services agreement                                |       | $                                  | —     |   | $ | 7,029 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

6

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

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**For the Three and Six MonthsEnded June 30, 2004 and 2005**

 

**1. Business and Organization**

 

***Organization***

 

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. Domestically, the Hallmark Channel isoperated and distributed by Crown Media United States, LLC (“Crown Media UnitedStates”). Significant investors in Crown Media Holdings include HallmarkEntertainment Investments Co. (“Hallmark Entertainment Investments”), asubsidiary of Hallmark Cards, Incorporated (“Hallmark Cards”), the NationalInterfaith Cable Coalition, Inc. (“NICC”), and, indirectly through theirinvestments in Hallmark Entertainment Investments, Liberty Media Corporation (“LibertyMedia”) and J.P. Morgan Partners (BHCA), L. P. (“J.P. Morgan”). Theinternational operations of the Hallmark Channel were operated in the UnitedKingdom, by Crown Entertainment Limited (“Crown Entertainment”) and elsewhereby Crown Media International, LLC (“Crown Media International”). Crown MediaInternational commenced its operations outside the United States in 1995.

 

***Saleof the International Business***

 

In April 2005, the Company completed the sale ofits international business to a group of investors comprised of EquityPartners, 3i and U.K. executive David Elstein (collectively, “Sparrowhawk,” the“buyer” or the “buyer of international business”). The sale included theinternational versions of the Hallmark Channel distributed outside the UnitedStates, the international rights to over 580 titles in the Crown Media filmlibrary, and the Network Operations Center based in Denver, Colorado.  The Company received cash proceeds of $209.3million, net of the prepayment described below, and recognized an accounting lossof $1.3 million from the sale. Approximately $4.7 million of transaction costswere incurred by the Company as a result of the sale.

 

In accordance with the conditions of the sale, the Companyhas accrued $24.6 million which represents the estimated present value of thecash that is expected to be paid to or on behalf of the buyer at various timesthrough December 31, 2015.  Includedin this amount is $16.7 million of estimated payments, which was determinedusing the contractual lease payments due on certain lease arrangements thatwere assumed by the buyer. Payments to the buyer are due at or about the sametime the buyer is obligated to pay the lessor. In addition, the Company agreed to pay the buyer approximately $3.2million in cash, which was determined as the difference between $4.0 millionand the estimated net realizable value of receivables of $0.8 million.  Also, the Company has estimated a liabilityof approximately $4.5 million to pay the estimated residual and participationcosts that the buyer would otherwise be obligated to pay to third partiesthrough April 2015.  The amount ofthis liability could fluctuate based upon the actual internal usage or sales ofthese films by the buyer. During the second quarter of 2005, the Company paid$5.8 million towards these obligations. Any revisions to these estimatedliabilities will be reflected as gain (loss) from the sale of discontinuedoperations in future periods.

 

TheCompany will continue to use the Network Operations Center sold to Sparrowhawk forthe distribution of the domesticchannel pursuant to a $25.3 million, seven year technical services agreementwith the buyer. The Company made a prepayment under the technical services agreementto the buyer in the amount of $12.7 million upon closing of the saletransaction and the balance is payable monthly in equal installments throughthe expiration of the agreement. The unused portion of the prepayment isclassified as Prepaid and Other Assets in the accompanying condensed consolidatedbalance sheet and will be amortized to operating expense over the life of thecontract. A deferred credit of $7.0 million ($6.7 million as of June 30,2005) was recorded to reflect the amount by which the $25.3 million contractexceeded the estimated fair value of the related services. The deferred creditwill be amortized over the life of the contract, resulting in a reduction ofoperating expenses in future periods.

 

7

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Subsequentto the sale, the Company has no continuing economic involvement with theoperations of the international business.

 

***Liquidity***

 

As of June 30,2005, the Company had $5.6 million in cash and cash equivalents on hand and $41.0million available under its bank credit facility. Forty million of theavailability is subject to the approval of Hallmark Cards prior to the Companybeing able to draw such funds. As of June 30, 2005, the Company hadborrowed $179.0 million under its bank credit facility, which matures May 31,2006.

 

TheCompany’s principal sources of funds are currently available cash on hand, periodictax sharing payments, and amounts available for borrowing under its bank creditfacility. However, the Company expects that cash payments under the tax sharingagreement with Hallmark Cards during the remainder of 2005 will be less thanprior periods as a result of the taxable gain anticipated on the sale of theinternational business.

 

Inconnection with the Company’s business strategy, the Company expects tocontinue making investments in programming and distribution during the nexttwelve months ending June 30, 2006. However, because of the near-termliquidity issues as reflected herein, absent financial assistance from HallmarkCards, in order to preserve cash and stay in operation, the Company will needto reduce some of this anticipated spending in the near term. The Company’sprincipal uses of funds for the remainder of 2005 are expected to include thepayment of operating expenses, licensing of programming, subscriber acquisitionfees and interest under its bank credit facility.

 

TheCompany currently believes that cash on hand and the remaining availabilityunder its bank credit facility (assuming that Hallmark Cards approvesadditional borrowings), both of which are currently its principal sources offunds, and periodic payments under the tax sharing agreement, will besufficient to fund the current level of operations and meet its liquidity needsthrough the maturity date of its bank credit facility (May 31, 2006). Asnoted above, Hallmark Cards is required to approve borrowings under our $220.0million bank credit facility in excess of $180.0 million. To date, Crown MediaHoldings has not requested Hallmark Cards to approve such drawing of funds;however, we anticipate that we will require such additional liquidity and willrequest approval of Hallmark Cards during the final six months of 2005. Therecan be no assurance that Hallmark Cards will approve such additional drawingsand, if such drawings are not approved, the Company will need alternativesources of funding or will need to significantly curtail expenses or programmingacquisitions and payments.

 

Due tothe Company’s liquidity needs, the Company anticipates that prior to August 31,2006, it will be necessary to either extend or refinance (i) the bankcredit facility and (ii) the license fees ($138.3 million at June 30,2005) and other amounts ($100.0 million at June 30, 2005) payable toaffiliates of Hallmark Cards.  In thealternative or as part of a combination of actions, the Company may seek, amongother things, to issue additional equity or debt securities to raise capitalfor the repayment of those obligations and for other future cash needs.

 

If theCompany is not able to arrange for the extension, refinancing or replacement ofthe bank credit facility prior to its maturity and the bank draws down on theirrevocable letter of credit, Hallmark Cards would acquire all obligations andthe rights of the lending banks under the bank credit facility.  In that event, Hallmark Cards could demandpayment of outstanding amounts at any time. However, Hallmark Cards has also confirmed to the Company that it willnot request any reimbursement of amounts drawn on such letter of credit priorto August 31, 2006.  Hallmark Cardsalso confirmed that it and its wholly-owned subsidiaries will not requestpayment of the license fees and other amounts payable to affiliates of HallmarkCards prior to August 31, 2006 (see note 9).

 

Asconsideration for extending the demand period for the possible reimbursement ofamounts drawn on the letter of credit supporting the credit facility and thepayment of license fees up to $150.0 million and other amounts up to $100.0million payable to Hallmark affiliates, the Company agreed, if so requested byHallmark Cards, to convert its license fees payable to Hallmark affiliates,which were approximately $138.3 million at June 30, 2005, to a promissorynote bearing interest at LIBOR plus 3% per annum (or another market appropriaterate for the Company).  The term of thepromissory note would begin on August 1, 2005, or other date acceptable toHallmark Cards and the Company’s banks, and would be payable in full on August 31,2006.  The conversion of the non-interest

 

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bearing license fees payable to an interest bearing promissory notewould be subject to the approval of the lenders in the bank syndicate to thecredit facility.

 

Upon the maturity of the credit facility on May 31,2006, the lending group led by JP Morgan Chase has the right to elect to foregothe receipt of cash to pay the principal amount of the credit facility in full,which is provided for under the terms of an irrevocable letter of creditprovided by Hallmark Cards described in note 9, but instead to initiate aprocess to foreclose on the Company’s assets. Such foreclosure proceedingscould affect our ability to continue our operations. Prior to any such possibleforeclosure proceedings, the Company would consider various alternatives asindicated above, including, among other things, extending or refinancing thebank credit facility or raising additional capital through the issuance ofequity or debt securities.

 

The outstanding borrowings under the creditfacility of $179.0 million at June 30, 2005, have been classified as acurrent liability.  Such balance sheetclassification was deemed necessary as the bank has the right, at the maturitydate, at its discretion, to either draw upon the outstanding letter of creditsupplied by Hallmark Cards in order to receive payment in full of theoutstanding principal amount under the credit facility (see note 9) or toinitiate other actions including foreclosure of the Company’s assets. As thisis outside the control of the Company, the obligation does not meet therequirements as long-term debt even though Hallmark Cards has committed to notrequest reimbursement from the Company prior to August 31, 2006 in theevent the banks exercise their rights under the irrevocable letter of creditdescribed in note 9.

 

The Company’s liquidity is also affected by cashgenerated from operations.  As a result,any decline in the popularity of the Hallmark Channel, any significant futuremodifications to the Company’s distribution agreements, an economic decline inthe advertising market, an increase in program acquisition costs, an increasein competition or other adverse operating conditions would impact the Company’sliquidity and its ability to fund the current level of operations.

 

**2. Summary of Significant Accounting Policies and Estimates**

 

***Interim Financial Statements***

 

In the opinion of management, the accompanyingcondensed consolidated balance sheets and related interim consolidatedstatements of operations and cash flows, include all adjustments, consisting ofnormal recurring items necessary for their fair presentation in conformity withaccounting principles generally accepted in the United States. Interim resultsare not necessarily indicative of results for a full year. These consolidatedfinancial statements should be read in conjunction with the auditedconsolidated financial statements and the notes to those statements for theyear ended December 31, 2004, including the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2004.

 

***Basis of Presentation***

 

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

 

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

 

***Use of Estimates***

 

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

 

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allowance for bad debts, useful lives of assets, ultimate revenue usedin the film asset amortization calculations, cash flow projections used invarious asset valuations, income taxes, reserves and other provisions forcontingencies are reasonable, based on information available at the time theyare made. These estimates, judgments and assumptions can affect the reportedamounts of assets and liabilities as of the date of the consolidated financialstatements, as well as the reported amounts of revenue and expenses during theperiods presented. Actual results could differ from these estimates.

 

***FilmAssets and Film Library Impairment***

 

The Company amortizes itsfilm assets using the individual-film-forecast-computation method over amaximum period of 9.25 years from the date of acquisition. Theindividual-film-forecast-computation method amortizes such assets in the sameratio that current period actual revenue bears to estimated ultimate futurerevenues.

 

On a quarterly basis, theCompany assesses whether events or circumstances have changed indicating thatthe fair value of a film is lower than its unamortized cost or carrying value.If the carrying value of any individual film asset exceeds its fair value, thefilm asset is written-down to its estimated fair value. A discounted cash flowmodel, based on management’s anticipated ultimate future revenue of the film,is used to estimate the fair value of the individual films. The Companyconsiders the following factors, among others, in estimating ultimate futurerevenue for each film:  (a) the film’sperformance in historical markets, (b) the public’s perception of the film’sstory, cast, director, or producer, (c) historical results of similarfilms, (d) historical results of the cast, director, or producer on priorfilms, and (e) running time of the film.  In estimating a film’s fairvalue, the Company considers those cash outflows necessary to generate the film’scash inflows such as exploitation, residual and participation costs andtaxes.  The discount rate used in the Company’s discounted cash flow modelis based upon management’s estimate of the rate a lender would require relatedto the risks and uncertainties surrounding the timing and probability of thecash flow estimates.

 

TheCompany reviews its estimates of ultimate future revenues and participationcosts as of each reporting date to reflect currently available information.Estimated ultimate future revenues are based on the history of each film andsimilar films, sales and marketing plans, and other factors, all of whichrequire significant judgment and estimation by management. Differences between amortizationexpense determined using the new estimates and any amounts previously expensedduring that current fiscal year are charged or credited to the statement ofoperations in the period in which the estimates are revised.

 

Foruse of the film assets on the Hallmark Channel and the Hallmark Movie Channel,the Company estimates the fair value of the internal usage based upon theportion of the film’s ultimate revenues attributable to the term of the licensewindow. The Company first calculates the amount of cost attributable to theinternal use using the individual-film-forecast-computation method describedabove and then expenses such amounts ratably over the term of the license window.

 

***Cash and Cash Equivalents***

 

Cashand cash equivalents include highly liquid investments with original maturitiesof three months or less that are readily convertible into cash and are notsubject to significant risk from fluctuations in interest rates. As a result,the carrying amount of cash and cash equivalents approximates fair value.

 

***Allowance for Doubtful Accounts***

 

The allowance for doubtful accounts is based upon theCompany’s assessment of probable loss related to uncollectible accounts receivable.  The Company uses a number of factors indetermining the allowance, including, among other things, collection trends andcurrent anticipated economic conditions in each country in which the Companyderives its revenue.  The Company’s baddebt recovery was $2.0 million and $1.0 million for the three and six monthsended June 30, 2004, respectively. The Company’s bad debt expense was $2.1million and $1.1 million for the three and six months ended June 30, 2005.

 

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***Program License Fees***

 

Program license fees are paid in connection with theacquisition of the rights to air programs acquired from others. Program rightsare generally deferred and then amortized on a straight-line basis over theircontractual license periods or anticipated usage. Crown Media Holdingsperiodically evaluates the realizability of these deferred license fees inrelation to the estimated future revenues.

 

Estimates of net realizable value for program licensefees are determined using future estimated advertising revenues and anticipatedpatterns of programming usage on a day part basis as it pertains to programminglicensed to the channel. These estimates of expected annual future estimatedrevenues are compared to net book value of the program license fee assets todetermine if the programming assets are expected to be recovered. Where theanalysis indicates the costs are in excess of the estimated net realizablevalue, additional amortization is provided.

 

***Subscriber Acquisition Fees***

 

Subscriberacquisition fees are generally required to be paid to obtain carriage ondomestic pay distributors systems. Under certain of these agreements with paydistributors, Crown Media United States is obligated to pay subscriberacquisition fees if defined subscriber levels are met or in order to obtainadditional carriage of the Hallmark Channel by those pay distributors. Suchcosts are accrued when Crown Media United States receives notice from thedistributors that they have met the contractual penetration percentage orsubscriber count.

 

Subscriber acquisition fees are amortized over thecontractual life of the distribution agreements (ranging from 4 to 9years) as a reduction of subscriber feerevenue. If the amortization expense exceeds the subscriber fee revenuerecognized on a per distributor basis, the excess amortization is included as acomponent of cost of services. Crown Media Holdings assesses the recoverabilityof these costs periodically by comparing the net carrying amount to the estimatesof future subscriber fee and advertising revenues. It also assesses therecoverability when events such as changes in distributor relationships occuror other indicators suggest impairment.

 

***Property and Equipment***

 

Property and equipment are stated at historical cost.Equipment under capital leases are initially recorded at the present value ofthe minimum lease payments.

 

Depreciation on equipment is calculated using thestraight-line method over the estimated useful lives of the assets. Equipmentheld under capital leases and leasehold improvements are amortizedstraight-line over the shorter of the lease term or estimated useful life ofthe asset.

 

When property and equipment is sold or otherwisedisposed of, the cost and related accumulated depreciation or amortization areremoved from the accounts and any resulting gain or loss is included in income.The costs of normal maintenance and repairs are charged to expense whenincurred.

 

***Long-Lived Assets***

 

TheCompany reviews long-lived assets, other than goodwill and other intangibleassets with indefinite lives, for impairment whenever facts and circumstancesindicate that the carrying amounts of the assets may not be recoverable. Animpairment loss is recognized if the carrying amount of the asset is notrecoverable and exceeds its fair value. Recoverability of assets to be held andused is measured by comparing the carrying amount of an asset to the estimatedundiscounted future net cash flows expected to be generated by the asset. Ifthe asset’s carrying value is not recoverable, an impairment charge isrecognized for the amount by which the carrying amount of the asset exceeds itsfair value. The Company determines fair values by using a combination ofcomparable market values and discounted cash flows, as appropriate.

 

Goodwillis reviewed for impairment annually on November 30 or whenever an eventoccurs or circumstances change that indicates fair value might be belowcarrying value. Goodwill is carried at historical cost if the estimated fairvalue is greater than the carrying amounts. However, if estimated fair value isless than the carrying amount,

 

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goodwill is reduced to estimated fair value through an impairmentcharge to the Company’s consolidated statements of operations.

 

***Revenue Recognition***

 

Subscriber revenue from pay television distributors isrecognized as revenue when an agreement is executed, programming is provided,the price is determinable, and collectibility is reasonably assured. Subscriberfees from pay television distributors are recorded net of amortization ofsubscriber acquisition costs. If the amortization expense exceeds the revenuerecognized on a per distributor basis, the excess amortization is included as acomponent of cost of services.

 

Advertisingrevenues are recognized as earned in the period in which the advertising istelecast. Revenue is recognized as commercial spots or long form programmingare aired and as ratings guarantees to advertisers are achieved. Advertisingrevenues are recorded net of agency commissions. Agency commissions arecalculated based on a stated percentage applied to gross billing revenue forthe Company’s broadcasting operations. Customers remit the gross billing amountto the agency and the agency remits gross billings less their commission to theCompany. Payments received in advance of being earned are recorded as deferredrevenue.

 

Advertising revenue and expenses in barter transactionsare recorded at the fair value of the advertising provided. The fair value isdetermined based upon amounts recently received in cash for similaradvertisements from buyers unrelated to the other party in the bartertransaction. If there are no recent indications of fair value via cashtransactions, no revenue is recognized.

 

Revenue from film asset licensing agreements isrecognized in accordance with Statement of Position (“SOP”) 00-02,*Accounting by Distributors or Producers of Films*.Revenues are recognized when all of the following have occurred:  an agreement is executed, the film isavailable for exhibition by the licensee, the license fee is fixed orreasonably determinable, collectibility is reasonably assured and the cost ofeach film is known or reasonably determinable. Revenue from film asset licensingagreements containing multiple film titles is allocated among the various filmtitles based on their relative estimated fair values. Payments received fromlicensees prior to the availability of a film are recorded as deferred revenue.Fees payable with terms in excess of one year are discounted for revenuerecognition purposes at the customer’s estimated incremental borrowing rate inaccordance with Accounting Principles Board (“APB’) Opinion No. 21, *Interest on Receivables and Payables.*

 

***Taxes on Income***

 

Pursuant to the tax sharing agreement entered into withHallmark Cards in March 2003, the Company’s results of operations for taxpurposes became a part of the Hallmark Cards consolidated federal tax return asof and subsequent to March 2003. However, the Company continues to account for income taxes on a separatereturn basis. Accordingly, the Company accounts for income taxes using an assetand liability method which requires the recognition of deferred tax assets andliabilities for the expected future tax consequences attributable todifferences between the financial statement carrying amounts of existing assetsand liabilities and their respective tax bases and net operating loss and taxcredit carryforwards. Deferred tax assets and liabilities are measured usingenacted tax rates expected to be applied to taxable income in the years inwhich those temporary differences are expected to be recovered or settled. TheCompany reduces deferred tax assets by a valuation allowance if it is morelikely than not that some portion or all of the deferred tax assets will not berealized. Any payments received from Hallmark Cards under the taxsharing agreement are recorded as an increase in additional paid-in capital andany future utilization of deferred tax assets generated after March 2003will be recorded as a reduction in paid-in capital, to the extent payments werepreviously received from Hallmark Cards for such benefits under the tax sharingagreement.

 

***Stock-Based Compensation***

 

The Company accounts for its stock-based employeecompensation plan using the intrinsic value method under the recognition andmeasurement principles of APB Opinion No. 25, *Accountingfor Stock Issued to Employees,* and related Interpretations.Accordingly, compensation cost for stock options issued to employees ismeasured as the excess, if any, of the quoted market price of the Company’sstock at the date of the grant over the exercise price of

 

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the underlying stock options. In December 2002,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“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 compensation expense for these plans been determinedconsistent with SFAS No. 123, Crown Media Holdings’ net loss and loss pershare would have been increased to the following pro forma amounts for thethree and six months ended June 30, 2004 and 2005:

 

**Pro Forma Effects**

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

 
| ** **                                              | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| ** **                                              | ** ** | **2004**                              | ** ** | **2005**                           | ** ** | **2004** | ** ** | **2005** | ** ** |
|                                                    |       |                                  |       |                               |       |   |   |   |   |
| Net loss                                                |       | $                                     | (40,587    | )                                  | $          | (56,255 | ) | $ | (82,063 | ) | $ | (107,162 | ) |
| Pro forma stock options expense at estimated fair value |       | (646                                  | )          | (93                                | )          | (1,323 | ) | (261 | ) |
| Stock plan expense included in net loss                 |       | —                                |       | 7                                  |       | — |   | 14 |   |
| Pro forma net loss                                      |       | $                                     | (41,233    | )                                  | $          | (56,341 | ) | $ | (83,386 | ) | $ | (107,409 | ) |
| Weighted average shares                                 |       | 104,533                               |       | 104,551                            |       | 104,533 |   | 104,542 |   |
| Pro forma net loss per share, basic and diluted         |       | $                                     | (0.39      | )                                  | $          | (0.54 | ) | $ | (0.80 | ) | $ | (1.03 | ) |

 

***Net Loss per Share***

 

Basic net loss per share is computed by dividing the netloss for the period by the weighted average number of common shares outstandingduring the period. Diluted net loss per share is computed based on the weightedaverage number of common shares and potentially dilutive common shares outstanding.The calculation of diluted net loss per share excludes potential common sharesif the effect would be antidilutive. Potential common shares consist ofincremental common shares issuable upon the exercise of stock options.Approximately 1.4 million and 1.2 million stock options for both the three andsix months ended June 30, 2004 and 2005, respectively, have been excludedfrom the calculations of loss per share because their effect would have beenantidilutive.

 

***Translation of Foreign Currency***

 

Through April 26, 2005, the balance sheets andstatements of operations of certain Crown Media Holdings’ foreign subsidiaries weremeasured using local currency as the functional currency. Revenues, expensesand cash flows of such subsidiaries were translated into United States dollarsat the average exchange rates prevailing during the period. Assets andliabilities were translated at the rates of exchange at the balance sheet date.Translation gains and losses were deferred as a component of accumulated other comprehensiveincome (loss). Foreign currency transaction gains and losses recorded upon theremeasurement of financial assets and liabilities denominated in currenciesother than the functional currency of the subsidiary were included indetermining net loss for the period. In conjunction with the sale of theinternational business, the cumulative foreign currency translation gain ofapproximately $3.1 million was realized as a component of the loss on sale ofdiscontinued operations in the accompanying consolidated statement ofoperations.

 

***Concentration of Credit Risk***

 

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

 

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***Reclassifications***

 

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

 

***Recently Issued Accounting Pronouncements***

 

In December 2004, the FASBissued 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 required thatthe accounting for an exchange of a productive asset for a similar productiveasset or an equivalent interest in the same or similar productive asset shouldbe based on the recorded amount of the asset relinquished. APB Opinion No. 29provided an exception to its basic measurement principle (fair value) forexchanges of similar productive assets. The FASB believes that exceptionrequired that some nonmonetary exchanges, although commercially substantive, berecorded on a carryover basis. By focusing the exception on exchanges that lackcommercial substance, the FASB believes SFAS No. 153 produces financialreporting that more faithfully represents the economics of the transactions.SFAS No. 153 is effective for nonmonetary asset exchanges occurring in fiscalperiods beginning after June 15, 2005. Earlier application is permittedfor nonmonetary asset exchanges occurring in fiscal periods beginning after thedate of issuance. The provisions of SFAS No. 153 shall be appliedprospectively. The Company does not anticipate that the adoption of SFAS No. 153will have a significant impact on the Company’s overall results of operationsor 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 issued guidance 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 objective; (b) expected volatility – the SAB provides guidanceon when 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.

 

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**3. Subscriber Acquisition Fees**

 

Subscriber acquisition fees are comprised of thefollowing:

 
| ** **                           | ** ** | **As of December 31,** | ** ** | **As of June 30,** | ** ** |
|--------------------------------------|------------|-----------------------------|------------|-------------------------|------------|
| ** **                           | ** ** | **2004**                    | ** ** | **2005**                | ** ** |
| ** **                           | ** ** | **(In thousands)**          | ** ** |
| Subscriber acquisition fees, at cost |       | $                           | 236,447    |                    | $          | 240,873 |   |
| Accumulated amortization             |       | (116,434                    | )          | (141,222                | )          |
| Subscriber acquisition fees, net     |       | $                           | 120,013    |                    | $          | 99,651 |   |

 

*Of the net balance at June 30,2005, the Company expects $21.9 million will be recognized as a reduction ofsubscriber fee revenue and $77.8 million will be recognized as subscriberacquisition fee expense in future periods.*

* *

*As of December 31, 2004, and June 30,2005, the consolidated balance sheets also reflect subscriber acquisition feespayable of $35.9 million and $10.6 million, respectively. For the three monthsended June 30, 2004 and 2005, Crown Media United States made cash paymentsof $984,000 and $25.9 million, respectively. For the six months ended June 30,2004 and 2005, Crown Media United States made cash payments of $3.5 million and$29.8 million, respectively.*

* *

**4. Program License Fees**

 

Program license fees are comprised of the following:

 
| ** **                                                      | ** ** | **As of December 31, 2004** | ** ** | **As of June 30, 2005** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                                                      | ** ** | **(In thousands)**               | ** ** |
| Program license fees — Hallmark Entertainment Distribution |       | $                                | 144,848    |                         | $          | 130,386 |   |
| Program license fees — NICC                                |       | 2,448                            |       | 9,465                        |       |
| Program license fees — other affiliates                    |       | 5,906                            |       | 5,594                        |       |
| Program license fees — non-affiliates                      |       | 329,021                          |       | 328,601                      |       |
| Program license fees, at cost                                   |       | 482,223                          |       | 474,046                      |       |
| Accumulated amortization                                        |       | (167,993                         | )          | (177,336                     | )          |
| Program license fees, net                                       |       | $                                | 314,230    |                         | $          | 296,710 |   |

 

Amortizationof program license fees for continuing operations, which is included as acomponent of programming cost in the accompanying consolidated statements ofoperations, was $20.1 million and $28.4 million for the three months ended June 30,2004 and 2005, respectively, and $39.1 million and $56.4 million for the sixmonths ended June 30, 2004 and 2005, respectively.

 

At December 31,2004, and June 30, 2005, $7.7 million and $2.6 million of program licensefees, respectively, were included in prepaid and other assets on theaccompanying condensed consolidated balance sheets as the Company had madepayments, but the airing windows had not commenced.

 

License fees payable are comprised of the following:

 
| ** **                                                      | ** ** | **As of December 31, 2004** | ** ** | **As of June 30, 2005** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                                                      | ** ** | **(In thousands)**               | ** ** |
| License fees payable — Hallmark Entertainment Distribution |       | $                                | 151,980    |                         | $          | 138,261 |   |
| License fees payable — NICC                                |       | —                           |       | 2,905                        |       |
| License fees payable — non-affiliates                      |       | 191,576                          |       | 194,811                      |       |
| Total license fees payable                                      |       | 343,556                          |       | 335,977                      |       |
| Less current maturities                                         |       | (79,815                          | )          | (69,780                      | )          |
| Long-term license fees payable                                  |       | $                                | 263,741    |                         | $          | 266,197 |   |

 

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**5. Property and Equipment**

 

Property and equipment are comprised of the following:

 
| ** **                        | ** ** | **As of December 31,** | ** ** | **As of June 30,** | ** ** | **Depreciable Life** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|-------------------------|------------|----------------------|------------|
| ** **                        | ** ** | **2004**                    | ** ** | **2005**                | ** ** | **(In years)**       | ** ** |
| ** **                        | ** ** | **(In thousands)**          | ** ** |
| Technical equipment and computers |       | $                           | 38,947     |                    | $          | 14,707               |       | 3-5 |   |
| Leased assets                     |       | 30,615                      |       | 17,363                  |       | 8-15                 |       |
| Furniture, fixtures and equipment |       | 2,078                       |       | 1,219                   |       | 5                    |       |
| Leasehold improvements            |       | 10,402                      |       | 3,329                   |       | 3-7                  |       |
| Construction-in-progress          |       | 161                         |       | 194                     |       |                 |       |
| Property and equipment, at cost   |       | 82,203                      |       | 36,812                  |       |                 |       |
| Accumulated depreciation          |       | (49,374                     | )          | (16,511                 | )          |                 |       |
| Property and equipment, net       |       | $                           | 32,829     |                    | $          | 20,301               |       |   |   |

 

Depreciation expense related to property and equipmentwas $886,000 for both the three months ended June 30, 2004 and 2005,respectively. Depreciation expense related to property and equipment was $1.8million for both the six months ended June 30, 2004 and 2005,respectively.

 

Software and other intangible assets of $3.2 million and$2.2 million as of December 31, 2004, and June 30, 2005,respectively, have been included in prepaid and other assets in theaccompanying condensed consolidated balance sheets.

 

**6. Reorganization**

 

In October 2002, theCompany reorganized its operations in order to concentrate its efforts on theHallmark Channel in the U.S.  Thefollowing table displays the activity and balances of the reorganizationaccrual account from December 31, 2003, to June 30, 2005, which isincluded in the current portion of accounts payable and accrued liabilities inthe accompanying condensed consolidated balance sheets.

 
| ** **                                            | ** ** | ** **         | ** ** | ** **     | ** ** | **Satellite and** | ** ** | ** ** | ** ** |
|-------------------------------------------------------|------------|--------------------|------------|----------------|------------|-------------------|------------|------------|------------|
| ** **                                            | ** ** | **Severance**      | ** ** | **Facilities** | ** ** | **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            | )          | (720              | )          | (780       | )          |
| Contracts  assumed by buyer of international business |       | —             |       | (1,000         | )          | (8,671            | )          | (9,671     | )          |
| Balance at  June 30, 2005                        |       | $                  | —     |           | $          | —            |       | $          | 269        |   | $ | 269 |   |

 

**7. Credit Facility**

 

The Company has a credit agreement with a syndicate ofbanks, led by JP Morgan Chase Bank, under which the banks have extended to theCompany a secured revolving credit facility of up to $220.0 million.  The Company and the lending banks originally enteredinto the facility in 2001 and have subsequently amended the terms of thisfacility, 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.  Theoriginal bank credit facility encompassed a term loan of $100.0 million and arevolving line of credit of $220.0 million, inclusive of up to $20.0 million ofletters of credit available to be issued at the Company’s request.  Upon

 

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the consummation of sale of the international business, the Companyrepaid and retired the $100.0 million term loan along with $95.0 million on therevolving line of credit under the credit facility. The credit facility nowconsists of the revolving line of credit of $220.0 million, which includes upto $20.0 million of letters of credit. In addition, following such closing, any borrowings by the Company ofamounts in excess of the $180.0 million under the revolving line of credit willrequire 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 FederalFunds effective 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 inquarterly installments.

 

As of 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 other significantchanges to the bank credit facility including elimination of certain financialcovenants, changes to and waivers of financial covenants concerning 2004violations and the future compliance, and a reduction in the interest rates andcommitment fees under the credit facility. See “Hallmark Letter of Credit” in note9 below regarding an irrevocable letter of credit of Hallmark Cards issued ascredit support for obligations under the credit facility.

 

Amendment No. 8 waived the Company’snon-compliance with the following financial covenants:  (1) capital expenditures in 2004; (2) cashprogram acquisition guarantees 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 June 30, 2005, Crown Media Holdings had outstanding borrowingsof $310.0 million and $179.0 million, respectively, under the credit facilityand there were no letters of credit outstanding. At June 30, 2005, theentire outstanding balance bore interest at the Eurodollar rate (4.33% at June 30,2005). Interest expense on borrowings underthe credit facility for the three months ended June 30, 2004 and 2005, was$3.3 million, and $2.0 million, respectively, and for the six months ended June 30,2004 and 2005, interest expense was $6.4 million, and $5.9 million,respectively.

 

**8.  Classification of CreditFacility as a Current Liability**

 

The outstanding borrowings under the creditfacility of $179.0 million at June 30, 2005, have been classified as acurrent liability.  Such balance sheetclassification was deemed necessary as the bank has the right, at the maturitydate, at its discretion, to either draw upon the outstanding letter of creditsupplied by Hallmark Cards in order to receive payment in full of theoutstanding principal amount under the credit facility (see note 9) or toinitiate other actions including foreclosure of the Company’s assets. As thisis outside the control of the Company, the obligation does not meet therequirements as long-term debt even though Hallmark Cards has committed to notrequest reimbursement from the Company prior to August 31, 2006 in theevent the banks exercise their rights under the irrevocable letter of creditdescribed in note 9.

 

**9.  Related Party Long-TermObligations**

 

***Hallmark Letter of Credit***

 

Pursuantto Amendment No. 8 to the bank credit facility, Hallmark Cards provided anirrevocable letter of credit issued to JP Morgan Chase Bank by Citibank, N.A.in the amount of $320.0 million, as credit support for the Company’sobligations under the credit facility. The letter of credit was reduced to $220.0 million upon the

 

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consummation of the sale of the Company’s international business andthe reduction of the aggregate outstanding credit exposure of its lenders to$220.0 million.  Drawdowns under theletter of credit may be made for amounts due and payable under the creditfacility. Amounts in excess of $180.0 million require the concurrence ofHallmark Cards.  Any proceeds received byJP Morgan Chase Bank from drawing under this support letter of credit will notbe applied to repay the Company’s obligations, but will be used to purchase onthe part of Hallmark Cards from the bank lenders subordinated participations inour obligations under its bank credit facility, junior in payment to the banklenders under the bank credit facility. The support letter of credit automatically expires on May 31, 2006.The Company pays to Hallmark Cards, as compensation for the support letter ofcredit, the amounts resulting from the 2% reduction in the interest rate andthe 0.3% reduction in the commitment fee payable by the Company under the bankcredit facility as provided in Amendment No. 8.

 

***Senior Unsecured Note***

 

In August 2003,the Company issued a senior unsecured note to HC Crown for $400.0 million. Aportion of the proceeds was used to repurchase the Company’s outstanding trustpreferred securities, and the balance of the proceeds, after expenses, was usedto reduce amounts outstanding under its bank credit facility.

 

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 June 30, 2005, $460.9million and $484.6 million, respectively, of principal and accrued interestwere included in the senior unsecured note payable in the accompanying condensedconsolidated balance sheet. The note purchase agreement for the senior unsecurednote contains certain covenants which restrict on the part of the Company,among other matters, from the incurrence of any additional indebtedness, therepurchase or other acquisitions of the Company’s stock, investments in otherparties and the incurrence of liens on the Company’s assets.  As a fee for the issuance of the notes, theCompany paid $3.0 million to HC Crown, which was initially capitalized and isbeing amortized as additional interest expense over the term of the notepayable.

 

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

 

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 June 30, 2005, borrowings under the note were $75.0 million.Accrued interest on the note of $6.1 million and $8.4 million are included inline of credit and interest payable to HC Crown as of December 31, 2004,and June 30, 2005, respectively, on the accompanying condensedconsolidated balance sheets.

 

***Hallmark Obligations***

 

By a letter dated August 1, 2005, whichsupplemented a previous letter dated February 28, 2005, Hallmark Cardsconfirmed to the Company that neither Hallmark Cards nor any of itswholly-owned subsidiaries would demand payment from the Company until August 31,2006, at the earliest, on (1) license fees and intercompany payables outstandingas of December 31, 2004, and June 30, 2005, and (2) anyreimbursements on the letter of credit supporting the bank line of credit ifdrawn to pay the bank credit facility which matures on May 31, 2006.Therefore, the Company has classified the license fees and payables to Hallmarkaffiliates as non-current liabilities on the accompanying condensed consolidatedbalance sheet.

 

**10. Related Party Transactions**

 

***Tax Sharing Agreement***

 

On March 11,2003, Crown Media Holdings became a member of Hallmark Cards consolidatedfederal tax group and entered into a federal tax sharing agreement withHallmark Cards (the “tax sharing agreement”). Hallmark Cards includes CrownMedia Holdings in its consolidated federal income tax return.  Accordingly, Hallmark Cards

 

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has benefited from past tax losses and will benefit from future federaltax losses, 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 June 30, 2005,Hallmark Cards has not exercised this option.

 

TheCompany received $9.3 million and $0 under the tax sharing agreement during thethree months ended June 30, 2004 and 2005, respectively. The Companyreceived $23.6 million and $21.4 million under the tax sharing agreement duringthe six months ended June 30, 2004 and 2005, respectively. These receiptshave been recorded as an addition to paid-in capital. The Company estimates that a gain will be recognized on the sale of theinternational business for income tax purposes, which will reduce currentperiod operating losses and will also reduce the tax sharing payments expectedto be received in 2005.

 

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

 

Since inception, Hallmark Entertainment has at timespaid certain costs on behalf of Crown Media Holdings. Non-interest bearingunreimbursed costs of $4.5 million and $5.1 million are included in payable toaffiliates in the accompanying condensed consolidated balance sheets as of December 31,2004, and June 30, 2005, respectively.

 

***Services Agreement with Hallmark Cards***

 

CrownMedia Holdings entered into an Intercompany Services Agreement with HallmarkCards, effective January 1, 2003, under which Hallmark Cards agreed for aterm of three years to provide Crown Media Holdings with tax, risk management,health safety, environmental, insurance, legal, treasury and cash managementservices and real estate consulting services. Under the agreement, the Company agreed to pay Hallmark Cards $515,000 peryear for these services, plus out-of-pocket expenses and third party fees,payable in arrears on the last business day of each quarter. However, the Company has not been paying theseamounts as they are due. For each of the three months ended June 30, 2004and 2005, Crown Media Holdings had accrued $129,000 under the agreement. Foreach of the six months ended June 30, 2004 and 2005, Crown Media Holdingshad accrued $258,000 under the agreement. At December 31, 2004, and June 30,2005, non-interest bearing unpaid accrued service fees and unreimbursed expensesof $8.6 million and $9.9 million, respectively, were included in payable toaffiliates in the accompanying condensed consolidated balance sheets.

 

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

 

The Company entered into a film asset services agreementwith Hallmark Entertainment, under which Hallmark Entertainment provides CrownMedia Holdings with services related to the administration, distribution andother exploitation of the Company’s film assets. In consideration for the servicesprovided by Hallmark Entertainment, Crown Media Holdings was, prior to the saleof the Company’s international operations, obligated to pay a service fee of$1.5 million per year, payable in quarterly installments of $375,000. At December 31,2004, and June 30, 2005, non-interest bearing unpaid accrued service feesof $375,000 and $617,000 were included in payable to affiliates in theaccompanying condensed consolidated balance sheets. Following the sale of theCompany’s international operations, the annual fee for these services was reducedto $750,000 per year and such amount has been prorated for the period April 26,2005, through December 31, 2005.

 

***Trademark Agreement with Hallmark Cards***

 

CrownMedia United States has trademark license agreement with Hallmark Licensing, Inc.for use of the “Hallmark” mark for the Hallmark Channel and for the HallmarkMovie Channel.  As amended in August 2005,the trademark license agreements for the Hallmark Channel and the Hallmark MovieChannel expire on September 1, 2006. The Company is not required to payany fees under the trademark license agreements.

 

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

 

The Company licenses programming for distribution in theUnited States from Hallmark Entertainment Distribution under a program licenseagreement, dated January 1, 2001. Under this program license agreement, theCompany licenses programs owned or controlled by Hallmark EntertainmentDistribution, as well as all programming produced by or on behalf of HallmarkEntertainment Distribution for the Company. The program agreement has a term offive years and is automatically renewable for additional three-year periods,subject to rate adjustments, so long as Hallmark Entertainment Distribution orits affiliates, owns an interest of 35% or more of Crown Media Holdings.  If, at any time, Hallmark EntertainmentDistribution ceases to own a 35% interest in Crown Media Holdings, and if, atthat time, the remaining term of the program agreement is less than two years,then the remaining term of the program agreement will be extended to the datetwo years after the date on which Hallmark Entertainment Distribution ceased toown a 35% interest in Crown Media Holdings.

 

If theCompany sub-licenses any licensed program to a third party, it must equallyshare with Hallmark Entertainment Distribution the excess, if any, of thesublicensing fee over the initial program license fee paid by the Company.  The Company did not sub-license any licensedprogramming to third parties during the three and six months ended June 30,2004 and 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 $4.8 million and $7.2 million for the three months ended June 30,2004 and 2005, respectively. Programming costs related to the Hallmark programagreements were $9.3 million and $13.8 million for the six months ended June 30,2004 and 2005, respectively. As of December 31, 2004, and June 30,2005, $152.0 million and $138.3 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 and its subsidiaries will not demand payment of these license fees priorto August 31, 2006.

 

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

 

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

 

 Under the companyagreement, 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 and reclassified tonon-current liabilities in accordance with the provisions of SFAS No. 150.

 

Underthe company agreement, Crown Media United States may be required to makecertain payments in regards to programming provisions to the NationalInterfaith Cable Coalition (“NICC”). Specifically, Crown Media United States may be required to pay licensefees to NICC or fund production costs consisting of: (i) a total of $5.3million per year, with consumer price index escalations, for two recurringprogramming blocks produced by NICC; (ii) up to $10.0 million per year foran additional recurring “signature” series program block co-produced by NICCand Crown Media United States; (iii) up to $600,000 per “non-dramatic”holiday special produced by NICC; and (iv) up to $1.0 million per “dramatic”holiday special co-produced by NICC and Hallmark Entertainment. In addition, six months prior to the expirationof the agreement, Crown Media United States must negotiate in good faith withNICC regarding a continuation of this programming and funding commitment. Ifagreement is not reached

 

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and Crown Media United States does not continuethe NICC programming and funding commitments at the same levels, NICC isentitled to compel Crown Media Holdings to repurchase all of NICC’s Crown MediaHoldings shares at their then-current market value no later than 60 daysfollowing the expiration of the amendment. Crown Media United States, however,can nullify this put by electing to continue the NICC programming and fundingcommitments at the same levels.

 

Pursuant to additionalamendments effective January 1, 2002, and January 1, 2004, CrownMedia United States agreed to advance NICC $3.0 million in each of 2002, 2003and 2004 to help fund NICC’s cost of expanding its production operations toproduce the aforementioned programming.  CrownMedia United States has agreed to extend a similar production advance of $3.0million to NICC in 2005. This advance will be recovered from the license feespayable for this programming when such programming is produced and accepted byCrown Media United States for distribution on the channel. The Company isexpensing these amounts as incurred given the uncertainty surrounding whetheror not the programming will be produced and/or accepted. These expenses areincluded as components of affiliate programming costs in the accompanyingconsolidated statements of operations. See note 14 regarding NICC’s threatened litigation against the Company.

 

During the three monthsended June 30, 2004 and 2005, Crown Media United States paid NICC $3.7million and $2.6 million, respectively, and during the six months ended June 30,2004 and 2005, $7.2 million and $5.2 million, respectively, related to thecompany agreement, as amended.

 

**12. Employee Incentives**

 

In April 2003, the Company’s Board of Directorsapproved actions to provide additional incentives to encourage retention of itsemployees. Crown Media Holdings’ then outstanding stock options held byemployees had exercise prices significantly above the market value of its Class Acommon stock.  The Company made an offerin May 2003 to senior management and vice presidents, totalingapproximately 55 persons, to exchange their options for restricted stock units(“RSUs”).  The exchange ratio was one RSUfor every 2.5 options for shares of the Company’s Class A common stock,resulting in a total of 5,126,732 options exchanged for 2,050,693 RSUs. EachRSU, upon vesting, represents the right to receive one share of Class Acommon stock or 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 and the Company is accruing expense related to theRSUs ratably over each increment’s vesting period using the price of our Class Acommon stock on the last day of the reporting period.

 

Options for 279,254 shares of common stock owned bycertain executives and vice presidents that were not exchanged are subject tovariable plan accounting in which compensation is remeasured at each reportingdate until the options are exercised, expire unexercised or are forfeited.

 

In May 2004, the Company’s Board of Directorsapproved an additional grant to employees of 1,065,000 RSUs. The EmploymentRSUs, which constitute 70% of the award granted in 2004, vest in equalone-third installments over the next three years on the anniversary of thegrant date each year. The Company is accruing expense related to the EmploymentRSUs ratably over each installment’s vesting period using the price of our Class Acommon stock on the last day of the reporting period. The Performance RSUs,constituting 30% of the award granted in 2004, vest on the 3rdanniversary of the grant date, provided that the price of the Crown commonstock is $14 or higher on that date. The Company will begin to accruecompensation expense for the Performance RSUs when it becomes probable that theprice of the Company’s stock will be $14 or more on the 3rdanniversary of the grant date.

 

The Company is recording compensation expense based onthe fair value of the common stock or cash equivalent required to settle theRSUs at each reporting period end during the vesting period of the RSUs. Suchcompensation expense is calculated using variable plan accounting.

 

The Company recorded $3.4million and $2.8 million, of compensation expense associated with the RSUsduring the three months ended June 30, 2004 and 2005, respectively, and $5.8million and $5.2 million, of compensation expense during the six months ended June 30,2004 and 2005, respectively, which has been recorded as a liability for RSUs inthe accompanying consolidated balance sheet and is included in selling, generaland administrative

 

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expense in theaccompanying consolidated statement of operations. The Company settled certain RSUs during the threemonths ended March 31, 2005, for approximately $4.2 million in cash.Additionally, in conjunction with the close of the international transaction,the Company immediately vested and settled RSUs held by individuals employed bythe international business in May 2005 for approximately $4.0 million incash.  In June 2005, the Companysettled the contractually vested RSUs for approximately $3.8 million in cash.

 

**13. Segment Reporting**

 

TheCompany’s continuing operations are currently organized into two principaldivisions representing operating segments: domestic channel and filmdistribution. The Company evaluates performance and allocates resources basedon the results of these segments. The key operating performance criteria usedin this evaluation include revenue, segment income (loss) and totalassets.  The results of operations of ourinternational channel operating segment are not included in the segmentreporting as they are classified separately as discontinued operations in theCompany’s consolidated financial statements (see note 13).

 

The following tables present theCompany’s segment information for the periods indicated (in thousands):

 

*Three Months Ended June 30, 2004*

 
| ** **                               | ** ** | ** **   | ** ** | **Film**         | ** ** | ** **      | ** ** | ** **       | ** ** |
|------------------------------------------|------------|--------------|------------|------------------|------------|-----------------|------------|------------------|------------|
| ** **                               | ** ** | **Domestic** | ** ** | **Distribution** | ** ** | **Adjustments** | ** ** | **Consolidated** | ** ** |
|                                     |       |         |       |             |       |            |       |             |       |
| Total revenue                            |       | $            | 32,189     |             | $          | 4,980           |       | $                | (6,778     | )(1) | $ | 30,391 |   |
|                                     |       |         |       |             |       |            |       |             |       |
| Segment income  (loss)                   |       | $            | (1,585     | )                | $          | 151             |       | $                | (3,784     | )(2) | $ | (5,218 | ) |
| Depreciation and  amortization expense   |       | (1,531       | )          | 1,549            |       | (1,645          | )(3)       | (1,627           | )          |
| Amortization of  film assets             |       | —       |       | (8,137           | )          | 6,790           | (5)        | (1,347           | )          |
| Subscriber  acquisition fee amortization |       | (9,700       | )          | 847              |       | (1              | )          | (8,854           | )          |
| Interest expense                         |       | (539         | )          | (12,599          | )          | (1,255          | )(2)       | (14,393          | )          |
| Loss from  continuing operations         |       | $            | (13,355    | )                | $          | (18,189         | )          | $                | 105        |   | $ | (31,439 | ) |
|                                     |       |         |       |             |       |            |       |             |       |
| Total assets                             |       | $            | 652,541    |             | $          | 561,538         |       | $                | 325,133    | (4) | $ | 1,539,212 |   |

 

*Three Months Ended June 30, 2005*

 
| ** **                               | ** ** | ** **   | ** ** | **Film**         | ** ** | ** **      | ** ** | ** **       | ** ** |
|------------------------------------------|------------|--------------|------------|------------------|------------|-----------------|------------|------------------|------------|
| ** **                               | ** ** | **Domestic** | ** ** | **Distribution** | ** ** | **Adjustments** | ** ** | **Consolidated** | ** ** |
|                                     |       |         |       |             |       |            |       |             |       |
| Total revenue                            |       | $            | 45,736     |             | $          | 4,986           |       | $                | (5,030     | )(1) | $ | 45,692 |   |
|                                     |       |         |       |             |       |            |       |             |       |
| Segment income  (loss)                   |       | $            | (281       | )                | $          | (4,080          | )          | $                | (1,414     | )(2) | $ | (5,775 | ) |
| Depreciation and  amortization expense   |       | (11,875      | )          | 11,376           |       | (973            | )(3)       | (1,472           | )          |
| Amortization of  film assets             |       | —       |       | (20,474          | )          | 6,810           | (5)        | (13,664          | )          |
| Subscriber  acquisition fee amortization |       | (12,967      | )          | 847              |       |            |       | (12,120          | )          |
| Income tax  provision                    |       |         |       |             |       | (6              | )          | (6               | )          |
| Interest expense                         |       | (1,097       | )          | (15,221          | )          | (1,126          | )(2)       | (17,444          | )          |
| Loss from continuing  operations         |       | $            | (26,220    | )                | $          | (27,552         | )          | $                | 3,291      |   | $ | (50,481 | ) |
|                                     |       |         |       |             |       |            |       |             |       |
| Total assets                             |       | $            | 783,724    |             | $          | 505,074         |       | $                | —     | (4) | $ | 1,288,798 |   |

 

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*Six Months Ended June 30, 2004*

 
| ** **                               | ** ** | ** **   | ** ** | **Film**         | ** ** | ** **      | ** ** | ** **       | ** ** |
|------------------------------------------|------------|--------------|------------|------------------|------------|-----------------|------------|------------------|------------|
| ** **                               | ** ** | **Domestic** | ** ** | **Distribution** | ** ** | **Adjustments** | ** ** | **Consolidated** | ** ** |
|                                     |       |         |       |             |       |            |       |             |       |
| Total revenue                            |       | $            | 60,987     |             | $          | 12,109          |       | $                | (9,304     | )(1) | $ | 63,792 |   |
|                                     |       |         |       |             |       |            |       |             |       |
| Segment income  (loss)                   |       | $            | (5,974     | )                | $          | 2,146           |       | $                | (3,623     | )(2) | $ | (7,451 | ) |
| Depreciation and  amortization expense   |       | (2,839       | )          | 2,377            |       | (2,849          | )(3)       | (3,311           | )          |
| Amortization of  film assets             |       |         |       | (15,467          | )          | 6,790           | (5)        | (8,677           | )          |
| Subscriber  acquisition fee amortization |       | (19,173      | )          | 1,693            |       | (1              | )          | (17,481          | )          |
| Interest expense                         |       | (1,075       | )          | (29,804          | )          | 2,268           | (2)        | (28,611          | )          |
| Loss from  continuing operations         |       | $            | (29,061    | )                | $          | (39,055         | )          | $                | 2,585      |   | $ | (65,531 | ) |
|                                     |       |         |       |             |       |            |       |             |       |
| Total assets                             |       | $            | 652,541    |             | $          | 561,538         |       | $                | 325,133    | (4) | $ | 1,539,212 |   |

 

*Six Months Ended June 30, 2005*

 
| ** **                               | ** ** | ** **   | ** ** | **Film**         | ** ** | ** **      | ** ** | ** **       | ** ** |
|------------------------------------------|------------|--------------|------------|------------------|------------|-----------------|------------|------------------|------------|
| ** **                               | ** ** | **Domestic** | ** ** | **Distribution** | ** ** | **Adjustments** | ** ** | **Consolidated** | ** ** |
|                                     |       |         |       |             |       |            |       |             |       |
| Total revenue                            |       | $            | 87,431     |             | $          | 6,907           |       | $                | (8,077     | )(1) | $ | 86,261 |   |
|                                     |       |         |       |             |       |            |       |             |       |
| Segment income  (loss)                   |       | $            | (5,323     | )                | $          | (6,933          | )          | $                | (1,251     | )(2) | $ | (13,507 | ) |
| Depreciation and  amortization expense   |       | (16,212      | )          | 17,179           |       | (4,078          | )(3)       | (3,111           | )          |
| Amortization of  film assets             |       |         |       | (26,155          | )          | 6,810           | (5)        | (19,345          | )          |
| Subscriber  acquisition fee amortization |       | (26,531      | )          | 1,693            |       |            |       | (24,838          | )          |
| Income tax  provision                    |       |         |       |             |       | (6              | )          | (6               | )          |
| Interest expense                         |       | (2,193       | )          | (33,725          | )          | 1,578           | (2)        | (34,340          | )          |
| Loss from  continuing operations         |       | $            | (50,259    | )                | $          | (47,941         | )          | $                | 3,053      |   | $ | (95,147 | ) |
|                                     |       |         |       |             |       |            |       |             |       |
| Total assets                             |       | $            | 783,724    |             | $          | 505,074         |       | $                | —     | (4) | $ | 1,288,798 |   |

 

----

(1) Adjustment represents netting ofcertain subscriber acquisition fee expense against revenue not allocated to domesticsegment and film asset license fees from international sources. Prior to thesale of the international business, film asset license fees earned frominternational sources were included in the Company’s Film Distribution segment.

(2) Represents amounts not allocated tothe individual segments on the financial reports reviewed by our chiefoperating decision maker.

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

(4) Represents assets held for sale fromthe international business sold in April 2005.

(5) Represents amortization associatedwith film asset license fees earned from international sources prior to thesale of the international business in April 2005.

 

23

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Four individual paytelevision distributors accounted for more than 15% of the Company’sconsolidated subscribers for the three and six months ended June 30, 2004and 2005.

 

**14.  Discontinued Operations**

 

On February 23,2005, the Company signed an agreement for the sale of its internationalbusiness and obtained other agreements enabling the Company to then conduct thesale.  The sale closed on April 26,2005. The accompanying condensed consolidated statements of operations and cashflows for each of the three and six month periods ended June 30, 2004 and2005 present the associated results of operations and cash flows of theinternational assets as “discontinued operations” pursuant to SFAS No. 144*Accounting for the Impairment or Disposal of Long-Lived Assets*.

 

Thenet losses from discontinued operations during each of the three and six monthperiods ended June 30, 2004 and 2005, were comprised of the following:

 

| ** **                         | ** ** | **Three Months**         | ** ** | **Six Months**           | ** ** |
|------------------------------------|------------|--------------------------|------------|--------------------------|------------|
| ** **                         | ** ** | **Ending June 30,** | ** ** | **Ending June 30,** | ** ** |
| ** **                         | ** ** | **2004**                 | ** ** | **2005**                 | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                         | ** ** | **(In thousands)**       | ** ** |
| ** **                         | ** ** | ** **               | ** ** | ** **               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                            |       | $                        | 25,447     |                     | $          | 8,361 |   | $ | 50,380 |   | $ | 34,575 |   |
| Costs and  expenses                |       | (32,605                  | )          | (12,168                  | )          | (62,898 | ) | (42,358 | ) |
| Interest expense                   |       | (1,520                   | )          | (309                     | )          | (3,070 | ) | (2,081 | ) |
| Income tax  provision              |       | (470                     | )          | (309                     | )          | (944 | ) | (802 | ) |
| Loss from  discontinued operations |       | $                        | (9,148     | )                        | $          | (4,425 | ) | $ | (16,532 | ) | $ | (10,666 | ) |

 

EffectiveFebruary 23, 2005, the Company ceased depreciating and amortizing certainof the international assets held for sale. Had the Company not ceased such depreciation and amortization, the lossfor discontinued operations for the three months ended June 30, 2005 wouldhave included an additional $835,000 of depreciation and amortization expenseand an additional $2.0 million of amortization of film assets. Had the Companynot ceased such depreciation and amortization, the loss for discontinuedoperations for the six months ended June 30, 2005 would have included anadditional $1.8 million of depreciation and amortization expense and anadditional $3.8 million of amortization of film assets.

 

Interestexpense includes an allocation of interest related to the Company’s bank creditfacility that was required to be paid as a result of the sale.  The allocation was required by EmergingIssues Task Force (“EITF”) Issue No. 87-24, *Allocationof Interest to Discontinued Operations*.  Such interest expense amounted to $1.2million and $193,000 for the three month periods ended June 30, 2004 and2005, respectively.  Such interestexpense amounted to $2.3 million and $1.6 million for the six month periodsended June 30, 2004 and 2005, respectively.  Upon receipt of cash from the sale, theCompany was required to repay and retire the $100.0 million term loan under theCompany’s bank credit facility.

 

**15. Commitments and Contingencies**

 

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

 

In 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 (see note 11).  The letter claims that, among other things,the Company and Hallmark Entertainment,

 

24

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Inc. (“HEI”) have not honored their commitments relating to theproduction and financing of certain NICC and “faith and values” programming forbroadcast on the Hallmark Channel in the United States.  NICC alleges that we and HEI have materiallybreached the Amendment, causing substantial damages to NICC in an amount whichexceeds $100.0 million.  The letterfurther indicated that NICC intended to file litigation for breaches of theAmendment unless we agreed, by June 1, 2005, to enter into a new, extendedagreement with NICC for the production, promotion and funding ofprogramming.  While we believe that theCompany and HEI have not breached the Amendment, the Company has been innegotiations with NICC to try to amicably resolve these issues and NICC has notyet filed litigation.  We cannot,however, predict at this time whether these negotiations will successfullyresolve NICC’s claims or whether there will be litigation. Accordingly, we havenot provided for any amount of loss in these condensed financial statements forthis matter.

 

25

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**ITEM 2.  *Management’sDiscussion and Analysis of 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,” the “HallmarkMovie Channel,” the “channel” or the “channels”) dedicated to high quality,entertainment programming for adults and families, in the United States and,prior to the sale of its international business, in various countriesthroughout the world.

 

At theend of the second quarter, the Hallmark Channel was in 68.5 million homes inthe United States.  The Hallmark Channelhas 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.  Duringthe second quarter, additional Mystery Movies were aired.  In addition, the Hallmark Channel premiered anumber of other original movies that also resulted in very strong ratings.  The success of our programming and ratingshad a positive impact on the demand for our advertising inventory in the firsthalf of 2005.  As a result, ouradvertising sales increased significantly during the first half of 2005 ascompared to the first half of 2004. Enhanced programming and increased ratings are also important tools touse to drive increased distribution with the multiple system operators who arethe distributors of the Hallmark Channel.

 

On April 26,2005, the sale of our international business was completed for $222.0 million.  Proceeds from the sale were used to repay andretire $100.0 million of our bank credit facility and reduce the outstandingbalance on our revolving credit facility by $95.0 million, pay transactioncosts of approximately $5.0 million and to prepay approximately $12.6 milliontowards the technical services agreement with the buyer of the internationalbusiness. The completion of the sale of the international business has allowedCrown Media Holdings to focus on the growth and success of the Hallmark Channelin the United States.

 

Welaunched our second 24-hour linear channel, the Hallmark Movie Channel, duringthe first quarter of 2005.  The HallmarkMovie Channel focuses on movies and mini-series and utilizes content from ourfilm library for programming.  The launchof the Hallmark Movie Channel provides an opportunity for the Company to builda second programming asset, use this programming asset as a value addedenhancement to increase distribution of the Hallmark Channel, and furtherleverage the content in our film library.

 

TheCompany also owns a film library comprised of approximately 640 titles.  Through our subsidiary, Crown MediaDistribution, we sell license rights to titles in the library to a variety of customers.In addition, the Company utilizes the film library for programming content onthe Hallmark Channel and Hallmark Movie Channel. We have increased the internaluse of the film assets on the Hallmark Channel as a result of a shift to airmore movies and the launch of the Hallmark Movie Channel.

 

As theHallmark Channel and the Hallmark Movie Channel continue to develop, the corefocus for the business remains unchanged. First, distribution must continue to expand. While the ratingsperformance the Hallmark Channel ranks in the top ten of cable networksaccording to Nielsen, in terms of distribution, the Hallmark Channel is only inthe top 40 cable networks. Increased distribution can have a positive impact onour subscriber revenue (depending on any subscriber acquisition fees incurred)and should increase our advertising revenue. As noted above, increaseddistribution in and of itself will enhance advertising sales simply because ofthe increased viewer universe. However, combining growing distribution withincreasing ratings is more powerful in terms of advertising

 

26

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revenue. As a result, the Hallmark Channel will continue to focus onenhancing its programming schedule through the acquisition of new series,additional original movies such as the recent Mystery Movies, and through uniquescheduling concepts.

 

Wealso plan to develop the Hallmark Movie Channel as an additional source of bothsubscriber and advertising revenue.

 

Inaddition, we plan to focus on library sales. Our film library is a largecollection of award winning movies and mini-series, which is unique in that itis such a large collection of family oriented films. We use the library on theHallmark Channel, the Hallmark Movie Channel and for sales to third parties.

 

All ofthe above needs to be accomplished in a cost efficient 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 current and long-termdistribution challenges will be renewing our distribution arrangements with themultiple system operators as they expire. While the economics of the renewals and potential cash incentivepayments are unknown and could have a significant impact on our business, webelieve that the success of the Hallmark Channel in terms of ratings and theenvironment we have created with our programming schedule will enhance ourrenewal discussions. We also believe that our ability to offer to multiplesystems operators a second channel, the Hallmark Movie Channel, is a valueadded component of the renewal equation. The largest factors contributing to the economics of the distributionagreements are license fees and subscriber acquisition fees.

 

Domestictelephone companies are entering into the business of distributing televisionchannels to households through their wirelines. We have been negotiating withseveral telephone companies for the carriage of the Hallmark Channel and MovieChannel.  We expect that subscribers tothese telephone services will in large part be customers previously served by existingcable television companies.

 

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**on thePrairie* and *Perry Mason* to *Walker, Texas Ranger* and *M*A*S*H* haveconsistently delivered strong ratings across all day-parts.  Original productions are our most highprofile 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 HallmarkEntertainment, a subsidiary of Hallmark Cards. The recent success of theMystery Movies and other recent originals drives this point home. Marketing andpromotion are responsible for attracting viewers to our big events as well asbuilding awareness 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 increaseits ratings and draw a younger more upscale audience, which is generally moreattractive to advertisers.

 

Deliveringstrong ratings growth to larger audiences has made it possible for ouradvertising sales to grow rapidly over the last few years.  To advertisers, the Hallmark Channel offers astrong brand, positive environment and family friendly programming with asuccessful 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 gain advertisers from the more lucrative financial servicesand automotive industries.

 

27

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**International Business**

 

As more fully described in the notes to condensedconsolidated financial statements included in this quarterly report on Form 10-Q,in April 2005, the Company completed the sale of its internationalbusiness. The international business is classified in the financial statementsfor the three and six months ended June 30, 2004 and 2005, as discontinuedoperations.

 

**Revenuefrom Continuing Operations**

 

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

* *

*Subscriber Fees*

* *

Subscriber fees are generally payable to us on a persubscriber basis by distributors for the right to carry our channels. We havepaid certain distributors up-front subscriber acquisition fees to carry ourchannels. Subscriber acquisition fees that we pay are capitalized and amortizedover the contractual term of the applicable distribution agreement as a reductionin subscriber fee revenue. If the amortization expense exceeds the revenuerecognized on a per distributor basis, the excess amortization is included as acomponent of cost of services.

* *

Rateswe receive per subscriber vary according to:

 

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

 

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

 

•                                          the packagingarrangements for the channel; and

 

•                                          othercommercial terms 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 carriage 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 subscriber revenue will continueto be negatively affected by subscriber acquisition fee amortization, waiver ofsubscriber fees and bulk discounts resulting from the attainment of certainsubscriber levels; however, we believe that as a result of these measures, oursubscriber levels will increase which in turn will allow us to attractadditional 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 subscriber churn and in what manner their churnrates affect our subscriber counts; instead, we are provided information on thetotal number of subscribers who receive 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. Anydecreases in subscribers due to these changes to distribution arrangements inthe second quarter of 2005 have not been significant. Management analyzes theestimated effect each new or amended distribution agreement will have onrevenues and costs. Based upon these analyses, management endeavors to achievea fair combination of subscriber commitments and subscriber acquisition feeswith each of our domestic distributors.

 

28

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#### 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 number of people viewing ourchannel. Rates vary on a market-by-market basis and differ amongst marketsdepending on audience demographics.

 

Ouradvertising rates are generally an agreed upon price per unit of audiencemeasurement in return for a guaranteed commitment by the advertiser. We committo provide advertisers certain rating levels and the resulting levels ofviewers watching their advertising material. Thus, our advertising revenue is afunction of the ratings garnered by the channel and the number of subscribersreceiving the channel. Revenue is recorded net of estimated delivery shortfalls,which are usually settled by providing the advertiser additional advertisingtime. Advertising rates also vary by time of year due to seasonal changes intelevision viewership.

 

*Film Asset License Fees*

 

The Company generates revenue from the film assets bygranting licenses to exhibit the films to third parties in the United States.We are also using the films as programming for the Hallmark Channel and the HallmarkMovie Channel. Customers for our film assets consist of other televisionchannels, syndicators, home video distributors and brokers who resell rights toour film assets. License fees for our film assets are generally negotiatedbased upon the perceived quality of the films, the size of the potentialaudience who will be viewing the programming and the length of the airingwindow. The market for our film library is typically seasonal, with over halfof the annual sales occurring in the fourth quarter. This seasonality is due tothe timing of our customers’ program scheduling activities.

* *

**Costof Services**

 

Our cost of services consists primarily of programlicense fees, amortization of our film assets; subscriber acquisition feeexpense; the cost of signal distribution; administration, distribution andother exploitation of our film assets; and the cost of promotional segmentsthat are aired between programs. We expect cost of services to continue toincrease in the future as we expand our existing distribution universe andthird 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 requires usto make estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosure of contingent liabilities at the date of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting period. Actual results could differ from those estimates.

 

For further information regarding our criticalaccounting policies, judgments and estimates, please see the Notes to UnauditedCondensed Consolidated Financial Statements contained in this Report and “CriticalAccounting Policies, Judgments and Estimates” beginning on page 32 of theCompany’s Annual Report on Form 10-K for the year ended December 31,2004, filed with the SEC.

 

**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, atax sharing agreement and the issuance of a $400.0 million seniorunsecured note. For information regarding such transactions and transactionswith other related parties, please see “Effects of Transactions with Relatedand Certain Other Parties” beginning on page 34 of the Company’s AnnualReport on Form 10-K for the year ended December 31, 2004, filed withthe SEC. In August 2005, Hallmark Cards and the Company extended theexpiration

 

29

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date of thetrademark license agreements for use of the name Hallmark to September 1,2006.

 

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

##  

In the table below, we provide selected historicalconsolidated financial and other data of Crown Media Holdings and itssubsidiaries. The following selected consolidated statement of operations datafor three and six months ended June 30, 2004 and 2005, are derived fromthe unaudited condensed consolidated financial statements of Crown MediaHoldings and its subsidiaries. This data should be read together with theconsolidated financial statements and related notes included elsewhere in this Form 10-Q.

 

30

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| ** **                                               | ** ** | ** **              | ** ** | ** **   | ** ** | **Percentage**          | ** ** | ** **   | ** ** | ** ** | ** ** | **Percentage** | ** ** |
|----------------------------------------------------------|------------|-------------------------|------------|--------------|------------|-------------------------|------------|--------------|------------|------------|------------|----------------|------------|
| ** **                                               | ** ** | **Three Months**        | ** ** | **Change**   | ** ** | **Six Months**          | ** ** | **Change**   | ** ** |
| ** **                                               | ** ** | **As of June 30,** | ** ** | **2005 vs.** | ** ** | **As of June 30,** | ** ** | **2005 vs.** | ** ** |
| ** **                                               | ** ** | **2004**                | ** ** | **2005**     | ** ** | **2004**                | ** ** | **2004**     | ** ** | **2005**   | ** ** | **2004**       | ** ** |
| ** **                                               | ** ** | **(unaudited)**         | ** ** |
| Revenues:                                                | ** ** | ** **              | ** ** | ** **   | ** ** | ** **              | ** ** | ** **   | ** ** | ** ** | ** ** | ** **     | ** ** |
| Subscriber fees                                          |       | $                       | 2,971      |         | $          | 4,193                   |       | 41           | %          | $          | 5,344      |           | $          | 8,803 |   | 65 | % |
| Advertising                                              |       | 26,457                  |       | 38,117       |       | 44                      | %          | 50,195       |       | 71,993     |       | 43             | %          |
| Film asset  license fees                                 |       | 963                     |       | 3,169        |       | 229                     | %          | 8,253        |       | 5,252      |       | -36            | %          |
| Other revenue                                            |       | 0                       |       | 213          |       | 100                     | %          | 0            |       | 213        |       | 100            | %          |
| Total revenues                                           |       | 30,391                  |       | 45,692       |       | 50                      | %          | 63,792       |       | 86,261     |       | 35             | %          |
| Cost of  Services:                                       |       |                    |       |         |       |                    |       |         |       |       |       |           |       |
| Programming  costs                                       |       | 20,053                  |       | 28,413       |       | 42                      | %          | 39,076       |       | 56,435     |       | 44             | %          |
| Amortization of  film assets                             |       | 1,347                   |       | 13,664       |       | 914                     | %          | 8,677        |       | 19,345     |       | 123            | %          |
| Subscriber  acquisition fee amortization                 |       | 6,091                   |       | 8,695        |       | 43                      | %          | 12,032       |       | 18,203     |       | 51             | %          |
| Operating costs                                          |       | 248                     |       | 4,730        |       | 1807                    | %          | 4,173        |       | 6,526      |       | 56             | %          |
| Total cost of  services                                  |       | 27,739                  |       | 55,502       |       | 100                     | %          | 63,958       |       | 100,509    |       | 57             | %          |
| Selling, general  and administrative expense             |       | 13,483                  |       | 15,801       |       | 17                      | %          | 26,418       |       | 29,303     |       | 11             | %          |
| Marketing  expense                                       |       | 6,215                   |       | 7,420        |       | 19                      | %          | 10,336       |       | 17,250     |       | 67             | %          |
| Loss from  continuing operations before interest expense |       | (17,046                 | )          | (33,031      | )          | 94                      | %          | (36,920      | )          | (60,801    | )          | 65             | %          |
| Interest expense                                         |       | (14,393                 | )          | (17,444      | )          | 21                      | %          | (28,611      | )          | (34,340    | )          | 20             | %          |
| Income tax  provision                                    |       | 0                       |       | (6           | )          | 100                     | %          | 0            |       | (6         | )          | 100            | %          |
| Loss from  continuing operations                         |       | (31,439                 | )          | (50,481      | )          | 61                      | %          | (65,531      | )          | (95,147    | )          | 45             | %          |
| Loss from  discontinued operations                       |       | (9,148                  | )          | (4,425       | )          | -52                     | %          | (16,532      | )          | (10,666    | )          | -35            | %          |
| Loss on sale of  discontinued operations                 |       | 0                       |       | (1,349       | )          | 100                     | %          | 0            |       | (1,349     | )          | 100            | %          |
| Net Loss                                                 |       | $                       | (40,587    | )            | $          | (56,255                 | )          | 39           | %          | $          | (82,063    | )              | $          | (107,162 | ) | 31 | % |
|                                                     |       |                    |       |         |       |                    |       |         |       |       |       |           |       |
| **Other  Data:**                                         |       |                    |       |         |       |                    |       |         |       |       |       |           |       |
| Net cash used in  operating activities                   |       | $                       | (6,499     | )            | $          | (84,952                 | )          | 1207         | %          | $          | (15,683    | )              | $          | (97,811 | ) | 524 | % |
| Capital  expenditures                                    |       | $                       | (619       | )            | $          | (310                    | )          | -50          | %          | $          | (683       | )              | $          | (558 | ) | -18 | % |
| Proceeds from  disposition of international business     |       | $                       | —     |         | $          | 221,979                 |       | 100          | %          | $          | —     |           | $          | 221,979 |   | 100 | % |
| Net cash  provided by (used in) financing activities     |       | $                       | 9,300      |         | $          | (136,338                | )          | -1566        | %          | $          | 33,600     |           | $          | (115,095 | ) | -443 | % |
| Net cash used in  discontinued operations                |       | $                       | (965       | )            | $          | (9,761                  | )          | 912          | %          | $          | (12,509    | )              | $          | (14,758 | ) | 18 | % |
| Total domestic  day household  ratings (1)(3)            |       | 0.564                   |       | 0.661        |       | 17                      | %          | 0.601        |       | 0.683      |       | 14             | %          |
| Total domestic  primetime household ratings (2)(3)       |       | 0.810                   |       | 0.907        |       | 12                      | %          | 0.846        |       | 0.935      |       | 11             | %          |
| Total  subscribers at period end:                        |       |                    |       |         |       |                    |       |         |       |       |       |           |       |
| Hallmark Channel  – International                   |       | 57,322                  |       | —       |       | -100                    | %          | 57,322       |       | —     |       | -100           | %          |
| Hallmark Channel  – U.S.                            |       | 60,605                  |       | 68,471       |       | 13                      | %          | 60,605       |       | 68,471     |       | 13             | %          |
| Total  subscribers                                       |       | 117,927                 |       | 68,471       |       | -42                     | %          | 117,927      |       | 68,471     |       | -42            | %          |

 

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(1)  Total day is the time periodmeasured from the time each day the broadcast of commercially sponsored programmingcommences to the time such commercially sponsored programming ends.

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

(3)  These Nielsen ratings are for thetime period April 1 through June 30 and January 1 through June 30.

 

31

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

### ** **

#### *Three andSix Months Ended June 30, 2004 Compared to Three and Six Months Ended June 30,2005*

####  

*Revenue.*

 

 Our revenue from continuing operations, whichis comprised of subscriber fees, advertising and film asset license fees,increased 50% and 35%, for the three and six months ended June 30, 2005, respectively,as explained below. Our 41% and 65% increasesin subscriber fee revenue for the three and six months ended June 30, 2005,respectively, were primarily the result of the expiration of free carriageperiods for certain of our domestic distributors. Many of the distribution arrangementswe have require us to provide a period of free carriage to the distributor. Asthese terms continue to expire, we expect to generate increased subscriberrevenue. Subscriber acquisition fee expense recorded as a reduction of revenuewas $3.4 million and $6.6 million for the three and six months ended June 30,2005, respectively, and $2.8 million and $5.4 million for the comparable periodsin 2004, respectively. Subscriber counts have increased as a result ofpreviously amended distribution agreements in the United States, which providefor financial incentives for distribution growth. The incentives under one ofthese agreements were extended and revised during second quarter of 2005. Seealso “Description of Business and Overview” above for information on revisionsto incentive payments for one large distributor. The ability to increase our subscriberbase is important both in terms of growing our subscriber revenue and ouradvertising sales.

 

The increases in advertising revenue to $38.1 million and$72.0 million for the three and six months ended June 30, 2005, respectively,compared to $26.5 million and $50.2 million for the three and six months ended June 30,2004, were due to increased advertising rates and volume. The increases inadvertising revenue reflect the following during 2005: the 13% growth indomestic subscribers and an increase in total day household ratings of 14% inthe United States. As we continue to grow distribution and ratings, we are ableto attract additional advertisers to our Channel, which generally puts upwardpressure on advertising rates. The number of our advertisers we have sold to increasedfrom 302 at June 30, 2004, to 432 at June 30, 2005. Generally, as wehave expanded our domestic subscribers and provided higher rated programming,our advertising revenues have increased. The three factors noted above, subscriberuniverse, ratings and advertising rates are the three critical drivers ofadvertising sales. We anticipate growth across each of these factors tocontinue. We also experienced, like others in the television industry,decreased demand from the up-front market for advertising during the upcoming broadcastseason, which requires that we rely more on sales in the “scatter” market.

 

Among the 52 ad-supported cable channels in the UnitedStates market, the Hallmark Channel ranked9th in totalday with a 0.661 household rating for the second quarter of 2005 and 15thfor primetime with a 0.907 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 $3.2 million and $5.3 million for the three and six monthsended June 30, 2005, respectively, compared with $1.0 million and$8.3 million for the comparable periods in 2004.  During the first quarterof 2004, the Company signed a large sale agreement with one customer, which didnot occur during the first quarter of 2005. Generally, our library sales occurin the second half of the year as this coincides with our customers schedulingof the upcoming programming schedules.

 

*Cost of services. *Cost of services as apercent of revenue increased to 121% and 116% for the three and six monthsending June 30, 2005, respectively, as compared to 91% and 100% for thecomparable periods in 2004. These increases were primarily due to the changesin operating expenses explained below.

 

Totalprogramming costs for the three and six months ended June 30, 2005,increased 42% and 44%, respectively, due toour focus on retaining higher quality series programming such as *M*A*S*H*, *Judging Amy,*and *J.A.G*.  and the related amortization. In addition,the Hallmark Channel introduced the Mystery Movies in the first

 

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quarter of 2005. The series and new original Mystery Movies have beenimportant to the Hallmark Channel in driving our ratings. In addition, the newprogramming schedule has been important in terms of driving increased distribution.The increase in amortization of film assets was primarily due to an increase inthe internal use of the library assets for the three and six months ended June 30,2005, on our new Hallmark Movie Channel.

 

Generally, our distribution agreements require theCompany to pay subscriber acquisition fees to distributors for additionalsubscribers. Our subscribers increased from 60.6 million at June 30, 2004,to 68.5 million at June 30, 2005, and the Company incurred additional subscriberacquisition fees for this increase in subscribers. The Company amortizes thesecosts over the remaining life of the distribution agreement, which has resultedin 43% and 51% increases in our subscriber acquisition fee amortization expensefor the three and six months ended June 30, 2005, as compared to the prioryear period.

 

Operatingcosts increased by $4.5 million and $2.4 million for the three and six monthsended June 30, 2005, respectively, primarily due to $4.1 million and $2.1million, respectively, increases in bad debt expense.

 

*Selling, general andadministrative expense.* For the three and six months ended June 30,2005, our selling, general and administrative expense increased 17% and 11%,respectively, primarily due to an increase in consulting expense, audit feesassociated with our regulatory requirements under the Sarbanes-Oxley Act andcompensation expense associated with our RSUs from our increased stock price.

 

*Marketing expense. *For the three and sixmonths ended June 30, 2005, our marketing expense increased 19% and 67%,respectively, primarily due to the 2005 Mystery Movie marketing campaign forthe Hallmark Channel. In order to build upon the success of our 2004 Holidaypromotion and to assist with the sale of our advertising inventory in the upfrontmarket, the Company has endeavored to drive up ratings by running the MysteryMovie promotion commencing in 2005. The prior year’s marketing activity wassignificantly less as there were not as many special programming events in the firsthalf of 2004.

 

*Interest expense. *Interest expense increasedfor the three and six months ended June 30, 2005, compared to June 30,2004, by $3.1 million and $5.7 million. This increase was due to interest on our $400.0 million senior unsecurednote payable, which increased by $1.1 million and $2.2 million for the threeand six months ended June 30, 2005, as compared to the prior year periods,and interest on our $75.0 million promissory note, which increased by $475,000and $779,000 for the three and six months ended June 30, 2005, as comparedto the prior year periods.

 

*Lossfrom Continuing Operations. *Lossfrom continuing operations for the three and six months ended June 30,2005, was $50.5 million and $95.1 million, respectively. Loss from continuingoperations for the three and six months ended June 30, 2004, was $31.4million and $65.5 million, respectively. Our loss from continuing operationsincreased primarily due to (1) a $1.2 million and $6.9 million increase inmarketing expenses to continue to drive ratings; (2) increases in lossgenerated from library sales and the internal use of the library product on theChannel of $10.1 million and $13.7 million primarily due to incrementalinternal use of the film library product on the Hallmark Channels; (3) increasein selling, general and administrative expense of $2.8 million and $3.7 million;and (4) and an increase in interest expense of $3.1 million and $5.7million due to relatively higher borrowings during the first six months of 2005as compared to the prior year period. These increases are partially offset bysubscriber and advertising revenue increasing greater than programming costs.

 

*Lossfrom Discontinued Operations. *Lossfrom discontinued operations for the three and six months ended June 30,2005, was $4.4 million and $10.7 million, respectively. Loss from discontinuedoperations for the three and six months ended June 30, 2004, was $9.1million and $16.5 million, respectively. Loss from discontinued operations wasless for the three and six months ended June 30, 2005, as compared to thecomparable period for 2004, because the Company sold the international businesson April 26, 2005.

 

## **Liquidityand Capital Resources**

##  

Cash used in operating activities from continuingoperations was $15.7 million and $97.8 million for the six months ended June 30,2004 and 2005, respectively. This increase in cash used in operating activitieswas due to approximately $20.0 million of subscriber acquisition fee paymentsand $40.0 million of affiliate programming

 

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payments made during the second quarter of 2005.  It was also due to the $29.6 million increasein loss from continuing operations during the six months ended June 30,2005.

 

Cash used in investingactivities was $683,000 for the six months ended June 30, 2004.  Cash provided by investing activities was $215.6million for the six months ended June 30, 2005. This increase is due to theproceeds from the sale of our international business of $222.0 million.

 

Cash provided by financing activities was $33.6 million forthe six months ended June 30, 2004. Cash used in financing activities was$109.3 million for the six months ended June 30, 2005. During the sixmonths ending June 30, 2005, we repaid $195.0 million under our bankcredit facility. Additionally, we borrowed $64.0 million under our creditfacility to repay certain programming obligations to Hallmark Cards affiliates,pay severance and RSU settlements for certain employees of the internationalbusiness and to meet our operating demands during the first six months of 2005.

 

Cash used in discontinued operations was $12.5 millionand $14.8 million for the six months ended June 30, 2004 and 2005,respectively.  Cash was used primarily tofund operating expenditures of the discontinued operations of $16.5 million and$10.7 million for the six months ended June 30, 2004 and 2005,respectively. The increase in cash used by discontinued operations is primarilydue to a reduction of international payables in the first six months of 2005.In the first six months of 2004, the Company did not retire the same level ofliabilities. This change in liability movements, coupled with management’sincremental focus on collections of international accounts receivable in 2005,resulted in the $2.3 million increase in cash utilization by the internationaloperations.

 

The following table aggregates all of our contractualcommitments as of June 30, 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                                                  |       | $                                | 179.2      |   | $ | 179.2 |   | $ | — |   | $ | — |   | $ | — |   |
| Company  Obligated Mandatorily Redeemable                                              |       |                             |       |   |   |   |   |   |   |   |   |
| Preferred  Interest                                                                    |       | 25.0                             |       | 2.6 |   | 10.0 |   | 10.0 |   | 2.4 |   |
| HC Crown Line of  Credit                                                               |       | 83.4                             |       | — |   | 83.4 |   | — |   |   |   |
| Senior Unsecured  Note to HC Crown, including accretion                                |       | 596.6                            |       | — |   | — |   | — |   | 596.6 |   |
| Capital Lease  Obligations                                                             |       | 17.0                             |       | 0.6 |   | 1.3 |   | 1.6 |   | 13.5 |   |
| Operating Leases                                                                       |       | 15.6                             |       | 4.1 |   | 6.8 |   | 4.0 |   | 0.7 |   |
| Other  Obligations                                                                     |       |                             |       |   |   |   |   |   |   |   |   |
| Program license  fees payable to non-affiliates and NICC                               |       | 194.8                            |       | 66.9 |   | 87.1 |   | 35.6 |   | 5.2 |   |
| Program license  fees payable to HED                                                   |       | 138.3                            |       | — |   | 138.3 |   | — |   | — |   |
| Program license  fees payable for future windows                                       |       | 105.0                            |       | 68.9 |   | 22.9 |   | 10.8 |   | 2.4 |   |
| Subscriber  acquisition fees (a)                                                       |       | 10.6                             |       | 10.6 |   | — |   | — |   | — |   |
| Deferred  compensation and interest                                                    |       | 3.0                              |       | — |   | 3.0 |   | — |   | — |   |
| Payable to buyer  of international business                                            |       | 18.8                             |       | 8.7 |   | 8.8 |   | 1.3 |   | — |   |
| Estimated  payable to buyer of international business for residuals and participations |       | 7.4                              |       | 0.7 |   | 2.2 |   | 1.7 |   | 2.8 |   |
| Payable to  Hallmark Entertainment affiliates                                          |       | 100.0                            |       | — |   | 100.0 |   | — |   | — |   |
| Total  Contractual Cash Obligations                                                    |       | $                                | 1,494.7    |   | $ | 342.3 |   | $ | 463.8 |   | $ | 65.0 |   | $ | 623.6 |   |

 

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(a)  Current domestic distributionagreements could significantly increase subscriber acquisition fees payable inthe future by a

maximum amount of $33.4 million, which wouldresult if 32.3 million additional subscribers were added to the Hallmark Channelsubscriber base.

 

*Cash Flows*

 

As of June 30,2005, the Company had $5.6 million in cash and cash equivalents on hand and$41.0 million available under its bank credit facility. Forty million of theavailability is subject to the approval of Hallmark Cards prior to the Companybeing able to draw such funds. As of June 30, 2005, the Company hadborrowed $179.0 million under its bank credit facility, which matures May 31,2006.

 

TheCompany’s principal sources of funds are currently available cash on hand, periodictax sharing payments, and amounts available for borrowing under its bank creditfacility. However, the Company expects that cash payments under the tax sharingagreement with Hallmark Cards during the remainder of 2005 will be less thanprior periods as a result of the taxable gain anticipated on the sale of theinternational business.

 

Inconnection with the Company’s business strategy, the Company expects tocontinue making investments in programming and distribution during the nexttwelve months ending June 30, 2006. However, because of the near-termliquidity issues as reflected herein, absent financial assistance from HallmarkCards, in order to preserve cash and stay in operation, the Company will needto reduce some of this anticipated spending in the near term. The Company’sprincipal uses of funds for the remainder of 2005 are expected to include thepayment of operating expenses, licensing of programming, subscriber acquisitionfees and interest under its bank credit facility.

 

TheCompany currently believes that cash on hand and the remaining availabilityunder its bank credit facility (assuming that Hallmark Cards approvesadditional borrowings), both of which are currently its principal sources offunds, and periodic payments under the tax sharing agreement, will besufficient to fund the current level of operations and meet its liquidity needsthrough the maturity date of its bank credit facility (May 31, 2006). Asnoted above, Hallmark Cards is required to approve borrowings under our $220.0million bank credit facility in excess of $180.0 million. To date, Crown MediaHoldings has not requested Hallmark Cards to approve such drawing of funds;however, we anticipate that we will require such additional liquidity and willrequest approval of Hallmark Cards during the final six months of 2005. Therecan be no assurance that Hallmark Cards will approve such additional drawingsand, if such drawings are not approved, the Company will need alternativesources of funding or will need to significantly curtail expenses orprogramming acquisitions and payments.

 

Due tothe Company’s liquidity needs, the Company anticipates that prior to August 31,2006, it will be necessary to either extend or refinance (i) the bankcredit facility and (ii) the license fees ($138.3 million at June 30,2005) and other amounts ($100.0 million at June 30, 2005) payable toaffiliates of Hallmark Cards.  In thealternative or as part of a combination of actions, the Company may seek, amongother things, to issue additional equity or debt securities to raise capitalfor the repayment of those obligations and for other future cash needs.

 

If theCompany is not able to arrange for the extension, refinancing or replacement ofthe bank credit facility prior to its maturity and the bank draws down on theirrevocable letter of credit, Hallmark Cards would acquire all obligations andthe rights of the lending banks under the bank credit facility.  In that event, Hallmark Cards could demandpayment of outstanding amounts at any time. However, Hallmark Cards has also confirmed to the Company that it willnot request any reimbursement of amounts drawn on such letter of credit priorto August 31, 2006.  Hallmark Cardsalso confirmed that it and its wholly-owned subsidiaries will not requestpayment of the license fees and other amounts payable to affiliates of HallmarkCards prior to August 31, 2006 (see note 9).

 

Asconsideration for extending the demand period for the possible reimbursement ofamounts drawn on the letter of credit supporting the credit facility and thepayment of license fees up to $150.0 million and other amounts up to $100.0million payable to Hallmark affiliates, the Company agreed, if so requested byHallmark Cards, to convert its license fees payable to Hallmark affiliates,which were approximately $138.3 million at June 30, 2005, to a promissorynote bearing interest at LIBOR plus 3% per annum (or another market appropriaterate for the

 

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Company).  The term of thepromissory note would begin on August 1, 2005, or other date acceptable toHallmark Cards and the Company’s banks, and would be payable in full on August 31,2006.  The conversion of the non-interestbearing license fees payable to an interest bearing promissory note would besubject to the approval of the lenders in the bank syndicate to the creditfacility.

 

Upon the maturity of the credit facility on May 31,2006, the lending group led by JP Morgan Chase has the right to elect to foregothe receipt of cash to pay the principal amount of the credit facility in full,which is provided for under the terms of an irrevocable letter of creditprovided by Hallmark Cards described in note 9, but instead to initiate aprocess to foreclose on the Company’s assets. Such foreclosure proceedingscould affect our ability to continue our operations. Prior to any such possibleforeclosure proceedings, the Company would consider various alternatives asindicated above, including, among other things, extending or refinancing thebank credit facility or raising additional capital through the issuance ofequity or debt securities. The Company’s management believes that it isimprobable that the lending banks would foreclose on the assets instead ofreceiving payment under the letter of credit supporting the credit facility.

 

The outstandingborrowings under the credit facility of $179.0 million at June 30, 2005,have been classified as a current liability. Such balance sheet classification was deemed necessary as the bank hasthe right, at the maturity date, at its discretion, to either draw upon theoutstanding letter of credit supplied by Hallmark Cards in order to receivepayment in full of the outstanding principal amount under the credit facility(see note 9) or to initiate other actions including foreclosure of the Company’sassets. As this is outside the control of the Company, the obligation does notmeet the requirements as long-term debt even though Hallmark Cards hascommitted to not request reimbursement from the Company prior to August 31,2006 in the event the banks exercise their rights under the irrevocable letterof credit described in note 9.

 

The Company’s liquidity is also affected by cashgenerated from operations.  As a result,any decline in the popularity of the Hallmark Channel, any significant futuremodifications to the Company’s distribution agreements, an economic decline inthe advertising market, an increase in program acquisition costs, an increasein competition or other adverse operating conditions would impact the Company’sliquidity and its ability to fund the current level of operations.

 

***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.

 

Asindicated the “Liquidity and Capital Resources” above, we entered into a letteragreement of August 1, 2005 with Hallmark Cards.  In the letter, Hallmark Cards confirmed to usthat neither Hallmark Cards nor any of its wholly-owned subsidiaries woulddemand payment from us on any of the following obligations until August 31,2006, at the earliest:

 

•                  $75.0 million note payable to HCCrown plus accrued interest thereon from time to time.

 

•                  $400.0 million note payable to HCCrown plus accrued interest thereon from time to time.

 

•                  $100.0 million payables to HallmarkEntertainment Holdings incurred in conjunction with the film librarytransaction in 2001.

 

•                  $150.0 million of license feespayable to Hallmark Entertainment Distribution Company.

 

## FurtherHallmark Cards stated that, in the event at any time prior to May 31, 2006our banks draw on the letter of credit provided in support of the bank line ofcredit, Hallmark Cards will not request reimbursement from us for such amountsprior to August 31, 2006.  Hallmarkalso stated its intent to re-evaluate these repayment schedules if all orsubstantially all of our assets were sold to a third party prior to August 31,2006.

 

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**Classification of Credit Facility as a Current Liability**

 

The outstanding borrowings under the creditfacility of $179.0 million at June 30, 2005, have been classified as acurrent liability.  Such balance sheetclassification was deemed necessary in order to recognize the remote andimprobable possibility that, upon maturity of the credit facility on May 31,2006, the lending group led by JP Morgan Chase might elect to forego thereceipt of cash to pay the principal amount of the credit facility in full,which is provided for under the terms of an irrevocable letter of creditprovided by Hallmark Cards, but instead might elect to initiate a process toforeclose on the Company’s assets.

 

## **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.***

 

Our domestic channels have a history of net losses andwe expect to continue to report net losses for the foreseeable future. As of June 30,2005, we had an accumulated deficit of approximately $1.4 billion, totalstockholders’ deficit of approximately $33.9 million, goodwill of approximately$314.0 million, and film assets of $438.3 million.

 

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, attractingmore viewers to our channels, attracting more advertisers, and increasing ouradvertising rates. Risks associated with these areas of our business aredescribed 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 June 30,2005, our total debt was $777.1 million and we had $5.6 million of cash andcash equivalents. In addition, we may borrow the remaining $41.0 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.

 

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

 

• our vulnerability to adverse general economicconditions is heightened;

 

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

 

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

 

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

 

• we are sensitive to fluctuations in interestrates; and

 

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

 

Our ability to meet our debt and 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. Interestexpense, which is net of interest income and includes amortization of debtissuance costs and interest expense on borrowings under our senior and demandnotes and bank credit facility, increased substantially over the past year. Theincrease in interest expense in the past twelve months resulted from anincrease in the average borrowings outstanding, due to cash generated fromoperations being insufficient to cover operating expenses and capitalexpenditures. A substantial portion of our cash flow from operations must beused to pay our interest expense and will not be available for other businesspurposes. In addition, we may need to incur additional indebtedness in thefuture. We cannot assure you that our business will generate sufficient cashflow or that future financings will be available to provide sufficient proceedsto meet our obligations or to service our total debt.

 

***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 such additional externalfinancings, whether debt or equity, and are not certain whether any such newexternal financing would be available on acceptable terms. Any new debtfinancing would require the cooperation and agreement of existing lenders.

 

Further, as discussed in this report under “Liquidityand Capital Resources” above, we need to extend, refinance or replace our bankline of credit on or prior to May 31, 2006, or to extend or replaceborrowings from Hallmark Cards by August 31, 2006, that would result fromthe banks drawing upon the irrevocable letter of credit (see note 9) supportedby the bank credit facility, and to extend or refinance license fees andpayables to Hallmark Cards and its subsidiaries on or prior to August 31,2006.

 

***Risk of Foreclosure***

 

Upon the maturity of our credit facility on May 31,2006, the lending group led by JP Morgan Chase might elect to forego thereceipt of cash to pay the amount of the credit facility in full, which isprovided for under the terms of an irrevocable letter of credit provided by HallmarkCards, but instead might elect to initiate a process to foreclose

 

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on the Company’s assets. Such foreclosure proceedings would be verydisruptive to our operations and may inhibit our ability to continue ouroperations.

 

***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.

 

***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 Acommon 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

 

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currently performed by Hallmark Entertainmentunder the service agreement. Our ability to do so is unproven and will requirefinancial, operational and management resources. We may not be able to hire thenumber of employees, or employees who are sufficiently qualified, to performthese services, 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 achieve orsustain profitability or to expand our business.  A failure to increase advertising revenue maybe a result of any or all of the following: (i) we have a limited history of marketing and selling advertising time; (ii) wemay be unable to identify, attract and retain experienced sales and marketingpersonnel with relevant experience for our channels; (iii) our sales andmarketing organization may be unable to successfully compete against thesignificantly more extensive and well-funded sales and marketing operations ofour current or potential competitors; (iv) the advancement of technologiessuch as Digital Video Recording may cause industry-wide changes concerning thefrequency in which individuals are exposed to advertising on television; and/or(v) we will not be able to increase our advertising sales rate-cardor may be required to run additional advertising spots which affect theavailability of advertising inventory for future sales. Success in increasing our advertising revenue also depends upon thenumber and coverage of the distributors who carry our channels, our number ofsubscribers, and the viewership ratings for our programming.

 

***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 Acommon stock could suffer, and our business could suffer. HallmarkEntertainment Investments’ control relationship with us also could give rise toconflicts 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 for the HallmarkChannel and the Hallmark Movie Channel. This license will expire on September 1,2006. If Hallmark Cards determines not to renew the trademark license agreementsfor any reason, including our failure to meet minimum thresholds for thebroadcast of programming provided by affiliates of Hallmark Cards or to complywith Hallmark Cards’ programming standards, we would be forced to significantlyrevise our business plan and operations, and could experience a significanterosion of our subscriber base and advertising revenue.

 

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***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.***

 

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 theorigination and playback of signals for the Hallmark Channel pursuant to aservice agreement. Consequently, we depend upon the buyer in providing theseservices for our domestic Channel. Like other single-point facilities, theNetwork Operations Center is subject to interruption from fire, tornadoes,lightning and other unexpected natural causes. Although we have redundantsystems in place, equipment failure, employee misconduct or outsideinterference could also disrupt the Network Operations Center’s services. Wehave certain backup facilities. Any significant interruption at the NetworkOperations Center affecting the distribution of our channels could have anadverse effect on our operating results and financial condition.

 

***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 continuedservice of our executive officers and key employees of our subsidiaries. If wefail to attract, hire or retain the necessary personnel, or if we lose theservices of our key executives, we may be unable to implement our business planor keep pace 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 results failing to meet theexpectations of securities analysts or investors in any quarter;

 

• material announcements by us or our competitors;

 

• governmental regulatory action;

 

• technological innovations by competitors orcompeting technologies;

 

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

 

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• changes in general market conditions or economictrends.

 

Additionally,of the approximately 73.9 million shares of the Company’s outstanding Class Acommon stock, only 9.6 million shares (approximately 13%) are not held byaffiliates of the Company. This stock ownership structure may also be a causeof volatility in the 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 with largediversified entertainment companies that have substantially greater resourcesthan we have, our operating margins and market share could be reduced, and thegrowth of our business inhibited. In particular, we compete for distributionwith other pay television channels and, when distribution is obtained, forviewers and advertisers with pay television channels, broadcast televisionnetworks, radio, the Internet and other media. We also compete, to varyingdegrees, with other leisure-time activities such as movie theaters, theInternet, radio, print media, 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 newcompetitors for us or intensify existing competition. Many of these combinedentities have more than one channel and resources far greater than ours. Thesecombined entities may provide bundled packages of programming, delivery andother services that compete directly with the products we offer. These entitiesmay also 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, such as our domestic HallmarkChannel, to accept decreasing amounts for subscriber fees, to pay highersubscriber acquisition fees or to allow carriage of the channel without thepayment of subscriber fees. Factors that may lead to this pressure include thenumber of competing pay TV channels, the limited space available on services ofdistributors in the United States and the desire of distributors to maintain orreduce costs. Any reduction in subscriber fees revenue now or in the future couldhave a material impact on our ability to achieve 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 significant technological change,including continuing developments in technology which do not

 

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presently have widely accepted standards; and

 

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

 

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 changeour operations.

 

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

 

Moreover, the increased capacity of 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 advertising and newdistribution at desired pricing levels, and could therefore hinder or preventthe 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 to current broadcastinglegislation or regulations could require adjustments to our 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, the Annual Report, our quarterlyreports on Form 10-Q, our current reports on Form 8-K, and amendmentsto such reports, as soon as reasonably practicable after we electronically fileor furnish such material with the Securities and Exchange Commission.**

 

**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 the GeneralCounsel at 12700 Ventura Boulevard, Studio City, California 91604.**

 

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

 

We only invest in instruments that meet high credit andquality standards, as specified in our investment policy guidelines. Theseinstruments, like all fixed income instruments, are subject to interest raterisk. The fixed income portfolio will decline in value if there is an increasein interest rates. If market interest rates were to increase immediately and uniformlyby 10% from levels as of June 30, 2005, the decline of the fair value ofthe fixed income portfolio would not be material.

 

As of June 30, 2005, our cash, cash equivalents andshort-term investments had a fair value of $5.6 million, which were invested incash and short-term commercial paper. The primary purpose of these investingactivities has been to preserve principal until the cash is required to fundoperations. Consequently, the size of this portfolio fluctuates significantlyas cash is provided by and used in our business.

 

The value of certain investments in this portfolio canbe impacted by the risk of adverse changes in securities and economic marketsand interest rate fluctuations. At June 30, 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 and six months ended June 30, 2005, theimpact of interest rate fluctuations, changed business prospects and all otherfactors did not have a material impact on the fair value of this portfolio, oron our income derived from this portfolio.

 

We have not used derivative financial instruments forspeculative purposes. As of June 30, 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 $5.6 million, or less than 1% of total assets, as of June 30,2005. 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$760.6 million, or 57% of total liabilities, as of June 30, 2005. Netinterest expense for the three and six months ended June 30, 2005, was$17.4 million and $34.3 million, 38% and 40%, of our total revenue,respectively. Our net interest expense of these liabilities is sensitive tochanges in the general level of interest rates, primarily U.S. and LIBORinterest rates. In this regard, changes in U.S. and LIBOR interest rates affectthe fair value of interest bearing 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

 

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operation of the Company’s disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934) as of June 30, 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 over Financial Reporting***

 

There were changes in the Company’s internal control over financial reporting that occurred during the quarter ended June 30, 2005, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting, as described below.

 

In the second quarter of 2005, the Company commenced the implementation of the following remediation steps to address the material weaknesses outlined in our Annual Report on Form 10-K:

 

•       The Company engaged consultants to assist withthe first quarter 2005 accounting for complex non-recurring transactions and toreview calculations, including calculations imbedded in spreadsheets. TheCompany also plans to retain consulting services to serve as contemporaneous,technical resources to review, evaluate and provide guidance on the mostappropriate accounting treatment for complex, non-recurring transactions.

 

•       The Company will adopt more stringent proceduresfor the review of computational and mathematical accuracy of valuationspreadsheets.

 

Although the Company has commenced the implementation of the remediation steps described above, at June 30, 2005, material weaknesses continue to impact the Company’s ability to account for non-routine, complex transactions in accordance with accounting principles generally accepted in the United States of America.

 

**PART II.  OTHER INFORMATION**

 

**Item 1.  *LegalProceedings***

 

InMay 2005, we received 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 letter claims that, amongother things, the Company and Hallmark Entertainment, Inc. have nothonored their commitments relating to the production and financing of certainNICC and “faith and values” programming for broadcast on the Hallmark Channelin the United States.  NICC alleges thatwe and HEI have materially breached the Amendment, causing substantial damagesto NICC in an amount which exceeds $100.0 million.  The letter further indicated that NICC intendedto file litigation for breaches of the Amendment unless we agreed, by June 1,2005, to enter into a new, extended agreement with NICC for the production,promotion and funding of programming.  While we believe that the Company and HEIhave not breached the Amendment, the Company has been in negotiations with NICCto try to amicably resolve these issues and NICC has not yet filedlitigation.  We cannot, however, predictat this time whether these negotiations will successfully resolve NICC’s claimsor whether there will be litigation. Accordingly, we have not provided for anyamount of loss in these condensed financial statements for this 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 |

 

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|   |   | 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).                                                                                                                                                                        |
| 10.1   |   | Letter Agreement  dated August 1, 2005 between Hallmark Cards, Incorporated and Crown  Media Holdings, Inc.                                                                                                                                                                                                                                                                           |
| 31.1   |   | Rule 13a-14(a) Certification  executed by the Company’s President and Chief Executive Officer.                                                                                                                                                                                                                                                                                   |
| 31.2   |   | Rule 13a-14(a) Certification  executed by the Company’s Executive Vice President and Chief Financial  Officer.                                                                                                                                                                                                                                                                   |
| 32     |   | Section 1350  Certifications.                                                                                                                                                                                                                                                                                                                                                              |

 

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**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 |   | August 9, 2005 |   |
|                       |   |   |   David J. Evans |   |   |   | Executive Officer |   |   |   |
|                       |   |   |   |   |   |   |   |
|                       | By: | /s/ | WILLIAM J. ALIBER |   |   |   | Principal Financial and |   | August 9, 2005 |   |
|                       |   |   |   William J. Aliber |   |   |   | Accounting Officer |   |   |   |
|                            |  |  |  |  |  |  |  |  |  |  |  |  |

 

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