UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

ý        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2004

or

o        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                to                .

Commission File Number: 000-30700

Crown Media Holdings, Inc.

(Exact Name of Registrant as Specified in Its Charter)

Indicate by check mark whether the registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes ý    No o

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

As of November 12, 2004, the number of shares of Class A Common Stock, $.01 par value outstanding was 73,863,037, and the number of shares of Class B Common Stock, $.01 par value, outstanding was 30,670,422.

TABLE OF CONTENTS

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In this Form 10-Q the terms “Crown Media 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 our businesses, Crown Media International, LLC (“Crown Media International”), Crown Media United States, LLC (“Crown Media United States”), Crown Media Distribution, LLC (“Crown Media Distribution”), Crown Entertainment Limited (“Crown Entertainment”), and Crown Media Trust (“Crown Media Trust”). The term “common stock” refers to our Class A common stock and Class B common stock, unless the context requires otherwise.

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

PART I. FINANCIAL INFORMATION

Item 1.  Financial Statements (Unaudited)

CROWN MEDIA HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share amounts)

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CROWN MEDIA HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts)

See accompanying notes to unaudited consolidated financial statements.

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CROWN MEDIA HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(In thousands, except per share amounts)

See accompanying notes to unaudited consolidated financial statements.

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CROWN MEDIA HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

See accompanying notes to unaudited consolidated financial statements.

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CROWN MEDIA HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

For the Three and Nine Months Ended September 30, 2003 and 2004

1. Business and Organization

Organization

Crown Media Holdings, Inc. (“Crown Media Holdings” or the “Company”), through its subsidiaries, owns and operates pay television channels (collectively the “Hallmark Channel” or the “channel”) dedicated to high quality, entertainment programming for adults and families, in the United States and in various countries throughout the world. The international operations of the Hallmark Channel are operated by Crown Media International LLC (“Crown Media International”) and, in the United Kingdom, by Crown Entertainment Limited (“Crown Entertainment”). Crown Media International commenced its operations outside the United States in 1995. Domestically, the Hallmark Channel is operated and distributed by Crown Media United States LLC (“Crown Media United States”). Crown Media International acquired an interest in Crown Media United States in 1998 and as a result of subsequent transactions Crown Media Holdings owned 100% of the common interests of Crown Media United States by March 2001. Significant investors in Crown Media Holdings include Hallmark Entertainment Investments Co. (“Hallmark Entertainment Investments”), a subsidiary of Hallmark Cards, Incorporated (“Hallmark Cards”), the National Interfaith Cable Coalition, Inc. (“NICC”), and, indirectly through their investments in Hallmark Entertainment Investments, Liberty Media Corporation (“Liberty Media”) and J.P. Morgan Partners (BHCA), L. P. (“J.P. Morgan”).

Potential Sale of the International Business

In April 2004, the Company announced that it is exploring strategic alternatives for its international operations and the international rights to its film library, including, but not necessarily limited to, a sale or other corporate transaction in an effort to maximize shareholder value.

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

Liquidity

Cash Flows

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

The Company’s principal uses of funds during 2004 and 2005 have been, and are expected to be, the payment of operating expenses, payments for licensing of programming and subscriber acquisition fees, and interest payments

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under its bank credit facility. As part of the Company’s growth strategy, the Company expects to continue making investments in programming and distribution during 2004 and 2005.

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

The Company is currently negotiating for the sale of the international operations which would provide cash resources to retire a portion of these obligations due and payable on September 1, 2005.  The Company intends to either extend or refinance the credit facility prior to its maturity date. In addition, other financing alternatives could include the issuance of additional equity or debt securities. There can be no assurance, however, that the credit facility can or will be extended or refinanced or that additional funding will be available, if at all, on terms acceptable to the Company.

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

2. Summary of Significant Accounting Policies

Interim Financial Statements

In the opinion of management, the accompanying consolidated balance sheets and related interim consolidated statements of operations and cash flows, include all adjustments, consisting of normal recurring items necessary for their fair presentation in conformity with accounting principles generally accepted in the United States. Interim results are not necessarily indicative of results for a full year. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes to those statements for the year ended December 31, 2003 including the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

Principles of Consolidation

The consolidated financial statements include the consolidated accounts of Crown Media Holdings, including those of its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

Cash and Cash Equivalents

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

Subscriber Acquisition Fees

Crown Media United States has distribution agreements with every major pay television distributor (based on  number of subscribers) in the United States. These distributors carry the Hallmark Channel on certain of their cable, satellite, terrestrial television, or satellite master antenna television systems. Under certain of these agreements, Crown Media United States is obligated to pay subscriber acquisition fees, if defined subscriber levels are met, in

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order to obtain additional carriage of the Hallmark Channel by those distributors. Such costs are accrued when Crown Media United States receives notice from the distributors that they have met the penetration percentage or subscriber count defined in the underlying agreements.

Subscriber acquisition fees are amortized over the contractual life of the distribution agreements (ranging from 4 to 9 years) as a reduction of subscriber fee revenue. If the amortization expense exceeds the revenue recognized on a per distributor basis, the excess amortization is included as a component of cost of services. Crown Media Holdings assesses the recoverability of these costs periodically. It also assesses the recoverability when events such as changes in distributor relationships occur or other indicators, which would suggest impairment.

Subscriber acquisition fees are comprised of the following:

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

Under certain of the agreements with distributors mentioned above, additional subscriber acquisition fees will become payable by the Company if defined incremental subscriber levels are reached. Under certain of the agreements, the Company may also be required to pay substantial marketing support payments, if subscribers exceed proscribed benchmarks, as defined in the respective agreements. These marketing support payments are expensed when it becomes probable that subscribers will meet such benchmarks.

Program License Fees

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

Subtitling and Dubbing

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

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Property and Equipment

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

Accounting for Trust Preferred Securities

In December 2001, Crown Media Holdings formed a special-purpose entity, Crown Media Trust. Crown Media Trust issued trust preferred securities in Crown Media Trust’s name to investors in a private placement and loaned the proceeds to Crown Media Holdings. This loan was designed so that interest and principal payments matched the dividend and any redemption requirements on the trust preferred securities issued by Crown Media Trust. Interest received by Crown Media Trust from Crown Media Holdings funded distributions to the holders of the preferred securities.

Crown Media Holdings owned 100% of the common equity in Crown Media Trust. The trust preferred securities included terms that allowed the holder to earn a return above the stated dividend rate on the securities under certain conditions. Based on fair value calculations using discounted cash flows and Black-Scholes models, a portion of the proceeds from the preferred securities was allocated and classified in Crown Media Holdings’ balance sheet as guaranteed preferred beneficial interest in Crown Media Trust’s debentures and a portion was classified as convertible debt. Issuance costs related to the guaranteed preferred beneficial interest portion were netted against the guaranteed preferred beneficial interest and accreted as additional expense in earnings. Issuance costs related to the convertible debt portion were recorded as a deferred debt issuance costs asset and were amortized as additional interest expense, using the effective interest method.

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

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

On August 5, 2003, Crown Media Holdings repurchased all of the preferred securities of Crown Media Trust and related contingent appreciation certificates issued by the Company. The securities were repurchased for approximately $329.1 million, including approximately $2.4 million of scheduled cash distributions on the trust preferred securities during the quarter.

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Revenue Recognition

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

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

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

Revenue from film asset licensing agreements is recognized 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 is available for exhibition by the licensee, the license fee is fixed or reasonably determinable, collectibility is reasonably assured and the cost of each film is known or reasonably determinable. Revenue from film asset licensing agreements containing multiple film titles is allocated among the various film titles based on their relative fair values. Payments received from licensees prior to the availability of a film are recorded as deferred revenue.

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

Cost of Services

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

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Long-Lived Assets

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

As a result of the Company exploring the sale of its international channel operations and the international rights to its film library, the Company analyzed its international channel operations for impairment during the three months ending September 30, 2004.  The Company’s projections of future cash flows to be generated by the international channel operations exceeded the carrying value of the net assets within the international channel operations asset group and therefore, the asset group was deemed to be recoverable.  For purposes of this assessment, the Company allocated the probability-weighted cash flows, taking in to account the probability of selling the business or continuing to operate the business, to the international channel operations and the international rights to the film assets based upon the relative fair values of the asset groups.

Film Assets

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

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

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

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Amortization expense for the film assets was $11.4 million and $8.9 million for the three months ended September 30, 2003 and 2004, respectively. Amortization expense for the film assets was $25.0 million and $24.4 million for the nine months ended September 30, 2003 and 2004, respectively. At September 30, 2004, the Company expects to amortize $55.0 million to $65.0 million of film assets during the year ending December 31, 2004.

Goodwill

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

Taxes on Income

Pursuant to the Tax Sharing Agreement entered into with Hallmark Cards on March 11, 2003, the Company’s results of operations for tax purposes became a part of the Hallmark Cards consolidated federal tax return as of and subsequent to March 11, 2003.  However, the Company continues to account for income taxes on a separate return basis. The Company accounts for income taxes using an asset and liability method that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and net operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to be applied to taxable income in the years in which those temporary differences are expected to be recovered or settled. The Company reduces deferred tax assets by a valuation allowance if it is more likely than not that some portion or all of the deferred tax assets will not be realized. Any payments received from Hallmark Cards under the Tax Sharing Agreement are recorded as an increase in paid-in capital and any future reversal of the valuation allowance will be recorded as a reduction in paid-in capital, to the extent payments were received for such benefits under the Tax Sharing Agreement.

Translation of Foreign Currency

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

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recorded upon the remeasurement of financial assets and liabilities denominated in currencies other than the functional currency of the subsidiary are included in determining net loss for the period.

Net Loss Per Share

Basic net loss per share is computed by dividing the net loss for the period by the weighted average number of common shares outstanding during the period. Diluted net loss per share is computed based on the weighted average number of common shares and potentially dilutive common shares outstanding. The calculation of diluted net loss per share excludes potential common shares if the effect would be antidilutive. Potential common shares consist of incremental common shares issuable upon the exercise of stock options and restricted stock units. Approximately 1.7 million and 1.4 million stock options for the three and nine months ended September 30, 2003 and 2004, respectively, have been excluded from the calculations of diluted earnings per share because their effect would have been antidilutive. Approximately 2.0 million restricted stock units for the three and nine months ended September 30, 2003, respectively, have been excluded from the calculations of diluted earnings per share because their effect would have been antidilutive. Approximately 2.8 million restricted stock units for the three and nine months ended September 30, 2004, respectively, have been excluded from the calculations of diluted earnings per share because their effect would have been antidilutive.

Stock-Based Compensation, Employee Incentives and Retention

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

In April 2003, the Company’s Board of Directors approved actions to provide additional incentives to encourage retention of its employees. Crown Media Holdings’ then outstanding stock options held by employees had exercise prices significantly above the current market value of its Class A common stock.  The Company made an offer in May 2003 to senior management and vice presidents, totaling approximately 55 persons, to exchange their options for restricted stock units (“RSUs”).  The exchange ratio was one RSU for 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. Each RSU, upon vesting, represents the right to receive one share of Class A common stock or the value of the share in cash at the time of vesting.  The RSUs vest over three years in one-third increments on the anniversary of the grant date each year. The Company’s Board may determine, at its discretion, whether the payment is made in common stock or cash for each of the one-third increments. As a result of the Board’s decision to settle the first one-third increment in cash, Crown Media Holdings is recording compensation expense based on the fair value of the common stock required to settle the RSUs at each reporting period end during the vesting period of the RSUs. Such compensation expense is calculated using variable plan accounting. Options for 279,254 shares of common stock that were not exchanged are also subject to variable plan accounting in which compensation is remeasured at each reporting date until the options are exercised, expire unexercised or are forfeited.

In May 2004, the Company’s Board of Directors approved an additional grant to employees of 1,065,000 RSUs. The Employment RSUs, which constitute 70% of the award granted in 2004, vest in equal one-third installments over the next three years on the anniversary of the grant date each year. The Company is accruing expense related to the Employment RSUs ratably over each installment’s vesting period. The Performance RSUs, constituting 30% of the award granted in 2004, vest on the 3^rd anniversary of the grant date, provided that the price of the Crown common stock is $14 or higher on that date. The Company will begin to accrue compensation expense for the Performance RSUs when it becomes probable that the price of the Company’s stock will be $14 or more on the 3^rd

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anniversary of the grant date. The Company’s Board may determine whether the RSUs are settled in cash or common stock. Crown Media Holdings is adjusting compensation expense at the end of each reporting period based on the fair value of the common stock required to settle the RSUs. Such compensation expense is calculated using variable plan accounting.

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

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

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

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

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Pro Forma Effects

(unaudited)

(In thousands, except per share amounts)

There were no stock options granted during 2003 or during the three and nine months ended September 30, 2003 and 2004.

Retention Program

The Company has established a retention program for approximately 175 employees who could be affected if Crown Media Holdings’ international business is sold.  Under the program, employees that remain with the Company through the earlier of the date on which a sale of the international business becomes effective or December 31, 2004, are entitled to retention of approximately $7.4 million. If the Company announces prior to December 31, 2004, that it has decided not to sell the international business, reduced retention payments of approximately $3.7 million will be payable within 30 days of that announcement. The Company recorded $2.2 million of expense for both the three and nine months ended September 30, 2004, respectively, in regard to this retention program.

Derivative Financial Instruments

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

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires Crown Media Holdings to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates employed by the Company are as follows.

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

When multiple films are sold under a single arrangement, in order to properly recognize revenue when each license fee commences, the Company must estimate the relative fair value of each film and allocate the total contracted price to the different films in the arrangement.

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

The initial recoverability of subscriber acquisition fees is evaluated by projecting the incremental subscriber fee and advertising revenue attributable to the incremental subscribers obtained through the distribution agreement.  This analysis includes significant judgment and estimation by management in terms of the estimated incremental advertising per subscriber.

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

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

Concentration of Credit Risk

Financial instruments, which potentially subject Crown Media Holdings to a concentration of credit risk, consist primarily of cash, restricted cash, cash equivalents and accounts receivable. Generally, Crown Media Holdings does not require collateral to secure receivables. Crown Media Holdings has no significant off-balance sheet financial instruments with risk of accounting losses.

Fair Value

Accounts payable and receivable, are reasonable estimates of their fair values because of their short-term nature. The interest rates on the bank credit facility and the line of credit with HC Crown are variable and/or reset periodically, therefore, the fair value of this debt is not significantly affected by fluctuations in interest rates. The carrying amount of the senior unsecured note to HC Crown at September 30, 2004, was $449.6 million, its fair value was $422.4 million and its unrealized gain was $27.2 million, assuming an interest rate of 11%. The company obligated mandatorily redeemable preferred interest was revalued to its fair value as of July 1, 2003, upon adoption of SFAS No. 150 Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. The Company estimates the fair value of the company obligated mandatorily redeemable preferred interest on an annual basis in November as it is not practicable to perform the valuation more frequently. The Company employs a discounted cash flows approach to value the company obligated mandatorily redeemable preferred interest that involves a significant amount of time to perform. The valuation is dependent upon the future pre-tax income of Crown Media United States since the Company is only obligated to make payments on the instrument to the extent pre-tax income is generated by Crown Media United States.

Recently Issued Accounting Pronouncements

At a recent meeting, the FASB unanimously voted for proposed accounting standards relating to equity-based compensation to be effective for fiscal periods beginning after December 15, 2004 (January 1, 2005 for the Company).  An exposure draft was released in the first quarter of 2004 and the final standard is expected to be issued in 2004.  The accounting standard is expected to require all companies to utilize the fair value method of accounting for equity-based compensation in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation.” Companies can voluntarily adopt SFAS No. 123, using a variety of adoption methods.  The Company is currently evaluating the impact of the proposed accounting standards and the adoption alternatives

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provided under both the current standards and the proposed standards.  Crown Media Holdings discloses the pro forma impact of stock based compensation on its earnings in its notes to financial statements.

In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 03-01, The Meaning of Other-Than-Temporary Impairment and Its Applications to Certain Investments. EITF Issue No. 03-01 includes new guidance on evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are considered to be temporarily impaired. The accounting guidance of EITF Issue No. 03-01 is effective for reporting periods beginning after June 15, 2004, while the disclosure requirements for debt and equity securities accounted for under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, are effective for annual periods ending after December 15, 2003. The Company believes that the adoption of EITF Issue No. 03-01 will not have a material impact on its financial position or results of operations.

In December 2003, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition”, which supercedes SAB No. 101, Revenue Recognition in Financial Statements. SAB No. 104’s primary purpose is to rescind accounting guidance contained in SAB No. 101 related to multiple element revenue arrangements, superceded as a result of the issuance of EITF Issue No. 00-21. Additionally, SAB No. 104 rescinds the SEC’s Revenue Recognition in Financial Statements Frequently Asked Questions and Answers (“FAQ”) issued with SAB No. 101 that had been codified in SEC Topic 13, Revenue Recognition. Selected portions of the FAQ have been incorporated into SAB No. 104. While the wording of SAB No. 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB No. 101 remain largely unchanged by the issuance of SAB No. 104. EITF 00-21 was effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. There was no impact to the Company’s consolidated financial statements related to SAB No. 104 for the three and nine months ended September 30, 2004.

3. Reorganization

In October 2002, the Company began reorganizing its operations in order to concentrate its efforts on the Hallmark Channel in the U.S. and in its more successful international markets.  The Company completed decentralizing many oversight and non-technical support functions formerly located in the Company’s U.S.-based offices and transferred those responsibilities to regional staff.  In Latin America, the Company entered into an agreement with a local distribution partner, Pramer S.C.A., who is now responsible for the day-to-day operations of the Hallmark Channel in this region.  At the completion of the reorganization in April 2003, the Company’s workforce was reduced by approximately 30% or 130 positions. Accordingly, the Company recorded a reorganization charge of $28.8 million during the fourth quarter of 2002. This charge was comprised of a charge of $5.5 million for severance costs and charges of $23.3 million related to exit costs for permanently abandoned satellite, transponder and facility leases.

The following table displays the activity and balances of the reorganization accrual account from December 31, 2003, to September 30, 2004, which have been included in accounts payable and accrued liabilities in the accompanying consolidated balance sheets.

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4. Program license fees

Program license fees are comprised of the following:

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

At December 31, 2003, and September 30, 2004, $4.8 million and $4.6 million, respectively, of program license fees were included in prepaid and other assets on the accompanying consolidated balance sheets since the airing windows had not begun but payment had been made.

License fees payable are comprised of the following:

5. Credit Facility

In connection with the completion of the purchase of the film assets in 2001, Crown Media Holdings entered into a credit agreement with a syndicate of banks, led by JP Morgan Chase Bank, under which the banks have extended to Crown Media Holdings a five-year $320.0 million secured credit facility. The credit facility includes a term loan of $100.0 million and a revolving line of credit of $220.0 million, up to $20.0 million of which can be letters of credit issued at the request of Crown Media Holdings. At September 30, 2004, Crown Media Holdings had outstanding borrowings of $310.0 million under the credit facility and there were no letters of credit outstanding. As a result of an amendment to the credit facility executed on October 28, 2004, the entire balance is due in 2005 and, therefore, is classified as a current liability in the accompanying consolidated balance sheets. (Of the outstanding amount, $130.0 million is due on the sale of the international operations and international film rights if such an event occurs earlier than the maturity date.) This loan is guaranteed by Crown Media Holdings’ subsidiaries and is secured by all tangible and intangible property of Crown Media Holdings and its subsidiaries. The Company is obligated to maintain certain financial debt covenants in conjunction with the credit facility. As a result of the film asset impairment charge recorded in the third quarter 2004, the Company was not in compliance with the trailing 12-month EBITDA (as defined) financial covenant at September 30, 2004.  The amendment to the credit facility

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

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

6. Related Party Transactions

Senior Unsecured Note

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

The senior unsecured note payable to HC Crown does not require interest or principal payments until August 2007. Instead, the principal amount of the senior unsecured note accretes at 10.25% per annum, compounding semi-annually, to $596.6 million at August 5, 2007.  From that date, interest at 10.25% per annum will be payable semi-annually on the accreted value of the senior unsecured note 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, 2003, $400.0 million of principal and $17.1 million of accreted interest were included in the senior unsecured note payable in the accompanying consolidated balance sheet. At September 30, 2004, $400.0 million of principal and $49.6 million of accrued interest were included in the senior unsecured note payable in the accompanying consolidated balance sheet. The note purchase agreement for the senior unsecured note contains certain covenants which restrict on the part of the Company, among other matters, from the incurrence of any additional indebtedness, the repurchase or other acquisitions of the Company’s stock, investments in other parties and the incurrence of liens on the Company’s assets.  As a fee for the issuance of the notes, the Company paid $3.0 million to HC Crown, which is being amortized as additional interest expense over the term of the note payable.

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 six months from the termination of the credit facility or December 21, 2007.  As discussed in note 8, the credit facility termination date has been amended to September 1, 2005, and as such, the line of credit becomes due and payable on February 2006.  This note replaced the promissory note previously issued to HC Crown dated September 28, 2001. This line of credit is subordinate to the credit facility. The rate of interest under this line of credit is equal to LIBOR plus three percent, payable quarterly. At both December 31, 2003, and September 30, 2004, borrowings under the note were $75.0 million. Accrued interest on the note of $2.7 million and $5.1 million as of December 31, 2003, and September 30, 2004, respectively, is included in interest payable to HC Crown on the accompanying consolidated balance sheets.

Tax Sharing Agreement

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

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

Hallmark Entertainment Investments

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

Costs Incurred on Crown Media Holdings’ Behalf

Since inception, Hallmark Entertainment has at times paid certain costs on behalf of Crown Media Holdings. For the three and nine months ended September 30, 2003, the Company paid $186,000 and $1.0 million to Hallmark Entertainment as a reimbursement of such costs. No amounts were reimbursed to Hallmark Entertainment during the three and nine months ended September 30, 2004. Hallmark Entertainment incurred $600,000 and $3.0 million, respectively, on Crown Media Holdings behalf for the three and nine months ended September 30, 2004. Unreimbursed costs of $670,000 and $3.7 million are included in payable to affiliates in the accompanying consolidated balance sheets as of December 31, 2003, and September 30, 2004, respectively.

Services Agreement with Hallmark Cards

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

Film Asset Services Agreement with Hallmark Entertainment

The Company entered into a film asset services agreement with Hallmark Entertainment, under which Hallmark Entertainment provides Crown Media Holdings with services related to the administration, distribution and other exploitation of the Company’s film assets. The services agreement expires on December 31, 2006, subject to cancellation by either party after the first or second year. In consideration for the services provided by Hallmark Entertainment, Crown Media Holdings is obligated to pay a service fee of $1.5 million per year, payable in quarterly installments of $375,000. Crown Media Holdings paid $375,000 to Hallmark Entertainment during both of the three months ended September 30, 2003 and 2004. Crown Media Holdings paid $1.1 million to Hallmark Entertainment during both of the nine months ended September 30, 2003 and 2004. At both December 31, 2003, and September 30, 2004, unpaid accrued service fees of $375,000 were included in payable to affiliates in the accompanying consolidated balance sheet.

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Trademark Agreement with Hallmark Cards

Crown Media United States, Crown Media International and Crown Entertainment have trademark license agreements with Hallmark Cards and Hallmark Licensing, Inc. for use of the “Hallmark” mark for the versions of the Hallmark Channel distributed both in the United States and internationally and for the Hallmark Movie Channel.  These trademark license agreements expire on September 1, 2005.

Program License Agreements with Hallmark Entertainment Distribution

Crown Media International has a program license agreement with Hallmark Entertainment Distribution dated January 1, 2001. The agreement expires on December 31, 2005, subject to a renewal through December 31, 2010. Under the terms of the agreement, Crown Media International has the exclusive right to exhibit Hallmark Entertainment Distribution produced programming in the territories in which Crown Media International operates during three 18-month windows. Crown Media International also has the exclusive right to exhibit programming in markets where it does not currently operate, if it elects to distribute the channel in those markets, subject to any agreement between Hallmark Entertainment Distribution and a third party existing at the time Crown Media International launches the channel in those markets. In addition, under the agreement, Hallmark Entertainment Distribution is generally obligated to sell to Crown Media International all of the programming it produces and Crown Media International is obligated to purchase up to 50 programs produced per year during the term of the agreement.

Crown Media United States also licenses programming for distribution in the United States from Hallmark Entertainment Distribution under a separate program license agreement, dated January 1, 2001. Under this program agreement, Crown Media United States licenses programs owned or controlled by Hallmark Entertainment Distribution, as well as all programming produced by or on behalf of Hallmark Entertainment Distribution for Crown Media United States. The program agreement has a term of five years and is automatically renewable for additional three-year periods, subject to rate adjustments, so long as Hallmark Entertainment Distribution or its affiliates, owns an interest of 35% or more of Crown Media Holdings.  If, at any time, Hallmark Entertainment Distribution ceases to own a 35% interest in Crown Media Holdings, and if, at that 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 date two years after the date on which Hallmark Entertainment Distribution ceased to own a 35% interest in Crown Media Holdings.

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

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

Company Obligated Mandatorily Redeemable Preferred Interest and NICC License Agreements

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

Under the company agreement, the members agreed that if during any year ending after January 1, 2005 and

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prior to December 31, 2009, Crown Media United States has net profits in excess of $10.0 million, and the preferred interest has not been redeemed, Crown Media United States will redeem the preferred interest in an amount equal to the lesser of: (i) such excess net profits; (ii) $5.0 million; or (iii) the amount equal to the preferred liquidation preference on the date of redemption.  Crown Media United 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 to non-current liabilities in accordance with the provisions of SFAS No. 150.

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

Pursuant to additional amendments effective January 1, 2002, and January 1, 2004, Crown Media United States agreed to advance NICC $3,000,000 in each of 2002, 2003 and 2004 to help fund NICC’s cost of expanding its production operations to produce the aforementioned programming.  This advance will be recovered from the license fees payable for this programming when such programming is produced and accepted by Crown Media United States for distribution on the channel. These expenses are included as components of affiliate programming costs in the accompanying consolidated statements of operations.

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

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7. Operations in Different Geographic Areas

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

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

8. Subsequent Events

On October 28, 2004, the Company entered into an amendment of its bank credit facility. The amendment modified certain covenants with regard to current EBITDA and Net Worth thresholds and eliminated the debt to capitalization and leverage ratios. As amended, the term loan of $100.0 million is payable on the earlier of a “Foreign Asset Sale Effective Date” or September 1, 2005.  A Foreign Asset Sale Effective Date is generally the date on which the Company sells its international business and international rights to its film library.  On a Foreign Asset Sale Effective Date, the revolving line of credit under the bank credit facility will be reduced from $220.0 million to $180.0 million and the line of credit will mature on September 1, 2005.  The Agent bank has the ability to approve on behalf of the lending banks the final terms of any sale of the international business as described above, including the documentation for the transaction.  In addition, certain of the financial covenants, as revised, will be effective only on a Foreign Asset Sale Effective Date, and proceeds of the sale are required to be used to pay down the credit facility so that the outstanding amount does not exceed $180.0 million and certain obligations due to Hallmark affiliates.

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

Overview

Current Challenges

The Company faces many challenges in the current domestic and international marketplaces. The domestic cable industry is saturated with channels striving to position themselves on lower analog tiers and on digital platforms of cable TV distributors. The Company has less leverage in the marketplace in regard to channel line-up positioning and advertising sales than many of our competitors since they operate multiple channels while we operate only one channel. Among other things, owners of multiple channels are able to leverage demand for their more popular channels to convince distributors and advertisers to distribute and advertise on their less successful channels. Our ratings and subscribers must continue to grow in future years in order to increase subscriber demand for our channel and our advertising revenues. The Company strives to obtain additional subscribers by renegotiating distribution agreements, and, as a result, may face increased subscriber acquisition fee payments. The Company also attempts, and has succeeded, in improving its ratings by acquiring new programming and revising its programming schedules to meet the demands of its viewers. A larger audience share results in higher advertising rates, which, in turn, increases revenue. Domestically, we foresee in 2004 an increase in our domestic advertising revenues due to an enhanced programming schedule and growing subscriber counts.

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

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

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

International Business

In April 2004, the Company announced that it is exploring strategic alternatives for its international operations and the international rights to its film library, including, but not necessarily limited to, a sale or other corporate transaction in an effort to maximize shareholder value.  The Company at the date of this Report is negotiating a sale to a third party of its international operations and the international rights to its film library. For information regarding a possible sale of the international business, see “Potential Sale of the International Business” in Note 1 of the Notes to the Unaudited Consolidated Financial Statements in this Report.

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

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

Cash Flow

Our management is striving to generate positive cash flows in 2004 and future years through the sale of advertising and ongoing cost management.  We will continue to monitor expenses, and, potentially, reduce certain expenses in 2004 to meet our cash flow goals.  Our cash flow goals will be significantly affected by a sale of our international operations and international film rights.

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

Writedown of Film Assets

For the third quarter of 2004, the Company reviewed each of its film assets for impairment as a result of the Company exploring the sale of its international operations and the international rights to its film library. The Company computed fair value of each film using the discounted cash flow model outlined above and also considered the indications of fair value for the international rights to its film library as a group.  A non-cash impairment charge was recorded in the third quarter 2004 for each film where the calculated fair value was less than its carrying value at September 30, 2004. The resulting impairment charge was $57.9 million. The Company concluded on November 11, 2004, that this non-cash impairment charge was required under generally accepted accounting principles to be recorded in the Company’s financial results for the third quarter of 2004. Please see Note 2 of Notes to the Unaudited Consolidated Financial Statements in this Report for additional information on this impairment charge.

Revenue

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

Subscriber Fees

Subscriber fees are generally payable to us on a per subscriber basis by pay television distributors for the right to carry our channels. In the United States, we pay certain television distributors up-front subscriber acquisition fees to carry our channel. However, such payments are not common in the international cable television markets. Subscriber acquisition fees that we pay are capitalized and amortized over the contractual term of the applicable distribution agreement as a reduction in subscriber fee revenue. If the amortization expense exceeds the revenue recognized on a per distributor basis, the excess amortization is included as a component of cost of services. At the time we sign a distribution agreement, we evaluate the recoverability of the costs we incur against the incremental revenue directly and indirectly associated with each agreement.

Rates we receive per subscriber vary according to:

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

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

•                                          the packaging arrangements for the channel; and

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

In some circumstances, international distributors provide minimum revenue guarantees.

We are in continuous negotiations with both our existing distributors and new distributors to increase our subscriber base in order to enhance our advertising results. In the United States, we are often subject to requests by distributors to pay subscriber acquisition fees for additional subscribers or to waive or accept lower subscriber fees if certain numbers of additional subscribers are provided. In both domestic and international markets we also may help fund the distributors’ efforts to market our channels or we may permit distributors to offer limited promotional periods without payment of subscriber fees. As we continue our efforts to add subscribers, our domestic subscriber revenue will continue to be negatively affected by subscriber acquisition fee amortization, waiver of subscriber fees and bulk discounts resulting from the attainment of certain subscriber levels; however, we believe that as a result of these measures, our subscriber counts will increase which in turn will allow us to attract additional advertisers and command higher advertising rates.

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

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

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

Our subscriber count depends on the number of distributors carrying the Hallmark Channel and the size of such distributors as well as the program tiers on which our channel is carried by these distributors. From time to time, we experience decreases in the number of subscribers domestically and internationally as promotional periods end or a distributor arrangement is amended or is terminated by us or the distributor. Changes to distribution arrangements in 2004 have not been significant. Management analyzes the estimated effect each new or amended distribution agreement will have on revenues and costs. Based upon these analyses, management endeavors to achieve a fair combination of subscriber commitments and subscriber acquisition fees with each of our domestic distributors.

Advertising

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

In markets where regular audience measurements are available, our advertising rates are generally calculated on the basis of an agreed upon price per unit of audience measurement in return for a guaranteed commitment by the

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advertiser. In these countries, we commit to provide advertisers certain rating levels in connection with their advertising. Revenue is recorded net of estimated delivery shortfalls, which are usually settled by providing the advertiser additional advertising time. In other less sophisticated markets, our advertising rates are calculated on the basis of cost per advertising spot or package of advertising spots, and the price varies by audience level expected (but not measured) during a particular time slot. This is the predominant arrangement in the countries outside the United States in which we sell advertising time. Advertising rates also vary by time of year due to seasonal changes in television viewership.

Film Licensing

Crown Media Distribution generates revenue from the film assets by granting licenses to exhibit the films to third parties. We are also using the films as programming for our channel. Customers for our film assets consist of other television channels, home video distributors and brokers who resell rights to our film assets in various international markets. License fees for our film assets are generally negotiated based upon the size of the potential audience who will be viewing the programming.

Cost of Services

Our cost of services consists primarily of program license fees, amortization of our film assets; subscriber acquisition fee expense; the cost of signal distribution; dubbing and subtitling programming for foreign audiences; administration, distribution and other exploitation of our film assets; and the cost of promotional segments that are aired between programs. We expect cost of services to continue to increase in the future as we expand our existing markets and third party programming to support our advertising strategy. We expect the cost of services to increase in 2004 as compared to 2003 because of the following: we intend to acquire or use a greater amount and variety of quality programming as a part of our efforts to continue the increases in our ratings; and we anticipate higher levels of subscriber acquisition fee amortization as result of incremental increases in the distribution of our channel.

Critical Accounting Estimates

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

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

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