Content

Making a Hallmark

7/14/2006 8:06 PM Eastern

During the five years since its relaunch, Hallmark Channel has racked up one success after another.

Distribution has soared to 73.5 million subscribers, a gain of 55 million full-time households in that time. The venturesome channel with the world-known brand now ranks as a Top 10-rated cable network. It’s won a reputation for quality, family-friendly programming, and expects to generate more than $170 million in ad revenue this year.

But, in an effort to reach profitability and fuel continued growth, Hallmark Channel tried in the past year to sell itself to a larger entity — and failed. As a result, in the next 18 months it faces a host of difficult challenges — all crucial to its future — as a standalone network.

Hallmark Channel must try to ink deals that account for four-fifths of its reach with a group that includes the multichannel industry’s largest distributors — Comcast Corp., Time Warner Cable, DirecTV Inc., EchoStar Communications Corp., Cablevision Systems Corp. and the National Cable Television Cooperative.

And the network must close those renewals as an independent, without the leverage or clout of a giant media company, such as Time Warner Inc., behind it.

Hallmark Channel’s parent, Crown Media Holdings Inc., is in the midst of choosing the network’s new CEO, who will guide it during this difficult period.

And the service, just as it is seeking license-fee increases from distributors, has gone into a difficult upfront ad market seeking price increases from sponsors.

“We’re significantly below where we deserve to be [in ad pricing],” said Bill Abbott, Crown Media’s executive vice president of ad sales for Hallmark Channel and Hallmark Movie Channel.

SNAPSHOT: Hallmark Channel
Parent: Crown Media Holdings Inc.
Headquarters: Studio City, Calif.
Acting Chief Executive: Paul FitzPatrick, executive vice president and chief operating officer
Challenges: Renewing carriage deals with major distributors; reducing debt; finding a permanent CEO; lowering median age of audience; securing price increases in upfront
Subscribers reached: 73.5 million
2005 revenue: $197.4 million
2005 adjusted cash flow: $1.9 million deficit before interest, taxes, depreciation and amortization
1Q 2006 revenue: $45 million
1Q 2006 adjusted cash flow: $5.5 million deficit before interest, taxes, depreciation and amortization
Long-term debt: $1 billion
Number of movies in library: 640
Value of library: $360 million, est.
Ownership: Hallmark Cards Inc., Liberty Media Corp., DirecTV Inc., J.P. Morgan Partners, VISN Management Corp. (a unit of the National Interfaith Cable Coalition).
SOURCES: Crown Media, Nielsen Media Research, company officials.

Having not attracted a suitable price offer, Crown Media in fact shelved the core network’s sale in April.

“I think, somewhat naively, they expected that somebody would write a $2 billion check,” said Herbert Granath, a cable-industry veteran who sits on Crown Media’s board. “And in this day and age, that’s probably not in the cards.”

It wasn’t “in the cards,” in part, because would-be suitors were concerned about the uncertainty regarding the network’s distribution, according to Hallmark Channel officials.

Independent networks such as Hallmark Channel, which aren’t part of a strong bundle of networks and video services sold by a media giant, can get squeezed by distributors. Lifetime Television, for example, this year was dropped and later restored by EchoStar’s Dish Network, the nation’s No. 2 direct-broadcast satellite provider — and one that Hallmark Channel has to strike a new deal with.

With that pending, Crown Media in the coming weeks expects to name a new CEO to replace David Evans. After seven years, Evans left in June, before his contract expired in September.

Some of the external candidates to lead the network are well-known cable-industry figures, according to Granath, who is currently chairman of the National Academy of Television Arts & Sciences and co-chair of Crown’s search committee.

The field had been narrowed down to a half-dozen candidates, half of whom are internal, Granath said. Outside the company, Crown has talked to Henry Schleiff, Court TV’s non-executive chairman, according to officials familiar with the search.

Granath wouldn’t discuss who is in the running, and Schleiff couldn’t be reached for comment last week.

“There’s just a real good selection, including some really big names in the business,” Granath said. “Henry Schleiff types are all over the place, and that’s good, from our standpoint.”

NO STANDING ROOM

Wall Street is keeping close watch on how Crown sets up the Hallmark networks for the future. Investors and analysts have not been happy with Crown, which is 67% owned by Hallmark Cards Inc. The thinly traded Crown stock is selling at about $4.20, not that far from its 52-week low.

The Street is bearish on Hallmark Channel’s future as an independent channel.

“The rationale for putting the company up for sale made a lot of sense,” said Alan Gould, a Natexis Bleichroeder Inc. analyst who owns Crown stock. “It’s very difficult being a standalone cable programmer, a one-network cable programmer. There’s no economies of scale.”

Analysts such as Gould and Robert Routh of Jefferies & Co. want Crown to pay down its roughly $1 billion in debt, most of which is owed to parent Hallmark Cards, by selling the company’s 640-title library. Its catalog includes made-for-TV movies like Lonesome Dove, Moby Dick, The Odyssey and Alice in Wonderland. Gould also suggests shutting down Hallmark’s small spin-off, Hallmark Movie Channel.

Crown Media, which tried to appease Wall Street with some cost-cutting this spring, is projecting positive operating cash flow this year, on revenue of about $225 million.

Hallmark Channel officials are championing the network’s odds going forward, saying its uniqueness gives it an edge. The network’s programming strategy — it airs roughly two dozen original family movies per year — has been a hit with audiences and advertisers alike.

Even with its relatively older audience, Hallmark has been on a ratings roll. In the second quarter, Hallmark Channel primetime viewership was up 22%, to a 1.1 rating, according to Nielsen Media Research.

Most recently, Hallmark Channel made a dramatic programming move in June when it acquired a package of 39 feature films from Warner Bros. Domestic Cable Distribution, including rights to air the world television premiere of the Oscar-winning March of the Penguins.

Hallmark Channel’s other card, so to speak, has been in marketing, by pioneering cross-platform promotions — typically tied to holidays — between the network, its affiliate partners, national advertisers, and more than 4,000 Hallmark Gold Crown stores, according to Crown Media chief operating officer and acting head Paul FitzPatrick. In one upcoming sweepstakes, promoted in stores and on TV, viewers can, for instance, win a trip to L.A. and a walk-on role in a Hallmark Channel original movie.

Hallmark Cards realizes “they’ve got an extremely valuable property [in Hallmark Channel] if a couple of things fall into place,” Granath said.

FAMILY ODYSSEY

Hallmark Cards acquired its stake in what was then called Odyssey Network in 1998. Two years later, it took full control of the one-time religious channel after an initial public offering that netted $130 million. It relaunched the network as Hallmark Channel, with family-oriented programming, in August 2001.

From the get-go, Crown’s five-year game plan was to jump-start the network by investing heavily so it could reach a critical mass and build scale as quickly as possible, according to FitzPatrick, an alumnus of C-SPAN, The Golf Channel and The Weather Channel.

“That was certainly a strategic objective and we did so with eyes wide open,” he said.

Thus, the aggressive effort to expand distribution, since Hallmark Channel was trying to grab a place in the market some 15 or 20 years after other programmers gained shelf space on cable and later satellite services.

In order to ramp up distribution, Hallmark Channel cut deals that permitted some cable operators and satellite providers to carry it free for a number of years. Hallmark also paid launch fees to get carriage.

But industry executives said that Hallmark’s license-fee rates took a hard hit because of a 2001 carriage deal that Crown Media struck with DirecTV. That pact gave the No. 1 U.S. satellite provider 5.4 million shares of Crown stock, then valued at about $80 million, in exchange for a rollout to 7 million DirecTV homes at that time.

That deal took Hallmark’s net effective license-fee rate to less than two cents a household for DirecTV. That prompted other distributors, citing so-called “most-favored nations” clauses in their contracts, to immediately demand similar lower net effective license-fee rates from Hallmark as well, according to one industry executive familiar with the situation.

DirecTV declined to comment, but Hallmark Channel officials defended their deal with the satellite provider, saying it was critical in driving the network’s growth. The company says that, overall, its license fee rates are now “increasing, due to the burn off of launch incentives’’ and ending free carriage.

In its annual 10-K filing with the Securities and Exchange Commission in March, Crown Media said that in the past, it had been asked to comply with distributors’ “MFN” clauses. And in the future, it said, it could have to pay cash or issue stock to distributors as the result of claims stemming from those clauses. That “would negatively affect subscriber revenue,” the company told the SEC.

With wide distribution, Hallmark Channel now has to come to distributors seeking adequate compensation for the network’s value. Right now, license fees — which in many cases are kicking in after free carriage periods — are small. Subscriber fees accounted for less than $20 million a year in revenue from all Hallmark Channel’s distributors last year.

Spike TV, with similar primetime ratings to Hallmark, this year will pull in about $207 million in license fees, earning 19 cents per household per month, according to Kagan Research.

Hallmark Channel’s monthly, per-subscriber license fee was about 4 cents last year, according to Gould and Kagan Research. The network itself pegs its current license fees at about 5 cents. But when launch fees are factored out, last year Hallmark was only netting about 2.3 cents a subscriber a month, and will net 3.3 cents this year, Gould said.

“What they’ve had to do is sacrifice a reasonable payment, what I would consider a reasonable payment,” for the kind of quality programming the network is offering, Granath said.

David Kenin, Crown’s executive vice president of programming, has multiplied the network’s ratings with a primetime strategy that has movies as its linchpin. Focusing on about 25 original films a year, rather than series, was the quickest way for Hallmark Channel “to put some points on the board,” he said.

Westerns and mysteries are two genres the network has focused on, in addition to scheduling on heavily marketed events during holidays. Wild Hearts, Desolation Canyon, Meet the Santas and Love’s Long Journey are among the Hallmark Channel movies that have performed especially well in the ratings.

“We are the poster boy for family-friendly content, and on that front, you’re not going to tune into us and see anyone get blood-spattered from a gun,” Kenin said.

It Ads Up: Where Hallmark Channel Makes Its Money
The vast bulk of Hallmark revenue comes from the sale of advertising.
Ad sales Subscriber fees
2004 $106.3 million $9.9 million
2005 $146.1 million $18.7 million
2006 [1] $170-$180 million $30-$35 million
1st Quarter 2006 $38.4 million $6.2 million
Source: SEC filings, the company [1] Projected.

JUST REWARDS

The network has delivered on its promises, and indications are that distributors will be willing to reward it for that, according to Hallmark Channel officials. The programmer completed what it considers a successful renewal with Charter Communications Inc. late last year.

Hallmark Channel plans to cite the network’s investment of hundreds of millions of dollars for programming and marketing during its negotiations with distributors like Comcast and Time Warner, FitzPatrick said. Hallmark Channel has carriage deals that expire on or before the end of 2007 that represent about 80% of its distribution, or about 55 million subscribers.

But industry executives and analysts predict it will be an uphill battle for Hallmark Channel to get the license-fee increases it’s seeking.

“Of all the major independents, they’re probably still in the best position,” said Rob Stengel, a principal with Continental Consulting Group. “They have a lot of good programming and they manage to get ratings. It’s just a difficult situation.”

Tensions this year between distributors have flared several times this year. EchoStar waged a very bitter public battle with Lifetime, which it dropped from its Dish Network lineup on New Year’s Eve. And Time Warner threatened to drop — or move to digital — a number of independent channels, including GSN and Outdoor Channel.

Hallmark Channel may have to accept flat or minimal rate increases, or moves to digital tiers in some cases, one cable-network chief said. Or distributors could threaten to just offer the network on their family tiers, he said.

“The fact is it’s an independent network, and the Matt Bonds and the Fred Dresslers of the world know they can squeeze independent networks,” the cable-network chief said, referring to the executive vice presidents of programming for Comcast and Time Warner Cable, respectively. Those are two of the four top distributors with whom Hallmark must sign deals.

Nonetheless, to keep up its quality, Hallmark Channel does “require a license fee beyond where we are now,” FitzPatrick said.

Those rate hikes — if achieved — will determine how much black ink Hallmark sees going forward.

“Where we end up on those renewals is really going to make a huge difference in terms of the financial performance of this channel, because the advertising is what it is,” said Bill Aliber, Crown Media’s chief financial officer. “We don’t have that second robust revenue stream called subscriber revenue. And I think where that shakes out makes a huge difference in terms of the financial strength of the channel, but also the valuation of the channel.”

Roughly 80% of Hallmark Channel’s revenue comes from advertising, with the remaining 20% derived from license fees. For most cable networks, that ad revenue to subscriber revenue ratio is usually 50-50 or 60-40.

Last year, Hallmark Channel tallied $146.1 million in ad sales, up 37%, with subscriber fees of $18.7 million, up 90%. This year, Hallmark Channel will rake in $170 million to $180 million in ad revenue, and $30 million to $35 million in subscriber revenue, according to Aliber.

“Hopefully, when we get to these renewals down the road we can see that $30 million become a much more significant number,” he said. “That’s where this business will start to throw off” cash.

And it should get better, if he’s right. He’s targeting $60 million to $70 million in subscriber fees by 2008.

THE POWER OF ONE

As a single network, Hallmark Channel doesn’t have a lot of negotiating power, according to Granath. But the network brings other attributes to the table, like family-friendly programming and on-demand content, Granath and FitzPatrick said.

“I don’t think there is any doubt that we will get renewals from all the majors,” Granath said. “The question is on what terms.”

Those looming contract expirations tempered interest from potential buyers of the channel, according to Aliber.

“As someone who sat through every due-diligence session, I think the biggest issue was the renewals,” he said. “If there was a factor that impacted value or people’s appetite to bid at all, it really was the uncertainty around the distribution agreements.”

There were two rounds of bidding, with media giants such as News Corp. and Time Warner Inc. weighing in. But Crown ultimately took the network off the block.

“There was enough interest evident from the major players,” Granath said. “I mean, everybody was interested, and everybody had kind of a deal they wanted to do. But it wasn’t writing a $2 billion check.”

Cable networks have traditionally been priced based on cash flow, and Hallmark Channel is only on the brink of turning cash-flow positive, according to Derek Baine, senior vice president for Kagan Research.

“At the end of the day, networks are going to be [valued] on what the cash flow is going to be,” Baine said. “It’s going to take them five to 10 years to get up to the range where they’re going to have cash flow to justify [a premium sale price].”

As he sees it, Hallmark Channel has “a tough seat to sit in” because “the question is all about that license fee and how do you get that up to a dime, or something more normalized, so they really would be getting more significant cash flow.”

Since it pulled Hallmark Channel off the block, Crown has made good on its promise to trim costs, to the tune of $14 million to $15 million, in part by making cuts in marketing spending, laying off 25 of its 175 employees in April, and improving ad sales, trafficking and information-technology systems.

Also in April, Chris Moseley, Crown Media’s highly compensated executive vice president and chief marketing officer, resigned. Moseley couldn’t be reached for comment.

Crown still has roughly $1 billion in debt, with $220 million from a group led by J.P. Morgan and roughly $800 million from Hallmark Cards, the bulk of that stemming from Crown’s purchase of the Hallmark library. The Hallmark Cards debt is interest-deferred until mid-2007.

“We’ve recognized the fact that the company’s got too much debt, that we need to adjust the capital structure,” Aliber said. “And one of the ways we can do that is to monetize the one asset that we’ve got that would allow us to clean up the balance sheet a little bit.”

That asset, the film library, generates $20 million to $25 million in revenue a year, and provides content for the spin- off movie network, according to Aliber.

Routh, who believes Hallmark Cards should forgive some of its debt to Crown, values the library at $300 million. Crown Media values it at $360 million.

There’s no question what Hallmark Channel should do, as Gould sees it.

“The company has to lower the debt, so long as it can get any sort of reasonable valuation for the library, in my opinion, they should sell the library, use the proceeds to pay down the debt, and close down the Hallmark Movie Channel,” he said.

Hallmark Cards CEO Don Hall Jr. declined to comment for this story.

But Crown Media is looking at possibly selling its film library, according to Aliber.

It’s a balancing act, he said, between getting cash flow every year from licensing its films “versus the desire to monetize that today and pay down debt and clean up the balance sheet.”

September