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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2006
OR
[ ] 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 000-51205
DISCOVERY HOLDING COMPANY
(Exact name of Registrant as specified in its charter)
STATE OF DELAWARE 20-2471174
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
12300 LIBERTY BOULEVARD
ENGLEWOOD, COLORADO 80112
(Address of principal executive offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
(720) 875-4000
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 for 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 [X] No [ ]
Indicate by check mark whether the Registrant is a large accelerated filer,
an accelerated filer, or a non-accelerated filer as defined in Rule 12b-2 of the
Exchange Act.
Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated
filer [X]
Indicate by check mark whether the Registrant is a shell company as defined
in Rule 12b-2 of the Exchange Act. Yes [ ] No [X]
The number of outstanding shares of Discovery Holding Company's common
stock as of April 28, 2006 was:
Series A common stock 268,114,869 shares; and
Series B common stock 12,086,093 shares.
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DISCOVERY HOLDING COMPANY
Condensed Consolidated Balance Sheets
(unaudited)
March 31, December 31,
2006 2005
------------- -------------
amounts in thousands
Assets
Current assets:
Cash and cash equivalents $ 150,821 250,352
Trade receivables, net 142,583 134,615
Prepaid expenses 14,763 10,986
Other current assets 4,426 4,433
------------- -------------
Total current assets 312,593 400,386
Investments in marketable securities 49,175 - -
Investment in Discovery Communications, Inc.
("Discovery") (note 8) 3,042,322 3,018,622
Property, plant, and equipment, net 259,104 256,245
Goodwill (note 7) 2,165,961 2,133,518
Other assets, net 20,226 10,465
------------- -------------
Total assets $ 5,849,381 5,819,236
============= =============
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 31,897 26,854
Accrued payroll and related liabilities 24,898 21,651
Other accrued liabilities 22,914 23,949
Deferred revenue 16,326 17,491
------------- -------------
Total current liabilities 96,035 89,945
Deferred income tax liabilities 1,140,780 1,131,505
Other liabilities 21,556 22,361
------------- -------------
Total liabilities 1,258,371 1,243,811
------------- -------------
Commitments and contingencies (note 9)
Stockholders' equity:
Preferred stock, $.01 par value. Authorized 50,000,000
shares; no shares issued - - - -
Series A common stock, $.01 par value. Authorized
600,000,000 shares; issued and outstanding
268,094,869 shares at March 31, 2006 and 268,097,442
shares at December 31, 2005 2,681 2,681
Series B common stock, $.01 par value. Authorized
50,000,000 shares; issued and outstanding 12,106,093
shares at March 31, 2006 and December 31, 2005 121 121
Series C common stock, $.01 par value. Authorized
600,000,000 shares; no shares issued - - - -
Additional paid-in capital 5,712,850 5,712,304
Accumulated deficit (1,126,206) (1,137,821)
Accumulated other comprehensive earnings (loss) 1,564 (1,860)
------------- -------------
Total stockholders' equity 4,591,010 4,575,425
------------- -------------
Total liabilities and stockholders' equity $ 5,849,381 5,819,236
============= =============
See accompanying notes to condensed consolidated financial statements.
I-1
DISCOVERY HOLDING COMPANY
Condensed Consolidated Statements of Operations and Comprehensive Earnings
(unaudited)
Three months ended
March 31,
---------------------
2006 2005
--------- ---------
amounts in thousands
Net revenue $ 153,568 174,290
Operating expenses:
Cost of services 97,599 110,854
Selling, general, and administrative (including
stock-based compensation of $546,000 and $213,000 in
2006 and 2005, respectively) (note 3) 43,171 43,798
Depreciation and amortization 15,655 16,761
--------- ---------
156,425 171,413
--------- ---------
Operating income (loss) (2,857) 2,877
Other income:
Share of earnings of Discovery (note 8) 21,173 22,814
Other, net 1,950 322
--------- ---------
23,123 23,136
--------- ---------
Earnings before income taxes 20,266 26,013
Income tax expense (8,651) (9,188)
--------- ---------
Net earnings 11,615 16,825
--------- ---------
Other comprehensive earnings (loss), net of taxes:
Foreign currency translation adjustments 2,637 (5,341)
Unrealized holding gains arising during the period 787 39
--------- ---------
Other comprehensive earnings (loss) 3,424 (5,302)
--------- ---------
Comprehensive earnings $ 15,039 11,523
========= =========
Basic and diluted earnings per common share (note 4) $ .04 .06
========= =========
See accompanying notes to condensed consolidated financial statements.
I-2
DISCOVERY HOLDING COMPANY
Condensed Consolidated Statements of Cash Flows
(unaudited)
Three months ended
March 31,
---------------------------
2006 2005
------------ ------------
amounts in thousands
(note 5)
Cash flows from operating activities:
Net earnings $ 11,615 16,825
Adjustments to reconcile net earnings to net cash provided
by operating activities:
Depreciation and amortization 15,655 16,761
Stock-based compensation 546 213
Share of earnings of Discovery (21,173) (22,814)
Deferred income tax expense 8,293 8,898
Other non-cash charges (credits), net 353 (75)
Changes in assets and liabilities (net of acquisitions):
Trade receivables (4,836) (2,807)
Prepaid expenses and other current assets (4,012) 2,710
Payables and other liabilities 3,827 (8,706)
------------ ------------
Net cash provided by operating activities 10,268 11,005
------------ ------------
Cash flows from investing activities:
Capital expenditures (13,802) (20,921)
Net purchases of marketable securities (49,175) - -
Cash paid for acquisitions, net of cash acquired (46,793) - -
Other investing activities, net (27) 2,217
------------ ------------
Net cash used in investing activities (109,797) (18,704)
------------ ------------
Cash flows from financing activities:
Net cash transfers from Liberty Media Corporation - - 1,242
Other financing activities, net (2) (3)
------------ ------------
Net cash provided (used) by financing activities (2) 1,239
------------ ------------
Net decrease in cash and cash equivalents (99,531) (6,460)
Cash and cash equivalents at beginning of period 250,352 21,641
------------ ------------
Cash and cash equivalents at end of period $ 150,821 15,181
============ ============
See accompanying notes to condensed consolidated financial statements.
I-3
DISCOVERY HOLDING COMPANY
Condensed Consolidated Statement of Stockholders' Equity
Three months ended March 31, 2006
(unaudited)
Accumulated
Common stock Additional other
Preferred ------------------------------ paid-in Accumulated comprehensive
stock Series A Series B Series C capital deficit income (loss) Total
--------- -------- -------- -------- ---------- ----------- ------------- ---------
amounts in thousands
Balance at January 1, 2006 $ - - 2,681 121 - - 5,712,304 (1,137,821) (1,860) 4,575,425
Net earnings - - - - - - - - - - 11,615 - - 11,615
Other comprehensive
earnings - - - - - - - - - - - - 3,424 3,424
Stock compensation - - - - - - - - 546 - - - - 546
-------- -------- -------- -------- --------- ---------- -------- ---------
Balance at March 31, 2006 $ - - 2,681 121 - - 5,712,850 (1,126,206) 1,564 4,591,010
======== ======== ======== ======== ========= ========== ======== =========
See accompanying notes to condensed consolidated financial statements.
I-4
DISCOVERY HOLDING COMPANY
Notes to Condensed Consolidated Financial Statements
March 31, 2006
(unaudited)
(1) BASIS OF PRESENTATION
The accompanying condensed consolidated financial statements of Discovery
Holding Company ("DHC" or the "Company") represent a combination of the
historical financial information of (1) Ascent Media Group, LLC ("Ascent
Media"), a wholly-owned subsidiary of Liberty Media Corporation
("Liberty"), and Liberty's 50% ownership interest in Discovery for
periods prior to the July 21, 2005 consummation of the spin off
transaction (the "Spin Off") described in note 2 and (2) DHC and its
consolidated subsidiaries for the period following such date. The Spin
Off has been accounted for at historical cost due to the pro rata nature
of the distribution. Accordingly, DHC's historical financial statements
are presented in a manner similar to a pooling of interest.
Ascent Media is comprised of three operating divisions or groups. Ascent
Media's Creative Services group provides services necessary to complete
the creation of original content, including feature films, mini-series,
television shows, television commercials, music videos, promotional and
identity campaigns, and corporate communications programming. The group
manipulates or enhances original visual images or audio captured in
principal photography or creates new three dimensional images, animation
sequences, or sound effects. The Media Management Services group provides
owners of content libraries with an entire complement of facilities and
services necessary to optimize, archive, manage, and repurpose media
assets for global distribution via freight, satellite, fiber and the
Internet. The Networks Services group provides the facilities and
services necessary to assemble and distribute programming content for
cable and broadcast networks via fiber, satellite and the Internet to
viewers in North America, Europe and Asia. Additionally, the Networks
Services group provides systems integration, design, consulting,
engineering and project management services.
Substantially all of the assets of AccentHealth, LLC were acquired by DHC
in January 2006. AccentHealth operates an advertising-supported captive
audience television network in approximately 11,000 doctor office waiting
rooms nationwide.
Discovery is a global media and entertainment company that provides
original and purchased cable and satellite television programming in the
United States and over 160 other countries. Discovery also develops and
sells branded commerce and educational product lines in the United
States.
The accompanying interim condensed consolidated financial statements are
unaudited but, in the opinion of management, reflect all adjustments
(consisting of normal recurring accruals) necessary for a fair
presentation of the results for such periods. The results of operations
for any interim period are not necessarily indicative of results for the
full year. These condensed consolidated financial statements should be
read in conjunction with the Company's consolidated financial statements
and notes thereto included in its Annual Report on Form 10-K for the year
ended December 31, 2005.
The preparation of financial statements in conformity with U.S. generally
accepted accounting principles ("GAAP") requires management to make
estimates and assumptions that affect the reported amounts of revenue and
expenses for each reporting period. The significant estimates made in
preparation of the Company's consolidated financial statements primarily
relate to valuation of goodwill, other intangible assets, long-lived
assets, deferred tax assets, and the amount of the allowance for doubtful
accounts. Actual results could differ from the estimates upon which the
carrying values were based.
I-5
DISCOVERY HOLDING COMPANY
Notes to Condensed Consolidated Financial Statements, continued
(2) SPIN OFF TRANSACTION
On July 21, 2005 (the "Spin Off Date"), Liberty completed the spin off of
the capital stock of DHC to the holders of Liberty common stock. The Spin
Off was effected as a dividend by Liberty to holders of its Series A and
Series B common stock of shares of DHC Series A and Series B common
stock, respectively. Holders of Liberty common stock on July 15, 2005
received 0.10 of a share of DHC Series A common stock for each share of
Liberty Series A common stock owned and 0.10 of a share of DHC Series B
common stock for each share of Liberty Series B common stock owned.
Approximately 268.1 million shares of DHC Series A common stock and 12.1
million shares of DHC Series B common stock were issued in the Spin Off.
The Spin Off did not involve the payment of any consideration by the
holders of Liberty common stock and is intended to qualify as a tax-free
transaction.
In addition to Ascent Media and its investment in Discovery, Liberty
transferred $200 million in cash to a subsidiary of DHC prior to the Spin
Off.
Following the Spin Off, the Company and Liberty operate independently,
and neither has any stock ownership, beneficial or otherwise, in the
other. In connection with the Spin Off, the Company and Liberty entered
into certain agreements in order to govern certain of the ongoing
relationships between the Company and Liberty after the Spin Off and to
provide for an orderly transition. These agreements include a
Reorganization Agreement, a Services Agreement and a Tax Sharing
Agreement.
The Reorganization Agreement provides for, among other things, the
principal corporate transactions required to effect the Spin Off and
cross indemnities. Pursuant to the Services Agreement, Liberty provides
the Company with office space and certain general and administrative
services including legal, tax, accounting, treasury and investor
relations support. The Company reimburses Liberty for direct,
out-of-pocket expenses incurred by Liberty in providing these services
and for the Company's allocable portion of facilities costs and costs
associated with any shared services or personnel. Liberty and DHC have
agreed that they will review cost allocations every six months and adjust
such charges, if appropriate.
Under the Tax Sharing Agreement, Liberty is generally responsible for
U.S. federal, state, local and foreign income taxes reported on a
consolidated, combined or unitary return that includes the Company or one
of its subsidiaries and Liberty or one of its subsidiaries. The Company
is responsible for all other taxes that are attributable to the Company
or one of its subsidiaries, whether accruing before, on or after the Spin
Off. The Tax Sharing Agreement requires that the Company will not take,
or fail to take, any action where such action, or failure to act, would
be inconsistent with or prohibit the Spin Off from qualifying as a
tax-free transaction. Moreover, the Company has indemnified Liberty for
any loss resulting from (i) such action or failure to act or (ii) any
agreement, understanding, arrangement or substantial negotiations entered
into by DHC prior to the day after the first anniversary of the Spin Off
Date, with respect to any transaction pursuant to which any of the other
shareholders in Discovery would acquire shares of, or other interests in
DHC's capital stock, in each case relating to the qualification of the
Spin Off as a tax-free transaction.
(3) STOCK-BASED COMPENSATION
As a result of the Spin Off and related adjustments to Liberty's stock
incentive awards, options ("Spin Off DHC Awards") to acquire an aggregate
of approximately 2.0 million shares of DHC Series A common stock and 3.0
million shares of DHC Series B common stock were issued to employees of
Liberty. In addition, employees of Ascent Media who held stock options or
stock appreciation rights ("SARs") to acquire shares of Liberty common
stock prior to the Spin Off continue to hold such options. Pursuant to
the Reorganization Agreement, DHC is responsible for all stock options
related to DHC
I-6
DISCOVERY HOLDING COMPANY
Notes to Condensed Consolidated Financial Statements, continued
common stock, and Liberty is responsible for all incentive awards related
to Liberty common stock. Notwithstanding the foregoing, the Company
records stock-based compensation for all stock incentive awards held by
DHC's and its subsidiaries' employees regardless of whether such awards
relate to DHC common stock or Liberty common stock. Any stock-based
compensation recorded by DHC with respect to Liberty stock incentive
awards is treated as a capital transaction with the offset to stock-based
compensation expense reflected as an adjustment of additional paid-in
capital.
In December 2004, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 123 (revised 2004),
"Share-Based Payments" ("Statement 123R"). Statement 123R, which is a
revision of Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" ("Statement 123") and
supersedes Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issued to Employees" ("APB Opinion No. 25"), establishes standards
for the accounting for transactions in which an entity exchanges its
equity instruments for goods or services, primarily focusing on
transactions in which an entity obtains employee services. Statement 123R
generally requires companies to measure the cost of employee services
received in exchange for an award of equity instruments (such as stock
options and restricted stock) based on the grant-date fair value of the
award, and to recognize that cost over the period during which the
employee is required to provide service (usually the vesting period of
the award). Statement 123R also requires companies to measure the cost of
employee services received in exchange for an award of liability
instruments (such as stock appreciation rights that will be settled in
cash) based on the current fair value of the award, and to remeasure the
fair value of the award at each reporting date.
The Company adopted Statement 123R effective January 1, 2006. The
provisions of Statement 123R allow companies to adopt the standard using
the modified prospective method or to restate all periods for which
Statement 123 was effective. The Company has adopted Statement 123R using
the modified prospective method, and will include in its financial
statements for periods that begin after December 31, 2005 pro forma
information as though the standard had been adopted for all periods
presented.
Liberty calculated the grant-date fair value for all of its awards using
the Black-Scholes Model. Liberty calculated the expected term of the
awards using the methodology included in SEC Staff Accounting Bulletin
No. 107. The volatility used in the calculation is based on the implied
volatility of publicly traded Liberty options with a similar term
(generally 20% - 21%). Liberty uses the risk-free rate for Treasury Bonds
with a term similar to that of the subject options. The Company has
allocated the grant-date fair value of the Liberty awards to the Spin Off
DHC Awards based on the relative trading prices of DHC and Liberty common
stock after the Spin Off.
No DHC options were granted or exercised during the three months ended
March 31, 2006. As of March 31, 2006, the total compensation cost related
to unvested equity awards was $2.3 million. Such amount will be
recognized in the Company's consolidated statements of operations through
2009.
Prior to the adoption of Statement 123R, the Company applied the
intrinsic-value-based method of accounting prescribed by APB Opinion No.
25, to account for its fixed-plan stock options. Under this method,
compensation expense was recorded on the date of grant only if the
current market price of the underlying stock exceeded the exercise price
and was recognized on a straight-line basis over the vesting period.
The following table illustrates the effect on net earnings for the three
months ended March 31, 2005 as if the fair-value-based method of
Statement 123R had been applied to all outstanding and unvested awards.
Compensation expense for SARs was the same under APB Opinion No. 25 and
Statement 123R. Accordingly, no pro forma adjustment
I-7
DISCOVERY HOLDING COMPANY
Notes to Condensed Consolidated Financial Statements, continued
for such awards is included in the following table (amounts in thousands,
except per share amounts).
Three months
ended
March 31,
2005
------------
Net earnings, as reported $ 16,825
Add:
Stock-based employee compensation expense included in
reported net earnings, net of taxes 566
Deduct:
Stock-based employee compensation expense determined
under fair value based method for all awards, net
of taxes (1,466)
------------
Pro forma net earnings $ 15,925
============
Pro forma basic and diluted earnings per share:
As reported $ .06
============
Pro forma for fair value stock compensation $ .06
============
(4) EARNINGS PER COMMON SHARE
Basic earnings per common share ("EPS") is computed by dividing net
earnings by the weighted average number of common shares outstanding for
the period. The weighted average number of shares outstanding for the
three months ended March 31, 2006 is 279,950,000 and the weighted average
number of shares outstanding for periods prior to the Spin Off Date is
280,199,000 shares, which is the number of shares that were issued on the
Spin Off Date. Dilutive EPS presents the dilutive effect on a per share
basis of potential common shares as if they had been converted at the
beginning of the periods presented. Due to the relative insignificance of
the dilutive securities in 2006 and 2005, their inclusion does not impact
the EPS amount as reported in the accompanying condensed consolidated
statements of operations.
(5) SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Three months ended
March 31,
--------------------
2006 2005
--------- --------
amounts in thousands
Cash paid for acquisitions:
Fair value of assets acquired $ 48,264 - -
Net liabilities assumed (1,471) - -
--------- --------
Cash paid for acquisitions, net of cash acquired $ 46,793 - -
========= ========
(6) ACQUISITION
ACCENTHEALTH
Effective January 27, 2006, a subsidiary of DHC acquired substantially
all of the assets of AccentHealth, LLC's healthcare media business
("AccentHealth") for cash consideration of $46,793,000, subject to
potential post-closing adjustments. AccentHealth operates an
advertising-supported captive audience television network in
approximately 11,000 doctor office waiting rooms nationwide. The Company
recorded
I-8
DISCOVERY HOLDING COMPANY
Notes to Condensed Consolidated Financial Statements, continued
goodwill of $32,224,000 and other intangible assets of $9,800,000 in
connection with this acquisition. Such amounts are preliminary and are
subject to adjustment pending completion of the Company's purchase price
allocation process. The excess purchase price over the fair value of
assets acquired is attributable to the growth potential of AccentHealth
and expected compatibility with Ascent Media's existing networks group.
For financial reporting purposes, the acquisition is deemed to have
occurred on February 1, 2006. The results of operations of AccentHealth
have been included in the consolidated results of DHC since the date of
acquisition. On a pro forma basis, the results of operations of
AccentHealth are not significant to those of DHC.
(7) GOODWILL
Goodwill is comprised of the following:
March 31, December 31,
2006 2005
----------- ------------
amounts in thousands
Goodwill
Creative Services Group $ 106,599 106,599
Media Management Services Group 93,402 93,402
Network Services Group 194,960 162,517
Discovery 1,771,000 1,771,000
----------- -----------
Total goodwill $ 2,165,961 2,133,518
=========== ===========
GAAP requires companies to allocate enterprise-level goodwill to all
reporting units, including equity method investments. Accordingly, the
Company has allocated $1,771,000,000 of enterprise-level goodwill to its
investment in Discovery. This allocation is performed for goodwill
impairment testing purposes only and does not change the reported
carrying value of the investment. However, to the extent the investment
is disposed of in the future, the allocated goodwill will be relieved and
included in the calculation of the gain or loss on disposal.
(8) INVESTMENT IN DISCOVERY
The Company has a 50% ownership interest in Discovery and accounts for
its investment using the equity method of accounting. Discovery is a
global media and entertainment company, that provides original and
purchased video programming in the United States and over 160 other
countries. Discovery also develops and sells branded commerce and
educational product lines in the United States.
DHC's carrying value for Discovery was $3,042,322,000 at March 31, 2006.
In addition, as described in note 7, enterprise-level goodwill of
$1,771,000,000 has been allocated to the investment in Discovery.
I-9
DISCOVERY HOLDING COMPANY
Notes to Condensed Consolidated Financial Statements, continued
Summarized financial information for Discovery is as follows:
CONSOLIDATED BALANCE SHEETS
March 31, December 31,
2006 2005
----------- ------------
amounts in thousands
Cash and cash equivalents $ 54,293 34,491
Other current assets 820,747 796,878
Property and equipment, net 399,705 397,578
Goodwill and intangible assets 444,270 397,927
Programming rights, long term 1,185,785 1,175,988
Other assets 334,243 371,758
----------- -----------
Total assets $ 3,239,043 3,174,620
=========== ===========
Current liabilities $ 546,397 692,465
Long term debt 2,748,402 2,590,440
Other liabilities 108,406 101,571
Mandatorily redeemable equity in subsidiaries 270,796 272,502
Stockholders' deficit (434,958) (482,358)
----------- -----------
Total liabilities and stockholders' deficit $ 3,239,043 3,174,620
=========== ===========
CONSOLIDATED STATEMENTS OF OPERATIONS
Three months ended
March 31,
--------------------------
2006 2005
----------- ------------
amounts in thousands
Revenue $ 659,601 601,471
Cost of revenue (240,342) (218,259)
Selling, general and administrative (274,348) (234,758)
Equity-based compensation (5,169) (22,867)
Depreciation and amortization (30,135) (28,821)
----------- -----------
Operating income 109,607 96,766
Interest expense (49,006) (44,908)
Other income, net 10,005 27,400
Income tax expense (28,259) (33,629)
----------- -----------
Net earnings $ 42,347 45,629
=========== ===========
(9) COMMITMENTS AND CONTINGENCIES
The Company is involved in litigation and similar claims incidental to
the conduct of its business. In management's opinion, none of the pending
actions is likely to have a material adverse impact on the Company's
financial position or results of operations.
The Company and its subsidiaries lease offices, satellite transponders
and certain equipment under lease arrangements.
(10) RELATED PARTY TRANSACTIONS
Certain third-party general and administrative and spin off related costs
were paid by Liberty on behalf of the Company prior to the Spin Off and
reflected as expenses in the accompanying condensed consolidated
statements of operations. In addition, certain
I-10
DISCOVERY HOLDING COMPANY
Notes to Condensed Consolidated Financial Statements, continued
general and administrative and other expenses are charged by Liberty to
DHC pursuant to the Services Agreement. Such expenses aggregated $634,000
and $1,242,000 for the three months ended March 31, 2006 and 2005,
respectively.
Ascent Media provides services such as satellite uplink, systems
integration, origination, and post-production to Discovery. Revenue
recorded by Ascent Media for these services for the three months ended
March 31, 2006 and 2005 aggregated $6,768,000 and $9,274,000,
respectively.
(11) INFORMATION ABOUT OPERATING SEGMENTS
The Company's chief operating decision maker, or his designee (the
"CODM"), has identified the Company's reportable segments based on (i)
financial information reviewed by the CODM and (ii) those operating
segments that represent more than 10% of the Company's consolidated
revenue or earnings before taxes. In addition, those equity investments
whose share of earnings represent more than 10% of the Company's earnings
before taxes are considered reportable segments.
Based on the foregoing criteria, the Company's business units have been
aggregated into five reportable segments: the Creative Services Group,
the Media Management Services Group, and the Network Services Group,
which are all operating segments of Ascent Media, Corporate and other,
and Discovery, which is an equity affiliate.
The Creative Services Group provides post-production services, which are
comprised of services necessary to complete the creation of original
content including feature films, television shows, movies of the
week/mini series, television commercials, music videos, promotional and
identity campaigns and corporate communications programming. The Media
Management Services Group provides (i) content storage services, which
are comprised of facilities and services necessary to optimize, archive,
manage and repurpose media assets for global distribution via freight,
satellite, fiber and the Internet; (ii) access to all forms of content,
duplication and formatting services; (iii) language conversions and
laybacks; (iv) restoration and preservation of old or damaged content;
(v) mastering from motion picture film to high resolution or data
formats; (vi) digital audio and video encoding services; and (vii)
digital media management services for global home video, broadcast,
pay-per-view and emerging new media distribution channels. The Network
Services Group provides broadcast services, which are comprised of
services necessary to assemble and distribute programming for cable and
broadcast networks via fiber and satellite to viewers in North America,
Europe and Asia. Additionally, the Networks Services Group provides
systems integration, design, consulting, engineering and project
management services.
The accounting policies of the segments that are consolidated
subsidiaries are the same as those described in the summary of
significant accounting policies and are consistent with GAAP.
The Company evaluates the performance of these operating segments based
on financial measures such as revenue and operating cash flow. The
Company defines operating cash flow as revenue less operating expenses
and selling, general and administrative expense (excluding stock and
other equity-based compensation). The Company believes this is an
important indicator of the operational strength and performance of its
businesses, including the ability to service debt and capital
expenditures. In addition, this measure allows management to view
operating results and perform analytical comparisons and identify
strategies to improve performance. This measure of performance excludes
depreciation and amortization and stock and other equity-based
compensation that are included in the measurement of operating income
pursuant to GAAP. Accordingly, operating cash flow should be considered
in addition to, but not as a substitute for, operating income, cash flow
provided by
I-11
DISCOVERY HOLDING COMPANY
Notes to Condensed Consolidated Financial Statements, continued
operating activities and other measures of financial performance prepared
in accordance with GAAP.
The Company's reportable segments are strategic business units that offer
different products and services. They are managed separately because each
segment requires different technologies, distribution channels and
marketing strategies.
Summarized financial information concerning the Company's reportable
segments is presented in the following tables:
Media
Creative Management Network Equity
Services Services Services Corporate Consolidated affiliate-
Group Group Group (1) and Other total Discovery
--------- ---------- --------- --------- ------------ ----------
amounts in thousands
Three months ended March 31, 2006
Revenue from external customers $ 73,482 25,602 54,484 - - 153,568 659,601
Operating cash flow $ 13,176 1,255 9,796 (10,883) 13,344 144,911
Capital expenditures $ 3,881 1,714 7,603 604 13,802 7,344
Total assets $ 300,479 181,733 373,102 4,994,067 5,849,381 3,239,043
Three months ended March 31, 2005
Revenue from external customers $ 74,228 28,776 71,286 - - 174,290 601,471
Operating cash flow $ 13,051 3,691 15,006 (11,897) 19,851 148,454
Capital expenditures $ 4,499 5,261 10,249 912 20,921 35,459
---------------------------
(1) Included in Network Services Group revenue is broadcast services revenue of
$38,736,000 and $35,912,000 and systems integration revenue of $15,748,000
and $35,374,000 for the three months ended March 31, 2006 and 2005,
respectively.
The following table provides a reconciliation of segment operating cash
flow to earnings before income taxes.
Three months ended
March 31,
----------------------
2006 2005
--------- ----------
amounts in thousands
Segment operating cash flow $ 13,344 19,851
Stock-based compensation (546) (213)
Depreciation and amortization (15,655) (16,761)
Share of earnings of Discovery 21,173 22,814
Other, net 1,950 322
--------- ----------
Earnings before income taxes $ 20,266 26,013
========= ==========
Information as to the Company's operations in different geographic areas
is as follows:
Three months ended
March 31,
---------------------
2006 2005
--------- ---------
amounts in thousands
Revenue
United States $ 116,189 132,499
United Kingdom 32,080 37,283
Other countries 5,299 4,508
--------- ---------
$ 153,568 174,290
========= =========
I-12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Certain statements in this Quarterly Report on Form 10-Q constitute
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995, including statements regarding our business,
marketing strategies, integration of acquired businesses, new service offerings,
and anticipated sources and uses of capital. Where, in any forward-looking
statement, we express an expectation or belief as to future results or events,
such expectation or belief is expressed in good faith and believed to have a
reasonable basis, but such statements necessarily involve risks and
uncertainties, and there can be no assurance that the statement of expectation
or belief will result or be achieved or accomplished. The following include some
but not all of the factors that could cause actual results or events to differ
materially from those anticipated:
- general economic and business conditions and industry trends including
the timing of, and spending on, feature film and television production;
- spending on domestic and foreign television advertising and spending on
domestic and foreign first-run and existing content libraries;
- the regulatory and competitive environment of the industries in which
we, and the entities in which we have interests, operate;
- continued consolidation of the broadband distribution and movie studio
industries;
- fluctuations in foreign currency exchange rates and political unrest in
international markets;
- uncertainties inherent in the development and integration of new
business lines, acquired businesses and business strategies;
- uncertainties associated with product and service development and market
acceptance, including the development and provision of programming for
new television and telecommunications technologies;
- changes in distribution and viewing of television programming, including
the expanded deployment of personal video recorders, video on demand and
IP television and their impact on television advertising revenue;
- rapid technological changes;
- future financial performance, including availability, terms and
deployment of capital;
- the ability of suppliers and vendors to deliver products, equipment,
software and services;
- the outcome of any pending or threatened litigation;
- availability of qualified personnel;
- the possibility of an industry-wide strike or other job action by or
affecting a major entertainment industry union;
- changes in, or failure or inability to comply with, government
regulations, including, without limitation, regulations of the Federal
Communications Commission, and adverse outcomes from regulatory
proceedings;
- changes in the nature of key strategic relationships with partners and
joint venturers;
- competitor responses to our products and services, and the products and
services of the entities in which we have interests; and
- threatened terrorists attacks and ongoing military action in the Middle
East and other parts of the world.
These forward-looking statements and such risks, uncertainties and other
factors speak only as of the date of this Quarterly Report, and we expressly
disclaim any obligation or undertaking to disseminate any updates or revisions
to any forward-looking statement contained herein, to reflect any change in its
expectations with regard thereto, or any other change in events, conditions or
circumstances on which any such statement is based.
The following discussion and analysis provides information concerning our
results of operations and financial condition. This discussion should be read in
conjunction with our accompanying condensed consolidated financial statements
and the notes thereto; and our "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and our consolidated financial
statements included in our Annual Report on Form 10-K for the year ended
December 31, 2005.
I-13
OVERVIEW
We are a holding company and our businesses and assets include Ascent
Media and AccentHealth, which we consolidate, and a 50% ownership interest in
Discovery, which we account for using the equity method of accounting.
Accordingly, as described below, Discovery's revenue is not reflected in the
revenue we report in our financial statements. In addition to the foregoing
assets, immediately prior to the Spin Off, Liberty transferred to a subsidiary
of our company $200 million in cash. The Spin Off was effected on July 21, 2005
as a distribution by Liberty to holders of its Series A and Series B common
stock of shares of our Series A and Series B common stock, respectively. The
Spin Off did not involve the payment of any consideration by the holders of
Liberty common stock and is intended to qualify as a tax-free spin off. The Spin
Off has been accounted for at historical cost due to the pro rata nature of the
distribution.
Following the Spin Off, we and Liberty operate independently, and neither
has any stock ownership, beneficial or otherwise, in the other.
Ascent Media provides creative, media management and network services to
the media and entertainment industries. Ascent Media's clients include major
motion picture studios, independent producers, broadcast networks, cable
programming networks, advertising agencies and other companies that produce, own
and/or distribute entertainment, news, sports, corporate, educational,
industrial and advertising content. Ascent Media's operations are organized into
the following four groups: creative services, media management services, network
services and corporate and other. Ascent Media has few long-term or exclusive
agreements with its creative services and media management services customers.
In 2006, Ascent Media continues to focus on leveraging its broad array of
media services to market itself as a full service provider to new and existing
customers within the feature film and television production industry. With
facilities in the U.S., the United Kingdom and Asia, Ascent Media also hopes to
increase its services to multinational companies. The challenges that Ascent
Media faces include (i) differentiating its products and services to help
maintain or increase operating margins and (ii) financing capital expenditures
for equipment and other items to satisfy customers' desire for services using
the latest technology.
Our most significant asset is Discovery, in which we do not have a
controlling financial interest. Discovery is a global media and entertainment
company that provides original and purchased video programming in the U.S. and
over 160 other countries. Discovery also develops and sells branded commerce and
educational product lines in the United States. We account for our interest in
Discovery using the equity method of accounting. Accordingly, our share of the
results of operations of Discovery is reflected in our consolidated results as
earnings or losses of Discovery. To assist the reader in better understanding
and analyzing our business, we have included a separate discussion and analysis
of Discovery's results of operations and liquidity below.
ACQUISITION
Effective January 27, 2006, one of our subsidiaries acquired
substantially all of the assets of AccentHealth, LLC's healthcare media business
for cash consideration of $46,793,000, subject to potential post-closing
adjustments. AccentHealth operates an advertising-supported captive audience
television network in approximately 11,000 doctor office waiting rooms
nationwide. For financial reporting purposes, the acquisition is deemed to have
occurred on February 1, 2006, and the results of operations of AccentHealth have
been included in our consolidated results since the date of acquisition.
OPERATING CASH FLOW
We evaluate the performance of our operating segments based on financial
measures such as revenue and operating cash flow. We define operating cash flow
as revenue less cost of services and selling, general and administrative expense
(excluding stock and other equity-based compensation). We believe this is an
important indicator of the operational strength and performance of our
businesses, including their ability to invest in ongoing capital expenditures
and service any debt. In addition, this measure allows management to view
operating results and perform analytical comparisons and identify strategies to
improve
I-14
performance. This measure of performance excludes depreciation and amortization
and stock and other equity-based compensation, that are included in the
measurement of operating income pursuant to GAAP. Accordingly, operating cash
flow should be considered in addition to, but not as a substitute for, operating
income, cash flow provided by operating activities and other measures of
financial performance prepared in accordance with GAAP. See note 11 to the
accompanying condensed consolidated financial statements for a reconciliation of
operating cash flow to earnings before income taxes.
RESULTS OF OPERATIONS
Our consolidated results of operations include general and administrative
expenses incurred at the DHC corporate level, 100% of the results of Ascent
Media and AccentHealth and our 50% share of earnings of Discovery.
Ascent Media's creative services group revenue is primarily generated
from fees for video and audio post production, special effects and editorial
services for the television, feature film and advertising industries. Generally,
these services pertain to the completion of feature films, television programs
and advertisements. These projects normally span from a few days to three months
or more in length, and fees for these projects typically range from $10,000 to
$1,000,000 per project. The media management services group provides owners of
film libraries a broad range of restoration, preservation, archiving,
professional mastering and duplication services. The scope of media management
services vary in duration from one day to several months depending on the nature
of the service, and fees typically range from less than $1,000 to $100,000 per
project. Additionally, the media management services group includes Ascent
Media's digital services group, which is developing new products and services
for studios, networks, producers, advertisers and distributors to create,
repurpose and distribute digital media. The network services group's revenue
consists of fees relating to facilities and services necessary to assemble and
transport programming for cable and broadcast networks across the world via
freight, fiber, satellite and the Internet. Additionally, the group earns
revenue by providing systems integration and field support services, technology
consulting services, design and implementation of advanced video systems,
engineering project management, technical help desk and field service.
Approximately 30% of the network services group's revenue relates to systems
integration and engineering services that are provided on a project basis over
terms generally ranging from three to twelve months. Approximately 70% of the
network services group's revenue relates to broadcast services, satellite
operations and fiber services that are earned monthly under long-term contracts
ranging generally from one to seven years. Cost of services and operating
expenses consists primarily of production wages, facility costs and other direct
costs and selling, general and administrative expenses.
Corporate related items and expenses are reflected in Corporate and
Other, below.
Three months ended
March 31,
---------------------
2006 2005
--------- ---------
amounts in thousands
Segment Revenue
Creative services group $ 73,482 74,228
Media management services group 25,602 28,776
Network services group 54,484 71,286
Corporate and other - - - -
--------- ---------
$ 153,568 174,290
========= =========
Segment Operating Cash Flow
Creative services group $ 13,176 13,051
Media management services group 1,255 3,691
Network services group 9,796 15,006
Corporate and other (10,883) (11,897)
--------- ---------
$ 13,344 19,851
========= =========
I-15
Revenue. Total revenue decreased 11.9% for the three months ended March
31, 2006, as compared to the corresponding prior year period. The creative
services group revenue decreased $746,000 or 1% for the three month period. This
decrease is due to a decline in feature film services provided in the U.K.,
lower sound services revenue in the U.S. and unfavorable changes in foreign
currency exchange rates, partially offset by higher commercial and television
revenue in the U.S. The media management services group revenue decreased
$3,174,000 or 11.0% for the three month period. This decrease in revenue was a
result of a decline from traditional media services, lower lab revenue, lower
DVD compression and authoring work in the U.S. and the impact of changes in
foreign currency rates of $638,000, offset by increases in library and
traditional media services in the U.K. The network services group revenue
decreased $16,802,000 or 23.6% for the three months ended March 31, 2006. This
decrease is due to fewer systems integration projects resulting in a drop in
revenue of $19,626,000, distribution contract terminations in the U.K. of
$1,849,000 and changes in foreign currency exchange rates of $977,000. These
decreases were partially offset by higher revenue due to the acquisition of
AccentHealth of $2,890,000, as well as higher staffing and post production
revenue in the U.S. and Singapore of $2,387,000.
Cost of Services. Cost of services decreased 12.0% for the three months
ended March 31, 2006, as compared to the corresponding prior year period. This
decrease is attributed to the revenue declines and the impact of changes in
foreign currency rates of $1,587,000 partially offset by the AccentHealth
acquisition which contributed $1,293,000 in cost of services for the three month
period. As a percent of revenue, cost of services remained consistent at 63.6%
year over year.
Selling, General and Administrative. Ascent Media's selling, general and
administrative expenses ("SG&A") decreased $1,304,000 or 3.1% for the three
months ended March 31, 2006 as compared to the corresponding prior year period.
This decrease is primarily due to lower Ascent Media corporate expenses and the
impact of changes in foreign currency rates of $895,000, partially offset by
higher staffing costs in the networks services group. Although Ascent Media's
SG&A expenses decreased in 2006, they increased as a percent of revenue from
24.3% to 26.7% due to the fixed-cost nature of a large percentage of these
expenses.
Corporate and Other operating cash flow (which includes DHC corporate
general and administrative expenses of $1,586,000 and $1,242,000 for the three
months ended March 31, 2006 and 2005, respectively) improved $1,014,000 in 2005
primarily due to lower Ascent Media corporate expenses.
Depreciation and Amortization. The changes in depreciation and
amortization expense for the three months ended March 31, 2006 are due to a
combination of capital expenditures, acquisitions and assets becoming fully
depreciated.
Stock-Based Compensation. In 2001, Ascent Media granted to certain of its
officers and employees stock options (the "Ascent Media Options") with exercise
prices that were less than the market price of Ascent Media common stock on the
date of grant. The Ascent Media Options became exercisable for Liberty shares in
connection with Liberty's 2003 acquisition of the Ascent Media outstanding
common stock that it did not already own. Prior to January 1, 2006, we amortized
the "in-the-money" value of these options over the 5-year vesting period.
Certain Ascent Media employees also hold options and stock appreciation rights
granted by companies acquired by Ascent Media in the past several years and
exchanged for Liberty options and SARs. Prior to January 1, 2006 we recorded
compensation expense for the SARs based on the underlying stock price and
vesting of such awards.
Effective January 1, 2006, we adopted Statement No. 123R. Statement No.
123R requires that we amortize the grant date fair value of our stock option and
SAR Awards that qualify as equity awards as stock compensation expense over the
vesting period of such Awards. Statement No. 123R also requires that we record
the liability for our liability awards at fair value each reporting period and
that the change in fair value be reflected as stock compensation expense in our
condensed consolidated statement of operations. Prior to adoption of Statement
No. 123R, the amount of expense associated with stock-based compensation was
generally based on the vesting of the related stock options and stock
appreciation rights and the market price of the underlying common stock. The
expense
I-16
reflected in our condensed consolidated financial statements was based on the
market price of the underlying common stock as of the date of the financial
statements.
As of March 31, 2006, the total compensation cost related to unvested
equity awards was $2.3 million. Such amount will be recognized in our
consolidated statements of operations through 2009.
Share of Earnings of Discovery. Our share of earnings of Discovery
decreased $1,641,000 or 7% for the three months ended March 31, 2006. This
decrease is due to lower derivative gains and higher interest expense for
Discovery in 2006, partially offset by higher operating income.
We have provided a more detailed discussion of Discovery's results of
operations below.
Income Taxes. Our effective tax rate was 42.7% and 35.3% for the three
months ended March 31, 2006 and 2005, respectively. Our income tax expense was
higher than the federal income tax rate of 35% in 2006 due to state and foreign
tax expense. In 2005, the effects of state and foreign tax expense were offset
by a reduction in our valuation allowance.
Net Earnings. Our net earnings decreased from $16,825,000 for the three
months ended March 31, 2005 to $11,615,000 for the three months ended March 31,
2006. Such decrease is due to the aforementioned fluctuations in revenue and
expenses.
LIQUIDITY AND CAPITAL RESOURCES
Our primary sources of funds are cash on hand and cash flows from
operating activities. During the three months ended March 31, 2006, our primary
uses of cash were capital expenditures ($13,802,000) and cash paid for
acquisitions ($46,793,000). Of the foregoing 2006 capital expenditures,
$4,806,000 relates to the buildout of Ascent Media's existing facilities for
specific customer contracts. The remainder of Ascent Media's capital
expenditures relates to purchases of new equipment and the upgrade of existing
facilities and equipment. Ascent Media currently expects to spend an additional
$42,000,000 for capital expenditures in 2006. For the foreseeable future, we
expect to have sufficient available cash balances and net cash from operating
activities to meet our working capital needs and capital expenditure
requirements. We intend to seek external equity or debt financing in the event
new investment opportunities, additional capital expenditures or increased
operations require additional funds, but there can be no assurance that we will
be able to obtain equity or debt financing on terms that are acceptable to us.
We do not have access to the cash Discovery generates from its
operations, unless Discovery pays a dividend on its capital stock or otherwise
distributes cash to its stockholders. Historically, Discovery has not paid any
dividends on its capital stock, and we do not have sufficient voting control to
cause Discovery to pay dividends or make other payments or advances to us.
DISCOVERY
We hold a 50% ownership interest in Discovery and account for this
investment using the equity method of accounting. Accordingly, in our financial
statements we record our share of Discovery's net income or loss available to
common shareholders and reflect this activity in one line item in our statement
of operations as "Share of earnings of Discovery." The following financial
information of Discovery for the three months ended March 31, 2006 and 2005 and
related discussion is presented to provide the reader with additional analysis
of the operating results and financial position of Discovery. Because we do not
control the decision-making process or business management practices of
Discovery, we rely on Discovery to provide us with financial information
prepared in accordance with GAAP that we use in the application of the equity
method. The following discussion and analysis of Discovery's operations and
financial position has been prepared based on information that we receive from
Discovery and represents our views and understanding of its operating
performance and financial position based on such information. Discovery is not a
separately traded public company, and we do not have the ability to cause
Discovery's management to prepare its own management's discussion and analysis
for our purposes. Accordingly, we note that the material presented in this
section might be different if Discovery's management had prepared it.
I-17
The following discussion of Discovery's results of operations is
presented on a consolidated basis. In order to provide a better understanding of
Discovery's operations, we have also included a summarized presentation of
revenue and operating cash flow of Discovery's three operating groups: Discovery
networks U.S., or U.S. networks, Discovery networks international, or
international networks, and Discovery commerce, education and other.
The U.S. networks is Discovery's largest division which owns and operates
12 cable and satellite channels and provides distribution and advertising sales
services for BBC America and BBC World News. International networks manages a
portfolio of channels, led by the Discovery Channel and Animal Planet brands,
that are distributed in virtually every pay-television market in the world via
an infrastructure that includes major operational centers in London, Singapore,
New Delhi and Miami. Discovery commerce, education and other includes
Discovery's retail chain store operations and other direct consumer marketing
activities, as well as Discovery education, which was formed to manage
Discovery's distribution of education content.
CONSOLIDATED RESULTS OF DISCOVERY
Three months ended
March 31,
----------------------
2006 2005
---------- ---------
amounts in thousands
Revenue:
Advertising $ 267,028 273,386
Distribution 346,014 281,642
Other 46,559 46,443
---------- ---------
Total revenue 659,601 601,471
---------- ---------
Expenses:
Cost of revenue (240,342) (218,259)
Selling, general and administrative ("SG&A") expense (274,348) (234,758)
---------- ---------
Operating cash flow 144,911 148,454
Expenses arising from long-term incentive plans (5,169) (22,867)
Depreciation and amortization (30,135) (28,821)
---------- ---------
Operating income 109,607 96,766
Other income (expense):
Interest expense, net (49,006) (44,908)
Unrealized gains from derivative instruments, net 6,725 12,253
Minority interests in consolidated subsidiaries 1,878 2,252
Other 1,402 12,895
---------- ---------
Income before income taxes 70,606 79,258
Income tax expense (28,259) (33,629)
---------- ---------
Net income $ 42,347 45,629
========== =========
I-18
BUSINESS SEGMENT RESULTS OF DISCOVERY
Three months ended
March 31,
----------------------
2006 2005
---------- ---------
amounts in thousands
Revenue:
U.S. networks $ 443,434 416,126
International networks 193,216 159,440
Discovery commerce, education and other 22,951 25,905
---------- ---------
Total revenue $ 659,601 601,471
========== =========
Operating Cash Flow:
U.S. networks $ 152,117 147,436
International networks 31,146 23,243
Discovery commerce, education and other (38,352) (22,225)
---------- ---------
Total operating cash flow $ 144,911 148,454
========== =========
---------------------------
Note: Discovery commerce, education and other includes intercompany
eliminations.
Revenue. Discovery's consolidated revenue increased 10% for the three
months ended March 31, 2006, as compared to the corresponding prior year period.
Increased revenue was primarily due to 23% increase in distribution revenue
offset by a 2% decrease in advertising revenue during the same period. Other
revenue was relatively consistent as growth in Discovery's education business
was offset by a decrease in store and licensing revenue within Discovery's
commerce business.
Distribution revenue grew 22% at the U.S. networks and 25% at the
international networks. The increase in distribution revenue at the U.S.
networks is due to an 11% increase in paying subscription units combined with
contractual rate increases at most networks. Free viewing periods related to a
number of U.S. networks, principally networks that are carried on the digital
tier, began expiring in 2004 and Discovery is now recognizing distribution
revenue for those networks. U.S. networks distribution revenue increases were
also helped by reduced launch fee amortization, a contra-revenue item, as a
result of extensions of certain affiliation agreements. Launch amortization at
the U.S. networks declined from $20,193,000 during the three months ended March
31, 2005 to $18,726,000 in 2006 primarily due to these extensions. Increases in
distribution revenue at the international networks were driven principally by
increases in paying subscription units in Europe, Latin America and Asia, as
well as the international joint venture channels combined with contractual rate
increases in certain markets.
The decrease in advertising revenue, which includes revenue from paid
programming, was primarily due to a 6% decrease at the U.S. Networks, offset by
a 16% increase at the international networks. The increase in international
networks advertising revenue was due primarily to higher viewership in Europe
and Latin America combined with an increased subscriber base in most markets
worldwide. Advertising revenue at the U.S. networks decreased 6% due primarily
to lower advertising sell-out rates combined with lower rates at certain
networks. Paid programming, where Discovery sells blocks of time primarily for
infomercials that are aired during the overnight hours on certain networks,
represented 7% of total advertising revenue for each of the three-month periods
ended March 31, 2006 and 2005.
The change in other revenue is the net effect of a 32% increase in
education revenue offset by a 9% or $2,299,000 decrease in commerce revenue. The
decrease in commerce revenue was due to a 6% decrease in store revenue resulting
from a 6% decrease in the number of stores, as Discovery continues to close
nonprofitable stores, combined with a $1,413,000 reduction in domestic licensing
revenue. The 32%, or $1,962,000, increase in education revenue is due to a 70%
increase in streaming service revenue resulting from a 59% increase in the
number of schools paying for the streaming service.
Cost of Revenue. Cost of revenue increased 10% for the three months ended
March 31, 2006, as compared to the corresponding prior year period. As a percent
of revenue, cost of
I-19
revenue was consistent at 36% for both the three months ended March 31, 2006 and
2005. The increase primarily resulted from higher programming expense due to
continued investment across all U.S. networks in original productions and high
profile specials.
SG&A Expenses. SG&A expenses increased 17% for the three months ended
March 31, 2006, as compared to the corresponding prior year period. SG&A
expenses were relatively consistent at the U.S. networks and within the commerce
group, but increased 26% at the international networks and more than doubled
($13,212,000 increase) at the education group. The increase at the international
networks was caused by increases in personnel expense resulting from adding
headcount as the business expands particularly in the U.K. and Europe combined
with an increase in marketing expense associated with branding and awareness
efforts, particularly in Europe, in association with the lifestyles category
initiative. The increase at Discovery education is due to increases in
personnel, overhead and marketing expenses to accommodate the growth of the
business.
Expenses Arising from Long-term Incentive Plans. Expenses arising from
long-term incentive plans are related to Discovery's unit-based, long-term
incentive plan, or LTIP, for its employees who meet certain eligibility
criteria. Units are awarded to eligible employees and generally vest at a rate
of 25% per year. In August 2005, Discovery discontinued one of its LTIPs and
settled all amounts with cash. Discovery established a new LTIP in October 2005
(the "2005 LTIP Plan") for certain eligible employees pursuant to which
participants in Discovery's remaining plan could elect to (1) continue in such
plan or (2) exercise vested units and convert partially vested units to the 2005
LTIP Plan. Substantially all participants in the remaining plan redeemed their
vested units and received partially vested units in the 2005 LTIP Plan. Certain
eligible employees were also granted new units in the 2005 LTIP Plan. The value
of units in the 2005 LTIP Plan is indexed to the value of DHC Series A common
stock, and upon exercise, participants receive a cash payment based on the
change in market price of DHC Series A common stock. Under the old plans, upon
exercise, participants received a cash payment for the increase in value of the
units from the unit value on the date of issuance determined by the year over
year change in Discovery's aggregate equity value, using a consistent
methodology. The appreciation in unit value of LTIP awards outstanding is
recorded as compensation expense over the vesting periods. Compensation expense
aggregated $5,169,000 for the three months ended March 31, 2006 compared to
$22,867,000 for the same period in 2005. The decrease is primarily the result of
the change in unit value determination for the 2005 LTIP Plan units. If the
remaining vested LTIP awards at March 31, 2006 were exercised, the aggregate
cash payments by Discovery would be approximately $9.6 million.
Depreciation and Amortization. The increase in depreciation and
amortization for the three months ended March 31, 2006 is due to an increase in
new assets placed in service during 2005.
OTHER INCOME AND EXPENSE
Interest Expense. The increase in interest expense for the three months
ended March 31, 2006 is primarily due to an increase in interest rates during
2005 and 2006.
Unrealized Gains from Derivative Instruments, net. Unrealized gains from
derivative transactions relate primarily to Discovery's use of derivative
instruments to modify its exposure to interest rate fluctuations on its debt.
These instrument contracts include a combination of swaps, caps, collars and
other structured instruments. As a result of unrealized mark to market
adjustments, Discovery recognized $6,725,000 and $12,253,000 in unrealized gains
on these instruments during the three months ended March 31, 2006 and 2005,
respectively. The foreign exchange hedging instruments used by Discovery are
spot, forward and option contracts. Additionally, Discovery enters into
non-designated forward contracts to hedge non-dollar denominated cash flows and
foreign currency balances.
Minority Interests in Consolidated Subsidiaries. Minority interest
represents increases and decreases in the estimated redemption value of
mandatory redeemable interests in subsidiaries which are initially recorded at
fair value.
Other. Other income in 2005 relates primarily to the gain on sale of one
of Discovery's investments.
I-20
Income Taxes. Discovery's effective tax rate was 40% and 42% for the
three months ended March 31, 2006 and 2005, respectively. Discovery's effective
tax rate differed from the federal income tax rate of 35% primarily due to
foreign and state taxes.
LIQUIDITY AND CAPITAL RESOURCES
Discovery used $24,193,000 and generated $28,317,000 of cash from
operations during the three months ended March 31, 2006 and 2005, respectively.
Discovery's use of cash from operations during the three months ended March 31,
2006 resulted from its operating cash flow offset by interest expense of
$49,006,000 and working capital fluctuations. During the three months ended
March 31, 2005, Discovery's cash provided by operations resulted from operating
cash flow less interest expense of $44,908,000, payments associated with the
company's long-term incentive plan in the amount of $18,171,000 and working
capital changes.
During the three months ended March 31, 2006, Discovery spent $7,344,000
on capital expenditures and paid $68,910,000 for business combinations, net of
the cash acquired. During the three months ended March 31, 2005, Discovery paid
$92,874,000 to acquire mandatorily redeemable securities related to minority
interests in certain subsidiaries and spent $35,459,000 on capital expenditures.
Subsequent to March 31, 2006, Discovery paid $80,000,000 to acquire additional
mandatorily redeemable securities.
In addition to cash provided by operations, Discovery funds its
activities with proceeds borrowed under various debt facilities, including a
term loan, two revolving loan facilities and various senior notes payable.
During the three months ended March 31, 2006 and 2005, net borrowings under debt
facilities were $147,950,000 and $102,000,000, respectively. Total commitments
of these facilities were $3,810,000,000 at March 31, 2006. Debt outstanding on
these facilities aggregated $2,720,500,000 at March 31, 2006, providing excess
debt availability of $1,089,500,000. Discovery's ability to borrow the unused
capacity is dependent on its continuing compliance with its covenants at the
time of, and after giving effect to, a requested borrowing.
All term and revolving loans and senior notes are unsecured. The debt
facilities contain covenants that require Discovery to meet certain financial
ratios and place restrictions on the payment of dividends, sale of assets,
additional borrowings, mergers, and purchases of capital stock, assets and
investments. Discovery has indicated it is in compliance with all debt covenants
at March 31, 2006.
During 2006, including amounts discussed above, Discovery expects to
spend approximately $115,000,000 for capital expenditures and $190,000,000 for
interest expense. Payments to satisfy LTIP obligations are not expected to be
significant in 2006. Discovery believes that its cash flow from operations and
borrowings available under its credit facilities will be sufficient to fund its
working capital requirements.
Discovery has agreements covering leases of satellite transponders,
facilities and equipment. These agreements expire at various dates through 2020.
Discovery is obligated to license programming under agreements with content
suppliers that expire over various dates. Discovery also has other contractual
commitments arising in the ordinary course of business.
In connection with the execution of long-term distribution agreements for
certain of its European cable networks, Discovery is committed to pay a
distributor a percentage increase in the value of these networks, if any, on
June 30, 2006, six months prior to the termination of the contract on December
31, 2006. Discovery adjusts its recorded liability for changes in the value of
these networks each period. However, Discovery is currently unable to predict
the likelihood or the terms and conditions of any renewal of the distribution
agreements. Discovery will record the effect of a renewed distribution agreement
when such terms are in place. The effect of a renewed agreement could result in
a payment for an amount significantly greater than the amount currently accrued.
I-21
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
FOREIGN CURRENCY RISK
We continually monitor our economic exposure to changes in foreign
exchange rates and may enter into foreign exchange agreements where and when
appropriate. Substantially all of our foreign transactions are denominated in
foreign currencies, including the liabilities of our foreign subsidiaries.
Although our foreign transactions are not generally subject to significant
foreign exchange transaction gains or losses, the financial statements of our
foreign subsidiaries are translated into United States dollars as part of our
consolidated financial reporting. As a result, fluctuations in exchange rates
affect our financial position and results of operations.
ITEM 4. CONTROLS AND PROCEDURES
In accordance with Exchange Act Rules 13a-15 and 15d-15, the Company
carried out an evaluation, under the supervision and with the participation of
management, including its chief executive officer, principal accounting officer
and principal financial officer (the "Executives"), of the effectiveness of its
disclosure controls and procedures as of the end of the period covered by this
report. Based on that evaluation, the Executives concluded that the Company's
disclosure controls and procedures were effective as of March 31, 2006 to
provide reasonable assurance that information required to be disclosed in its
reports filed or submitted under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in the Securities and
Exchange Commission's rules and forms.
There has been no change in the Company's internal controls over
financial reporting that occurred during the three months ended March 31, 2006
that has materially affected, or is reasonably likely to materially affect, its
internal controls over financial reporting.
I-22
DISCOVERY HOLDING COMPANY
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
For information regarding institution of, or material changes in,
material legal proceedings that have been reported this fiscal year, reference
is made to Part I, Item 3 of our Annual Report on Form 10-K filed on March 23,
2006.
ITEM 6. EXHIBITS
(a) Exhibits
31.1 Rule 13a-14(a)/15d-14(a) Certification.
31.2 Rule 13a-14(a)/15d-14(a) Certification.
31.3 Rule 13a-14(a)/15d-14(a) Certification.
32 Section 1350 Certification.
II-1
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DISCOVERY HOLDING COMPANY
Date: May 10, 2006 By: /s/ Charles Y. Tanabe
-------------------------------------
Charles Y. Tanabe
Senior Vice President and
General Counsel
Date: May 10, 2006 By: /s/ David J.A. Flowers
-------------------------------------
David J.A. Flowers
Senior Vice President
and Treasurer
(Principal Financial
Officer)
Date: May 10, 2006 By: /s/ Christopher W. Shean
-------------------------------------
Christopher W. Shean
Senior Vice President
and Controller
(Principal Accounting
Officer)
II-2
EXHIBIT INDEX
Listed below are the exhibits which are filed as a part of this Report
(according to the number assigned to them in Item 601 of Regulation S-K):
31.1 Rule 13a-14(a)/15d-14(a) Certification.
31.2 Rule 13a-14(a)/15d-14(a) Certification.
31.3 Rule 13a-14(a)/15d-14(a) Certification.
32 Section 1350 Certification.