UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form10-Q
 
 
   
þ
 QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
  For the quarterly period ended September 30, 2007March 31, 2008
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 Number000-51205
 
DISCOVERY HOLDING COMPANY
(Exact name of Registrant as specified in its charter)
 
   
State of Delaware
 20-2471174
(State or other jurisdiction of
incorporation or organization)		 (I.R.S. Employer
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 þ     No o
 
Indicate by check mark whether the Registrantregistrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, as definedor a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in RuleRule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer þ
Large accelerated filer þ
Accelerated filer o     Non-accelerated filer oNon-accelerated filer o
(Do not check if a smaller reporting company)		Smaller reporting company o
 
Indicate by check mark whether the Registrant is a shell company (as defined inRule 12b-2 of the Exchange Act).  Yes o     No þ
 
The number of outstanding shares of Discovery Holding Company’s common stock as of October 31, 2007April 30, 2008 was:
 
Series A common stock 269,159,338268,091,082 shares; and

Series B common stock 11,869,69613,138,236 shares.
 

TABLE OF CONTENTS

Condensed Consolidated Balance Sheets (unaudited)
Condensed Consolidated Statements of Operations and Comprehensive Earnings (Loss) (unaudited)
Condensed Consolidated Statements of Cash Flows (unaudited)
Condensed Consolidated Statement of Stockholders’ Equity Nine months ended September 30, 2007 (unaudited)
Notes to Condensed Consolidated Financial Statements
Item 2. Management’s2.Management’s Discussion and Analysis of Financial Condition and Results Of Operations
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Item 4. Controls and Procedures
PART II —-- OTHER INFORMATION
Item 1. Legal Proceedings
Item 6. Exhibits
2005 Incentive Plan, As Amended and RestatedCertification of John C. Malone
2005 Non-Employee Director Incentive Plan, as Amended and RestatedCertification of David J.A. Flowers
Transitional Stock Adjustment Plan, as Amended and RestatedCertification of Christopher W. Shean
Rule 13a-14(a)/15d-14(a) Certification
Rule 13a-14(a)/15d-14(a) Certification
Rule 13a-14(a)/15d-14(a) Certification
pursuant to Section 1350 Certification906

 
DISCOVERY HOLDING COMPANY AND SUBSIDIARIES
 
Condensed Consolidated Balance Sheets
(unaudited)
 
                
 September 30,
 December 31,
  March 31,
 December 31,
 
 2007 2006  2008 2007 
 amounts in thousands  amounts in thousands 
ASSETS
ASSETS
ASSETS
Current assets:                
Cash and cash equivalents $157,461   154,775  $222,577   209,449 
Trade receivables, net  152,413   147,436   172,624   144,342 
Prepaid expenses  15,424   11,522   15,324   14,815 
Other current assets  11,077   3,629   3,752   3,101 
          
Total current assets  336,375   317,362   414,277   371,707 
Investments in marketable securities  51,878   51,837   —   23,545 
Investment in Discovery Communications Holding, LLC (“Discovery”) (note 7)  3,294,999   3,129,157 
Investment in Discovery Communications Holding, LLC (“Discovery”) (note 6)  3,330,030   3,271,553 
Property and equipment, net  278,503   280,775   262,744   269,742 
Goodwill (note 6)  2,075,671   2,074,789 
Goodwill (note 5)  1,909,823   1,909,823 
Other assets, net  15,710   17,062   18,964   19,382 
          
Total assets $6,053,136   5,870,982  $5,935,838   5,865,752 
          
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:                
Accounts payable $32,984   43,656  $48,555   26,298 
Accrued payroll and related liabilities  25,985   32,292   22,839   26,127 
Other accrued liabilities  32,468   29,924   42,536   42,761 
Deferred revenue  21,792   16,015   23,472   24,951 
          
Total current liabilities  113,229   121,887   137,402   120,137 
Deferred income tax liabilities  1,240,090   1,174,594   1,252,033   1,228,942 
Other liabilities  29,808   25,237   21,830   22,352 
          
Total liabilities  1,383,127   1,321,718   1,411,265   1,371,431 
          
Commitments and contingencies (note 9)        
Commitments and contingencies (note 8)         
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 268,868,635 shares at September 30, 2007 and 268,194,966 shares at December 31, 2006  2,689   2,682 
Series B common stock, $.01 par value. Authorized 50,000,000 shares; issued and outstanding 11,869,696 shares at September 30, 2007 and 12,025,088 shares at December 31, 2006  119   120 
Series A common stock, $.01 par value. Authorized 600,000,000 shares; issued and outstanding 269,180,104 shares at March 31, 2008 and 269,159,928 shares at December 31, 2007  2,692   2,691 
Series B common stock, $.01 par value. Authorized 50,000,000 shares; issued and outstanding 11,869,696 shares at March 31, 2008 and December 31, 2007  119   119 
Series C common stock, $.01 par value. Authorized 600,000,000 shares; no shares issued  —   —   —   — 
Additional paid-in capital  5,727,019   5,714,379   5,728,701   5,728,213 
Accumulated deficit  (1,082,903)  (1,183,831)  (1,219,492)  (1,253,483)
Accumulated other comprehensive earnings  23,085   15,914   12,553   16,781 
          
Total stockholders’ equity  4,670,009   4,549,264   4,524,573   4,494,321 
          
Total liabilities and stockholders’ equity $6,053,136   5,870,982  $5,935,838   5,865,752 
          
 
See accompanying notes to condensed consolidated financial statements.


I-1

DISCOVERY HOLDING COMPANY AND SUBSIDIARIES
 
Condensed Consolidated Statements of Operations and Comprehensive Earnings (Loss)
(unaudited)
 
                        
 Three Months Ended
 Nine Months Ended
  Three Months Ended
 
 September 30, September 30,  March 31, 
 2007 2006 2007 2006  2008 2007 
 amounts in thousands, except per share amounts  amounts in thousands, except per share amounts 
Net revenue $177,913   169,876   529,015   489,233  $189,305   173,882 
              
Operating expenses:                        
Cost of services  122,539   111,503   362,174   318,725   138,060   121,542 
Selling, general, and administrative, including stock-based compensation (notes 2 and 10)  39,644   42,772   122,497   131,894 
Selling, general, and administrative, including stock-based
compensation (notes 3 and 9)		  41,155   38,004 
Restructuring and other charges  192   3,633   192   3,963   1,257   — 
Gain on sale of operating assets  (85)  (120)  (327)  (287)  (78)  (34)
Depreciation and amortization  17,176   16,036   50,162   47,995   16,540   15,571 
Impairment of goodwill (note 6)  —   93,402   —   93,402 
              
  179,466   267,226   534,698   595,692   196,934   175,083 
              
Operating loss  (1,553)  (97,350)  (5,683)  (106,459)  (7,629)  (1,201)
Other income:                        
Share of earnings of Discovery (note 7)  10,493   32,051   157,847   83,569 
Share of earnings of Discovery (note 6)  66,402   21,557 
Other income, net  2,653   2,581   14,268   7,054   1,684   9,297 
              
  13,146   34,632   172,115   90,623   68,086   30,854 
              
Earnings (loss) before income taxes  11,593   (62,718)  166,432   (15,836)
Earnings before income taxes  60,457   29,653 
Income tax expense  (4,086)  (13,915)  (64,244)  (35,448)  (26,466)  (9,189)
              
Net earnings (loss)  7,507   (76,633)  102,188   (51,284)
Net earnings  33,991   20,464 
              
Other comprehensive earnings, net of taxes:                
Other comprehensive earnings (loss), net of taxes:        
Foreign currency translation adjustments  4,826   4,873   9,529   13,961   4,009   1,354 
Unrealized holding gains (losses) arising during the period  (4,514)  160   (2,358)  844   (8,237)  456 
              
Other comprehensive earnings  312   5,033   7,171   14,805 
Other comprehensive earnings (loss)  (4,228)  1,810 
              
Comprehensive earnings (loss) $7,819   (71,600)  109,359   (36,479)
Comprehensive earnings $29,763   22,274 
              
Basic and diluted earnings (loss) per common share (note 3) $.03   (.27)  .36   (.18)
Basic and diluted earnings per common share — Series A and Series B (note 4) $.12   .07 
              
 
See accompanying notes to condensed consolidated financial statements.


I-2

DISCOVERY HOLDING COMPANY AND SUBSIDIARIES
 
Condensed Consolidated Statements of Cash Flows
(unaudited)
 
                
 Nine Months Ended
  Three Months Ended
 
 September 30,  March 31, 
 2007 2006  2008 2007 
 amounts in thousands (note 4)  amounts in thousands 
Cash flows from operating activities:                
Net earnings (loss) $102,188   (51,284)
Adjustments to reconcile net earnings (loss) to net cash provided by operating activities:        
Net earnings $33,991   20,464 
Adjustments to reconcile net earnings to net cash provided by (used in) operating activities:        
Depreciation and amortization  50,162   47,995   16,540   15,571 
Stock-based compensation  1,652   1,200   (116)  966 
Impairment of goodwill  —   93,402 
Share of earnings of Discovery  (157,847)  (83,569)  (66,402)  (21,557)
Gain on lease buyout  (6,992)  —   —   (6,992)
Deferred income tax expense  62,768   33,649   25,754   8,508 
Other non-cash charges (credits), net  (1,008)  135 
Other non-cash credits, net  (502)  (487)
Changes in assets and liabilities, net of acquisitions:                
Trade receivables  (4,492)  (21,875)  (28,048)  (1,082)
Prepaid expenses and other current assets  (3,964)  (3,730)  (1,157)  (1,197)
Payables and other liabilities  (9,960)  33,213   17,769   (11,629)
          
Net cash provided by operating activities  32,507   49,136 
Net cash provided by (used in) operating activities  (2,171)  2,565 
          
Cash flows from investing activities:                
Capital expenditures  (36,310)  (51,220)  (8,552)  (13,407)
Proceeds from lease buyout  7,138   — 
Net purchases of marketable securities  (41)  (51,052)
Cash paid for acquisitions, net of cash acquired  —   (46,793)
Cash proceeds from lease buyout  —   7,138 
Net sales (purchases) of marketable securities  23,545   (665)
Other investing activities, net  (4,765)  1,431   145   90 
          
Net cash used in investing activities  (33,978)  (147,634)
Net cash provided by (used in) investing activities  15,138   (6,844)
          
Cash flows from financing activities:                
Net cash from option exercises  4,626   —   329   — 
Other financing activities, net  (469)  (6)  (168)  (19)
          
Net cash provided (used) by financing activities  4,157   (6)  161   (19)
          
Net increase (decrease) in cash and cash equivalents  2,686   (98,504)  13,128   (4,298)
Cash and cash equivalents at beginning of period  154,775   250,352   209,449   154,775 
          
Cash and cash equivalents at end of period $157,461   151,848  $222,577   150,477 
          
 
See accompanying notes to condensed consolidated financial statements.


I-3

DISCOVERY HOLDING COMPANY AND SUBSIDIARIES


Condensed Consolidated Statement of Stockholders’ Equity
Nine
Three months ended September 30, 2007
March 31, 2008
(unaudited)
 
                                 
                    Accumulated
    
              Additional
     Other
  Total
 
  Preferred
  Common Stock  Paid-in
  Accumulated
  Comprehensive
  Stockholders’
 
  Stock  Series A  Series B  Series C  Capital  Deficit  Earnings  Equity 
  amounts in thousands 
 
Balance at January 1, 2007 $—   2,682   120   —   5,714,379   (1,183,831)  15,914   4,549,264 
Net earnings  —   —   —   —   —   102,188   —   102,188 
Other comprehensive earnings  —   —   —   —   —   —   7,171   7,171 
Stock compensation  —   —   —   —   634   —   —   634 
Cumulative effect of accounting change (note 8)  —   —   —   —   —   (1,260)  —   (1,260)
Conversion of Series B to Series A  —   1   (1)  —   —   —   —   — 
Stock option exercises  —   6   —   —   12,006   —   —   12,012 
                                 
Balance at September 30, 2007 $—   2,689   119   —   5,727,019   (1,082,903)  23,085   4,670,009 
                                 
                                 
                    Accumulated
    
              Additional
     Other
  Total
 
  Preferred
  Common stock  Paid-in
  Accumulated
  Comprehensive
  Stockholders’
 
  Stock  Series A  Series B  Series C  Capital  Deficit  Earnings  Equity 
  amounts in thousands 
 
Balance at January 1, 2008 $—   2,691   119   —   5,728,213   (1,253,483)  16,781   4,494,321 
Net earnings  —   —   —   —   —   33,991   —   33,991 
Other comprehensive loss  —   —   —   —   —   —   (4,228)  (4,228)
Stock compensation  —   —   —   —   160   —   —   160 
Stock option exercises  —   1   —   —   328   —   —   329 
                                 
Balance at March 31, 2008 $—   2,692   119   —   5,728,701   (1,219,492)  12,553   4,524,573 
                                 
 
See accompanying notes to condensed consolidated financial statements.


I-4

DISCOVERY HOLDING COMPANY AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements
March 31, 2008
(unaudited)
September 30, 2007
(unaudited)
 
(1)  Basis of Presentation
 
The accompanying condensed consolidated financial statements include the accounts of Discovery Holding Company and its consolidated subsidiaries (“DHC” or the “Company”). DHC’s two wholly-owned operating subsidiaries are Ascent Media Group, LLC (“Ascent Media”) and AccentHealth,Ascent Media CANS, LLC (dba AccentHealth) (“AccentHealth”). DHC also has a 662/3% ownership interest in Discovery, previously a 50% interest through May 14, 2007, which it accounts for as an equity method investment (see note 7)6). All significant intercompany accounts and transactions have been eliminated in consolidation.
 
Ascent Media is comprised of two operating segments. 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 orand creates new three dimensional images, animation sequences, or sound effects. In addition, the creative services group provides a full complement of facilities and services necessary to optimize, archive, manage, and repurpose completed media assets for global distribution via freight, satellite, fiber and the Internet. The network 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 viewersprogramming providers in North America, Europe and Asia. Additionally, the network services group provides systems integration, design, consulting, engineering and project management services.
 
Substantially all of the assets of AccentHealth were acquired by a subsidiary of DHC in January 2006, and are included as part of the network services group for financial reporting purposes. AccentHealth operates an advertising-supported captive audience television network in doctor office waiting rooms nationwide.nationwide, and is included as part of the network services group for financial reporting purposes.
 
Discovery is a leading global media and entertainment company that provides original and purchased cable and satellite television programming across multiple platforms in the United States and overmore than 170 other countries.countries, including television networks offering customized programming in 35 languages. Discovery also develops and sells branded commerceconsumer and educational product linesproducts and services in the United States.States and internationally, and owns and operates a diversified portfolio of website properties and other digital services.
 
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 onForm 10-K, as amended, for the year ended December 31, 2006.2007.
 
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 condensed 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.
(2)  Stock Options and Other Long-Term Incentive Compensation
Stock Options
On July 21, 2005, Liberty Media Corporation (“Liberty”) completed the spin off of the capital stock of DHC (the “Spin Off”). 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. 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.


I-5

 
DISCOVERY HOLDING COMPANY AND SUBSIDIARIES
 
Notes to Condensed Consolidated Financial Statements — (Continued)
 
(2)  Newhouse Transaction and Ascent Spin Off
In December 2007, DHC announced that it had signed a non-binding letter of intent with Advance/Newhouse Programming Partnership (“Advance/Newhouse”) to combine their respective stakes in Discovery. As currently contemplated by the non-binding letter of intent, the transaction, if completed, would involve the following steps:
• DHC will spin-off to its shareholders a wholly-owned subsidiary holding substantially all of DHC’s cash, AccentHealth and Ascent Media, except for those businesses of Ascent Media that provide sound, music, mixing, sound effects and other related services (the “Ascent Media Spin Off”);
• Immediately following the Ascent Media Spin Off, DHC will combine with a new holding company(“New DHC”), and DHC’s existing shareholders will receive shares of common stock of New DHC;
• As part of this transaction, Advance/Newhouse will contribute its interests in Discovery and Animal Planet to New DHC in exchange for preferred stock of New DHC that, immediately after the closing of the transactions, will be convertible at any time into shares initially representing one-third of the outstanding shares of common stock of New DHC on an as-converted basis. The preferred stock held by Advance/Newhouse will entitle it to elect three members to New DHC’s board of directors and to exercise approval rights with respect to the taking of specified actions by New DHC and Discovery.
Although no assurance can be given, consummation of this transaction is expected in the third quarter of 2008. The Ascent Media Spin Off did not involvewas approved in connection with the paymentproposed transaction between DHC and Advance/Newhouse, and it is a condition of any consideration by the holders of Liberty common stockAscent Media Spin Off that the agreement between DHC and was intendedAdvance/Newhouse be in effect and that all conditions precedent to qualifythat transaction (other than the Ascent Media Spin Off) shall have been satisfied.
It is currently expected that the Ascent Media Spin Off will be effected for federal income tax purposes as a tax-free transaction.
As a resultdistribution to DHC’s shareholders and be accounted for at historical cost due to the pro rata nature of the distribution. Subsequent to the completion of the Ascent Media Spin Off, and related adjustments to Liberty’s stock incentive awards, options (“Spin Off DHC Awards”) to acquire an aggregatethe historical results 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, employeesoperations of Ascent Media who held stock options or stock appreciation rights (“SARs”) to acquire shares of Liberty common stock prior to the Ascent Media Spin Off continuewill be included in discontinued operations in DHC’s consolidated financial statements. The acquisition of Advance/Newhouse’s interests in Discovery and Animal Planet will result in New DHC owning 100% of Discovery, and accordingly, New DHC will consolidate Discovery’s financial position and results of operations effective with the closing of the transaction. Pursuant to hold such options.FASB TechnicalBulletin 85-5, the contribution of interests to New DHC is responsible for all stock options related to DHC common stock,will be treated as a non-substantive merger, and Liberty is responsible for all incentive awards related to Liberty common stock. therefore, interests will be recorded at carry over basis.
(3)  Stock Options and Other Long-Term Incentive Compensation
Stock Options
The Company records stock-based compensation for all stock incentive awards held by DHC’s and its subsidiaries’ employees.
The Company accounts formajority of these stock optionincentive awards pursuantwere issued on or prior to Statement of Financial Accounting Standards No. 123 (revised 2004),“Share-Based Payment”DHC’s spin off from Liberty Media Corporation (“Statement 123R”Liberty”) on July 21, 2005 (the “2005 Spin Off”). Statement 123R generally requires companiesStock option grants have also been issued 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).
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 used 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.
On May 4, 2006, each of the non-employee directors of DHC was granted 10,000 optionsand to purchase DHC Series A common stock with an exercise price of $14.48 per share. Such options vested one year from the date of grant, terminate 10 years from the date of grant and had a grant-date fair value of $4.47 per share, as determined using the Black-Scholes Model.
On May 16, 2007, each of the non-employee directors of DHC was granted 10,000 options to purchase DHC Series A common stock with an exercise price of $22.90 per share. Such options vest on the date of the 2008 DHC annual stockholder meeting. Also on May 16, 2007, the president of DHC subsequent to that date. For the three months ended March 31, 2008 and 2007, stock-based compensation related to these awards was granted 10,000 options$160,000 and $137,000, respectively.


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DISCOVERY HOLDING COMPANY AND SUBSIDIARIES
Notes to purchase DHC Series A common stock with an exercise price of $22.90 per share. Such options vest one year from the date of grant. All 40,000 options granted on May 16, 2007 terminate 10 years from the date of grant and had a grant-date fair value of $7.74 per share, as determined using the Black-Scholes Model.Condensed Consolidated Financial Statements — (Continued)
 
As of September 30, 2007,March 31, 2008, the following DHC options were outstanding and vested:
 
                                
   Weighted
   Weighted
    Weighted
   Weighted
   Average
   Average
    Average
   Average
 DHC
 Exercise
 DHC
 Exercise
  DHC
 Exercise
 DHC
 Exercise
 Series A Price Series B Price  Series A Price Series B Price
Outstanding  1,215,000  $15.33   2,997,000  $18.87   1,132,036  $15.31   2,996,525  $18.87 
                  
Exercisable  971,000  $15.49   2,937,000  $18.93   908,002  $15.45   2,936,525  $18.93 
                  
 
As of September 30, 2007,March 31, 2008, the total compensation cost related to unvested equity awards was $772,000.$379,000. Such amount will be recognized in the Company’s consolidated statements of operations over a weighted average period of approximately 1.1 years.
 
2006 Ascent Media Long-Term Incentive Plan
 
Effective August 3, 2006, Ascent Media adopted its 2006 Long-Term Incentive Plan (the “2006 Plan”). The 2006 Plan provides the terms and conditions for the grant of, and payment with respect to, Phantom Appreciation Rights (“PARs”) granted to certain officers and other key personnel of Ascent Media. The value of a single PAR


I-6

DISCOVERY HOLDING COMPANY AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements — (Continued)
(“PAR Value”) is calculated asequal to the positive amount (if any) of (a) the sum of (i) 6% of cumulative free cash flow (as defined in the 2006 Plan) over a period of up to six years, divided by 500,000500,000; plus (ii) 5% of the increase in the calculated value of Ascent Media, based on a formula set forth in the 2006 Plan, divided by 10,000,000; over (b) a baseline value determined at the time of grant, divided by 10,000,000.grant. The 2006 Plan is administered by a committee that consists of two individuals appointed by DHC. Grants are determined by the committee, with the first grant occurring on August 3, 2006. The maximum number of PARs that may be granted under the 2006 Plan is 500,000, and there were 438,500483,500 PARs granted as of September 30, 2007.March 31, 2008. The PARs vest quarterly over a three year period, and are payable on March 31, 2012 (or, if earlier, on the six-month anniversary of a grantee’s termination of employment without cause). Ascent Media records a liability and a charge to expense based on the PAR Value and percent vested at each reporting period. Ascent Media recorded 2006 Plan expense of $112,000 and $1,031,000 for the three and nine months ended September 30, 2007, respectively.
 
(3)(4)  Earnings (Loss) Per Common Share — Series A and Series B
 
Basic earnings (loss) per common share (“EPS”) is computed by dividing net earnings (loss) by the weighted average number of common shares outstanding for the period. The weighted average number of shares outstanding for the three and nine months ended September 30,March 31, 2008 and 2007 is 280,474,000281,044,000 and 280,350,000,280,222,000, respectively. The weighted average number of shares outstanding for each of the three and nine months ended September 30, 2006 is 279,949,000. 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 20072008 and 2006,2007, their inclusion does not impact the EPS amount as reported in the accompanying condensed consolidated statements of operations.
 
(4)  Supplemental Disclosure of Cash Flow Information
     
  Nine Months
 
  Ended
 
  September 30, 2006 
  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 
     
(5)  AcquisitionGoodwill
 
Effective January 27, 2006, one of DHC’s subsidiaries acquired substantially allGoodwill is comprised of the assets of AccentHealth’s healthcare media business for cash consideration of $46,793,000. AccentHealth operates an advertising-supported captive audience television network in doctor office waiting rooms nationwide. The Company recorded goodwill of $32,224,000 and other intangible assets of $9,800,000 in connection with this acquisition. Other intangible assets are included in Other assets, net in the accompanying condensed consolidated balance sheets. 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 network services group.following:
         
  March 31,
  December 31,
 
  2008  2007 
  amounts in thousands 
 
Goodwill        
Creative Services group $106,599   106,599 
Network Services group  32,224   32,224 
Discovery  1,771,000   1,771,000 
         
Total goodwill $1,909,823   1,909,823 
         
 
For financialGAAP requires companies to allocate enterprise-level goodwill to all reporting purposes,units, including equity method investments. Accordingly, the acquisition is deemedCompany has allocated $1,771,000,000 of enterprise-level goodwill to have occurred on February 1, 2006. The results of operations of AccentHealth have been included in the consolidated results of DHC as part of the network services group since the date of acquisition. On a pro forma basis, the results of operations of AccentHealth are not significant to those of DHC for the nine months ended September 30, 2006.its investment


I-7

 
DISCOVERY HOLDING COMPANY AND SUBSIDIARIES
 
Notes to Condensed Consolidated Financial Statements — (Continued)
 
(6)  Goodwill
Goodwill is comprised of the following:
         
  September 30,
  December 31,
 
  2007  2006 
  amounts in thousands 
 
Goodwill        
Creative Services group $106,599   106,599 
Network Services group  198,072   197,190 
Discovery  1,771,000   1,771,000 
         
Total goodwill $2,075,671   2,074,789 
         
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 that all or a portion of an equity method investment is disposed of in the future, the allocated portion of goodwill will be relieved and included in the calculation of the gain or loss on disposal.
 
On August 18, 2006, Ascent Media announced that it intended to streamline its structure into two global operating divisions — creative services group and network services group — to better align Ascent Media’s organization with the company’s strategic goals and to respond to changes within the industry driven by technology and customer requirements. The operations of the media management services group were realigned with the other two groups, and such realignment was completed in the fourth quarter of 2006.
As technology and customer requirements drove changes in this industry, revenue and operating cash flows had been declining for the media management services group. As a result of the restructuring, and the declining financial performance of this group, including ongoing operating losses, the media management services group was tested for goodwill impairment in the third quarter of 2006, prior to DHC’s annual goodwill valuation assessment of the entire company. DHC estimated the fair value of that reporting unit principally by using trading multiples of revenue and operating cash flows of similar companies in the industry. In September 2006, Ascent Media recognizedthe Financial Accounting Standards Board issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a goodwill impairment lossframework for measuring fair value under GAAP, and expands disclosures about fair value measurements. SFAS 157 was effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2007. However, the effective date of SFAS 157 has been deferred to fiscal years beginning after November 15, 2008 and interim periods within those years, and DHC has elected the deferral provision, as it relates to fair value measurement requirements for (i) nonfinancial assets and liabilities that are not remeasured at fair value on a recurring basis (e.g. asset retirement obligations, restructuring liabilities and assets and liabilities acquired in business combinations) and (ii) fair value measurements required for impairments under SFAS No. 142, “Goodwill and Other Intangible Assets” and SFAS No. 144, “Accounting for the media management services groupImpairment or Disposal of $93,402,000, which represents the excess of the carrying value over the implied fair value of such goodwill.Long-Lived Assets.”
 
(7)(6)  Investment in Discovery
 
Discovery was formed in the second quarter of 2007 as part of a restructuring (the “DCI Restructuring”) completed by Discovery Communications, Inc. (“DCI”). In the DCI Restructuring, DCI became a wholly-owned subsidiary of Discovery, and the former shareholders of DCI, including DHC, became members of Discovery. Discovery is the successor reporting entity to DCI. In connection with the DCI Restructuring, Discovery applied “pushdown” accounting and each shareholder’s basis in DCI as of May 14, 2007 has been pushed down to Discovery. The result was $4.4$4.3 billion in goodwill being recorded by Discovery. Since goodwill is not amortizable, there is no current income statement impact for this change in basis.
 
Discovery is a leading global media and entertainment company that provides original and purchased video programming across multiple platforms in the United States and in overmore than 170 other countries.countries, including television networks offering customized programming in 35 languages. Discovery also develops and sells branded commerceconsumer and educational product linesproducts and services in the United States.States and internationally, and owns and operates a diversified portfolio of website properties and other digital services.
 
On May 14, 2007, Discovery and Cox Communications Holding,Holdings, Inc. (“Cox”) completed an exchange of Cox’s 25% ownership interest in Discovery for all of the capital stock of a subsidiary of Discovery that held Travel Channel, travelchannel.com and approximately $1.3 billion in cash.cash (the “Cox Transaction”). Discovery raised the cash component through additional debt financing, and retired the membership interest previously owned by Cox. Upon completion of this


I-8

DISCOVERY HOLDING COMPANY AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements — (Continued)
transaction, DHC owns a 662/3% interest in Discovery and Advance/Newhouse Communications owns a 331/3% interest.interest in Discovery.
In connection with the Cox Transaction, DHC reallocated its excess basis related to its investment in Discovery. Such allocation process was completed in the first quarter of 2008 and resulted in approximately 48% of the excess basis created by the Cox Transaction being allocated to intangible assets with determinable useful lives. Amortization of such intangible assets aggregated $3,744,000 (net of related taxes) for the three months ended March 31, 2008 and is included in DHC’s share of earnings of Discovery.
 
DHC continues to account for its investment in Discovery using the equity method of accounting due to governance rights possessed by Advance/Newhouse Communications which restrict DHC’s ability to control Discovery. From January 1, 20062007 through May 14, 2007, DHC recorded its 50% share of the earnings of DCI. Subsequent to May 14, 2007, DHC has recorded its 662/3% share of the earnings of Discovery.
 
DHC does not have access to the cash Discovery generates from its operations, unless Discovery makes a distribution with respect to its membership interests or makes other payments or advances to its members. Prior to


I-8

DISCOVERY HOLDING COMPANY AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements — (Continued)
May 14, 2007, DCI did not pay any dividends on its capital stock, and since that date, Discovery has not made any distributions to its members, and DHC does not have sufficient voting control to cause Discovery to make distributions or make other payments or advances to DHC.
DHC’s carrying value for Discovery was $3,294,999,000$3,330,030,000 at September 30, 2007.March 31, 2008. In addition, as described in note 6,5, enterprise-level goodwill of $1,771,000,000 has been allocated to the investment in Discovery.
 
Summarized financial information for Discovery is as follows:
 
Consolidated Balance Sheets
 
        
         March 31,
 December 31,
 
 September 30,
 December 31,
  2008 2007 
 2007 2006  amounts in thousands 
 amounts in thousands 
Cash and cash equivalents $55,310    52,263  $68,654   44,951 
Other current assets  982,431    918,373   1,021,658   1,032,282 
Property and equipment, net  383,989    424,041   379,125   397,430 
Goodwill and intangible assets  4,807,931    472,939   5,041,554   5,051,843 
Programming rights, long term  1,143,477    1,253,553   1,045,593   1,048,193 
Other assets  354,198    255,384   364,753   385,731 
            
Total assets $7,727,336    3,376,553  $7,921,337   7,960,430 
            
Current liabilities $740,068    734,524  $681,805   850,495 
Long term debt  3,978,252    2,633,237   4,088,607   4,109,085 
Other liabilities  220,756    175,255   300,610   243,867 
Mandatorily redeemable equity in subsidiaries  48,010    94,825   48,721   48,721 
Members’ equity (deficit)  2,740,250    (261,288)
Members’ equity  2,801,594   2,708,262 
            
Total liabilities and members’ equity (deficit) $7,727,336    3,376,553 
Total liabilities and members’ equity $7,921,337   7,960,430 
            


I-9

 
DISCOVERY HOLDING COMPANY AND SUBSIDIARIES
 
Notes to Condensed Consolidated Financial Statements — (Continued)
 
Consolidated Statements of Operations
 
                
 Nine Months Ended
  Three Months Ended
 
 September 30,  March 31, 
 2007 2006  2008 2007 
 amounts in thousands  amounts in thousands 
Revenue $2,241,238   2,061,036  $794,578   710,198 
Cost of revenue  (735,159)  (706,008)  (230,435)  (243,523)
Selling, general and administrative ��(819,997)  (793,525)  (278,211)  (276,247)
Restructuring and other charges  (15,798)  —   —   (10,999)
Equity-based compensation  (129,226)  (10,561)  35,857   (11,721)
Depreciation and amortization  (95,891)  (87,036)  (37,720)  (32,433)
Asset impairment  (26,174)  — 
Gain on sale of operating assets  134,671   — 
          
Operating income  553,664   463,906   284,069   135,275 
Interest expense, net  (179,135)  (149,828)  (68,720)  (44,558)
Other income, net  6,031   21,261 
Other income (expense), net  (22,590)  2,407 
Income tax expense  (73,938)  (143,727)  (87,541)  (41,710)
          
Earnings from continuing operations  306,622   191,612   105,218   51,414 
Loss from discontinued operations, net of income taxes  (60,532)  (24,473)
Loss from discontinued operations, net of income tax  —   (8,300)
          
Net earnings $246,090   167,139  $105,218   43,114 
          
DHC’s share of Discovery’s net earnings $157,847   83,569 
     
 
Note: In the third quarter of 2007, Discovery completed the closure ofclosed its 103 mall-based and stand-alone Discovery Channel stores. As a result, Consolidated StatementsDiscovery’s consolidated statement of Operations above haveoperations for the three months ended March 31, 2007 has been prepared to reflect the retail store business as discontinued operations.
 
(8)(7)  Income Taxes
 
Effective January 1, 2007,During the Company adoptedfirst quarter of 2008, Liberty reached an agreement with the IRS related to certain disputed tax items that arose in periods prior to DHC’s spin off from Liberty on July 21, 2005. The agreement resulted in a reduction to the initial amount of federal and California net operating losses by $28,554,000 and $49,667,000, respectively, that Liberty had allocated to DHC at the spin off date. In addition, during the first quarter of 2008, DHC reduced its reserve against the net operating losses allocated from Liberty from $11,877,000 to $2,662,000 under FASB Interpretation No. 48, “Accounting“Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”)109”. FIN 48 clarifiesHowever, since DHC had previously recorded a full valuation allowance against these net operating losses, the accounting for uncertaintyreversal of the net operating losses, the decrease in income taxes recognized in a company’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. In instances wherereserve on the Company has taken or expects to take a tax position in its tax returnnet operating losses, and the Company believes it is more likely than not that such tax position will be upheld byreversal of the relevant taxing authority, the Company may record the benefits of such tax positioncorresponding valuation allowance resulted in itsno net impact to DHC’s condensed consolidated financial statements. Upon adoption of FIN 48 on January 1, 2007, the Company’s wholly-owned subsidiary, Ascent Media, reversed $255,000 of tax liabilities included in the Company’s December 31, 2006 consolidated balance sheet with a corresponding decrease to accumulated deficit. Discovery recorded a $5,011,000 net tax liability upon adoption of FIN 48, and the Company recorded its 50% share, or $2,506,000, directly to accumulated deficit, net of a $991,000 deferred tax impact.
 
As of January 1, 2007,2008, the Company’s tax reserves related to unrecognized tax benefits for uncertain tax positions was not significant. The Company does not expect that the total amounts of unrecognized tax benefits will significantly increase or decrease during the year ended December 31, 2007.2008.
 
When the tax law requires interest to be paid on an underpayment of income taxes, the Company recognizes interest expense from the first period the interest would begin accruing according to the relevant tax law. Such interest expense is included in other income, net in the accompanying condensed consolidated statements of operations. Any accrual of penalties related to underpayment of income taxes on uncertain tax positions is included in other income, net in the accompanying condensed consolidated statements of operations. As of January 1, 2008, accrued interest and penalties related to uncertain tax positions was not significant.
As of March 31, 2008, the Company’s tax returns for the period July 21, 2005 through December 31, 2007 remain subject to examination by the IRS for federal income tax purposes.


I-10

 
DISCOVERY HOLDING COMPANY AND SUBSIDIARIES
 
Notes to Condensed Consolidated Financial Statements — (Continued)
 
interest expense is included in Other income, net in the accompanying condensed consolidated statements of operations. Any accrual of penalties related to underpayment of income taxes on uncertain tax positions is included in Other income, net in the accompanying condensed consolidated statements of operations. As of January 1, 2007, accrued interest and penalties related to uncertain tax positions was not significant.
As of September 30, 2007, the Company’s tax returns for the period July 21, 2005 through December 31, 2006 remain subject to examination by the IRS for federal income tax purposes.
(9)(8)  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 capital and operating lease arrangements.
 
On December 31, 2003, Ascent Media acquired the operations of Sony Electronic’s systems integration center business and related assets, which we refer to as SIC. In exchange, Sony received the right to be paid in 2008 an amount equal to 20% of the value of the combined business of Ascent Media’s wholly owned subsidiary, AF Associates, Inc. and SIC. The value of 20% of the combined business of AF Associates and SIC is estimated at $6,100,000, which liability is included in long-term other accrued liabilities in the accompanying condensed consolidated balance sheets. SIC is included in Ascent Media’s network services group.
 
(10)(9)  Related Party Transactions
 
In connection with the 2005 Spin Off, DHC and Liberty entered into a Services Agreement. 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. Amounts charged to DHC by Liberty under the Services Agreement aggregated $1,712,000$499,000 and $1,695,000$552,000 for the ninethree months ended September 30,March 31, 2008 and 2007, and 2006, 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 ninethree months ended September 30,March 31, 2008 and 2007 aggregated $9,311,000 and 2006 aggregated $34,281,000 and $24,977,000,$4,960,000, respectively.
 
(11)(10)  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 three reportable segments: the creative services group and the network services group, which are consolidated operating segments, and Discovery, which is an equity affiliate. Corporate related items and unallocated income and expenses are reflected in the corporate and other category listed below.
 
The creative services group provides various technical and creative services necessary to complete principal photography into final products, such asthe creation of original content, including feature films, movie trailers, documentaries and independent films, episodicmini-series, television TV movies and mini-series,shows, television commercials, music videos, interactive games and new


I-11

DISCOVERY HOLDING COMPANY AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements — (Continued)
digital media, promotional and identity campaigns and corporate communications. These services are referred to generally in the entertainment industry as “post-production” services. In addition, the creative services group provides a full complement of facilities and services necessary to optimize, archive, manage and repurpose completed media assets for global distribution via freight, satellite, fiber and the Internet. The network services group provides broadcast services, which are comprised ofthe facilities and services necessary to assemble and distribute programming content for cable and broadcast networks via fiber, satellite and satellitethe Internet to viewersprogramming providers in North America, Europe and Asia. Additionally, the networksnetwork services group provides systems integration, design, consulting, engineering and project management services.


I-11

 
DHC corporate related items and unallocated Ascent Media corporate expenses are reflected in the Corporate and Other column listed below. As a result of Ascent Media’s reorganization completed in the fourth quarter of 2006, the segment presentation for prior periods has been conformedDISCOVERY HOLDING COMPANY AND SUBSIDIARIES
Notes to the current period segment presentation.Condensed Consolidated Financial Statements — (Continued)
 
The accounting policies of the segments that are consolidated entities 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 cost of services and selling, general and administrative expense (excluding stock and other equity-based compensation and accretion expense on asset retirement obligations). The Company believes this is an important indicator of the operational strength and performance of its businesses, including the businesses’ ability to service debt and capital expenditures. In addition, this measure allowsis used by management to view operating results and perform analytical comparisons and identify strategies to improve performance. This measure of performance excludes depreciation and amortization, stock and other equity-based compensation, accretion expense on asset retirement obligations and restructuring and impairment charges 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.
 
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.


I-12

DISCOVERY HOLDING COMPANY AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements — (Continued)
 
Summarized financial information concerning the Company’s reportable segments is presented in the following tables:
 
                                        
 Consolidated Reportable Segments    Consolidated Reportable Segments   
 Creative
 Network
     Equity
  Creative
 Network
     Equity
 
 Services
 Services
 Corporate
 Consolidated
 Affiliate-
  Services
 Services
 Corporate
 Consolidated
 affiliate-
 
 group group(1) and other Total Discovery  group group(1) and other Total Discovery 
 amounts in thousands  amounts in thousands 
Nine months ended September 30, 2007                    
Three months ended March 31, 2008                    
Revenue from external customers $316,401   212,614   —   529,015   2,241,238  $91,782   97,523   —   189,305   794,578 
Operating cash flow (deficit) $35,478   32,507   (21,753)  46,232   686,082  $3,817   17,170   (10,948)  10,039   285,932 
Capital expenditures $19,240   13,482   3,588   36,310   55,317  $3,753   3,728   1,071   8,552   13,955 
Total assets $413,219   388,992   5,250,925   6,053,136   7,727,336  $375,690   265,268   5,294,880   5,935,838   7,921,337 
Nine months ended September 30, 2006                    
Three months ended March 31, 2007                    
Revenue from external customers $303,498   185,735   —   489,233   2,061,036  $110,712   63,170   —   173,882   710,198 
Operating cash flow (deficit) $32,241   34,576   (27,003)  39,814   561,503  $14,284   8,288   (7,210)  15,362   190,428 
Capital expenditures $19,243   29,481   2,496   51,220   40,109  $6,132   5,587   1,688   13,407   13,407 
 
 
(1)Included in network services group revenue is broadcast services revenue of $113,951,000$42,588,000 and $119,118,000$37,415,000 and systems integration revenue of $98,663,000$54,935,000 and $66,617,000 for the nine months ended September 30, 2007 and 2006, respectively.
                     
  Consolidated Reportable Segments 
  Creative
  Network
        Equity
 
  Services
  Services
  Corporate
  Consolidated
  Affiliate-
 
  group  group(1)  and other  Total  Discovery 
  amounts in thousands 
 
Three months ended September 30, 2007                    
Revenue from external customers $99,959   77,954   —   177,913   744,631 
Operating cash flow (deficit) $9,995   13,407   (7,248)  16,154   231,170 
Capital expenditures $5,815   5,014   387   11,216   18,682 
Three months ended September 30, 2006                    
Revenue from external customers $101,567   68,309   —   169,876   704,530 
Operating cash flow (deficit) $8,181   15,503   (7,868)  15,816   204,960 
Capital expenditures $7,142   10,472   1,206   18,820   14,334 
(1)Included in network services group revenue is broadcast services revenue of $38,145,000 and $41,178,000 and systems integration revenue of $39,809,000 and $27,131,000$25,755,000 for the three months ended September 30,March 31, 2008 and 2007, and 2006, respectively.


I-13I-12

 
DISCOVERY HOLDING COMPANY AND SUBSIDIARIES
 
Notes to Condensed Consolidated Financial Statements — (Continued)
 
 
The following table provides a reconciliation of consolidated segment operating cash flow to earnings before income taxes.
 
                        
 Three Months Ended
 Nine Months Ended
  Three Months Ended
 
 September 30, September 30,  March 31, 
 2007 2006 2007 2006  2008 2007 
 amounts in thousands  amounts in thousands 
Consolidated segment operating cash flow $16,154   15,816   46,232   39,814  $10,039   15,362 
Stock-based compensation  (344)  (215)  (1,652)  (1,200)  116   (966)
Depreciation and amortization  (17,176)  (16,036)  (50,162)  (47,995)  (16,540)  (15,571)
Impairment of goodwill  —   (93,402)  —   (93,402)
Share of earnings of Discovery  10,493   32,051   157,847   83,569   66,402   21,557 
Other, net  2,466   (932)  14,167   3,378   440   9,271 
              
Earnings (loss) before income taxes $11,593   (62,718)  166,432   (15,836)
Earnings before income taxes $60,457   29,653 
              
 
Information as to the Company’s operations in different geographic areas is as follows:
 
                
 Nine Months Ended
  Three Months Ended
 
 September 30,  March 31, 
 2007 2006  2008 2007 
 amounts in thousands  amounts in thousands 
Revenue                
United States $420,081   373,697  $150,172   137,212 
United Kingdom  90,339   98,976   33,042   30,140 
Other countries  18,595   16,560   6,091   6,530 
          
 $529,015   489,233  $189,305   173,882 
          
 
                
 September 30,
 December 31,
  March 31,
 December 31,
 
 2007 2006  2008 2007 
 amounts in thousands  amounts in thousands 
Property and equipment, net                
United States $185,326   184,052  $175,515   178,299 
United Kingdom  70,293   70,363   65,661   68,548 
Other countries  22,884   26,360   21,568   22,895 
          
 $278,503   280,775  $262,744   269,742 
          


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Item 2.Management’s Discussion and Analysis of Financial Condition and Results Of Operations
 
Certain statements in this Quarterly Report onForm 10-Q constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements regarding our business, marketing and operating strategies, integration of acquired businesses, new service offerings, financial prospects, 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 there can be no assurance that the 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, television and television commercial 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;
 
 • uncertainties inherent in the development of new business lines and business strategies;
 
 • integration of acquired operations;
 
 • 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 the 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;
 
 • fluctuations in foreign currency exchange rates and political unrest in international markets;
 
 • 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;union, or the duration of any existing strike or job action;
 
 • 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.
 
For additional risk factors, please see our Annual Report onForm 10-K, as amended, for the year ended December 31, 2006.2007. 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 our expectations


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with regard thereto, or any other change in events, conditions or circumstances on which any such statement is based.


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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 onForm 10-K, as amended, for the year ended December 31, 2006.
Recent Events
On Monday, November 5, 2007, the Writers Guild of America declared a strike that will affect the script writing for television shows and films. This strike may have an adverse effect on the revenue generated by Ascent Media’s creative services business for services provided on new entertainment projects utilizing scripted content. The impact is unknown at this time, as it is dependent upon the number of television episodes and feature films which have already been written and the undeterminable length of the strike.2007.
 
Overview
 
We are a holding company and our businesses and assets include consolidated subsidiaries Ascent Media Group, LLC (“Ascent Media”) and AccentHealth, which we consolidate,Ascent Media CANS, LLC (dba AccentHealth) (“AccentHealth”), and a 662/3% ownership interest in Discovery Communications Holding, LLC (“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 condensed consolidated financial statements.
Ascent Media
 
Ascent Media provides creative and network services to the media and entertainment industries in the United States, the United Kingdom (“UK”) and Singapore. Ascent Media’s clients include major motion picture studios, independent producers, broadcast networks, cable programming networks, advertising agencies and other companies that produce, ownand/or distribute entertainment, news, sports, corporate, educational, industrial and advertising content. Ascent Media’s operations are organized into the following three groups: creative services, group, network services group and corporate and other.
On November 5, 2007, Writers Guild of America, East and West (“Writers Guild”) declared a strike affecting the script writing for television shows and films. The strike has had a significant adverse effect on the revenue generated by Ascent Media has few long-term or exclusive agreements with itsMedia’s creative services customers.business for services provided on new entertainment projects utilizing scripted content and the production of new television commercials. On February 10, 2008, the Writers Guild announced that its governing boards had voted to recommend the terms of a proposed new contract with the Alliance of Motion Picture and Television Producers (“AMPTP”) and suspended picketing by the Writers Guild against producers. Members of the Writers Guild voted to end the strike on February 12, 2008. On February 26, 2008, the Writers Guild announced that its members had ratified the new contract, the term of which runs through May 1, 2011. The2007-2008 television season has been significantly affected by the strike. Networks and producers have resumed production of some scripted television programming interrupted by the strike. However, it is expected that some programming will not resume production this season, if at all. Accordingly, the full impact of the strike cannot currently be determined.
 
AccentHealth, which we acquired on January 27, 2006On February 21, 2008, the Directors Guild of America announced that its members had ratified a new contract with the AMPTP for cash consideration of $46,793,000, operates an advertising-supported captive audiencea term ending June 30, 2011.
The current contract between the Screen Actors Guild and AMPTP is scheduled to expire June 30, 2008, as does the contract governing primetime dramatic television network in 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 as partprogramming for members of the network services group sinceAmerican Federation of Television and Radio Artists, which traditionally negotiates labor terms with the date of acquisition.producers in conjunction with the Screen Actors Guild.
Discovery
 
Our most significant asset is our interest in Discovery, which we do not control. Discovery is a leading global media and entertainment company that provides original and purchased programming across multiple platforms in the U.S. and more than 170 other countries. Discovery also develops and sells consumer and educational products and services in the United States and internationally, and owns and operates a diversified portfolio of website properties and other digital services. Our share of the results of operations of Discovery is reflected in our condensed consolidated results as earnings or losses of Discovery. To assist the reader in better understanding and


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analyzing our business, we have included a separate discussion and analysis of Discovery’s results of operations and financial condition below.
During the second quarter of 2007, each of the shareholders of DCIDiscovery Communications, Inc (“DCI”), including our company, contributed its DCI common stock to a newly formed company, Discovery, in exchange for Discovery membership interests. Subsequent to the DCI Restructuring,contribution, each of the members of Discovery holdheld the same ownership interests in Discovery as they previously held in DCI. DCI became a wholly-owned subsidiary of Discovery, and Discovery is the successor reporting entity of DCI.DCI
 
On May 14, 2007, Discovery and Cox Communications Holdings, Inc. (“Cox”) completed an exchange of Cox’s 25% ownership interest in Discovery for all of the capital stock of a subsidiary of Discovery that held Travel Channel, travelchannel.com and approximately $1.3 billion in cash (the “Cox Transaction”). Discovery raised the cash component through additional debt financing, and retired the membership interest previously owned by Cox. Upon completion of this transaction, we own a 662/3% interest in Discovery and Advance/Newhouse CommunicationsProgramming Partnership (“Advance/Newhouse”) owns a 331/3% interest.interest in Discovery. We continue to account for our investment in Discovery using the equity method of accounting due to governance rights possessed by Advance/Newhouse Communications which restrict our ability to control Discovery.
 
Newhouse Transaction and Ascent Spin Off
In December 2007, we announced that we had signed a non-binding letter of intent with Advance/Newhouse to combine our respective stakes in Discovery. As currently contemplated by the non-binding letter of intent, the transaction, if completed, would involve the following steps:
• We will spin-off to our shareholders a wholly-owned subsidiary holding substantially all of DHC’s cash, AccentHealth and Ascent Media, except for those businesses of Ascent Media that provide sound, music, mixing, sound effects and other related services (the “Ascent Media Spin Off”);
• Immediately following the Ascent Media Spin Off, we will combine with a new holding company (“New DHC”), and our existing shareholders will receive shares of common stock of New DHC;
• As part of this transaction, Advance/Newhouse will contribute its interests in Discovery and Animal Planet to New DHC in exchange for preferred stock of New DHC that, immediately after the closing of the transactions, will be convertible at any time into shares initially representing one-third of the outstanding shares of common stock of New DHC on an as-converted basis. The preferred stock held by Advance/Newhouse will entitle it to elect three members to New DHC’s board of directors and to exercise approval rights with respect to the taking of specified actions by New DHC and Discovery.
Although no assurance can be given, consummation of this transaction (the “Newhouse Transaction and Ascent Spin Off”) is expected in the third quarter of 2008. The Ascent Media Spin Off was approved in connection with the proposed transaction between DHC and Advance/Newhouse, and it is a global mediacondition of the Ascent Media Spin Off that the agreement between DHC and entertainment companyAdvance/Newhouse be in effect and that provides originalall conditions precedent to that transaction (other than the Ascent Media Spin Off) shall have been satisfied.
It is currently expected that the Ascent Media Spin Off will be effected for federal income tax purposes as a tax-free distribution to DHC’s shareholders and purchased video programming across multiple platforms inbe accounted for at historical cost due to the U.S. and over 170 other countries. Discovery also develops and sells branded commerce and educational product lines inpro rata nature of the United States. Our sharedistribution. Subsequent to the completion of the Ascent Media Spin Off, the historical results of operations of Ascent Media prior to the Ascent Media Spin Off will be included in discontinued operations in DHC’s consolidated financial statements. The acquisition of Advance/Newhouse’s interests in Discovery is reflectedand Animal Planet will result in our consolidated results as earnings or lossesNew DHC owning 100% of Discovery. To assist the reader in better understandingDiscovery, and analyzing our business, we have included a separate discussionaccordingly, New DHC will consolidate Discovery’s financial position and analysis of Discovery’s results of operations effective with the closing of the transaction. Pursuant to FASB TechnicalBulletin 85-5, the contribution of interests to New DHC will be treated as a non-substantive merger, and financial condition below.therefore, interests will be recorded at carry over basis.


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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 and accretion expense on asset retirement obligations). 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 allowsis used by management to view operating results and perform analytical comparisons and identify strategies to improve performance. This measure of performance excludes depreciation and amortization, stock and other equity-based compensation, accretion expense on asset retirement obligations, restructuring and impairment charges that are included in the measurement of operating income pursuant to U.S. 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 1110 to the accompanying condensed consolidated financial statements for a reconciliation of operating cash flow to earnings before income taxes.
 
Results of Operations
 
Our condensed consolidated results of operations include 100% of theAscent Media’s and AccentHealth’s results of Ascent Media and AccentHealth,operations, general and administrative expenses incurred at the DHC corporate level, and our share of earnings of Discovery.
 
OurAscent Media’s creative services group generates 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.television commercials. 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. Additionally, the creative services group provides owners of film libraries a broad range of restoration, preservation, archiving, professional mastering and duplication services. The scope of these creative 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. The creative services group includes Ascent Media’s digital media distribution center, which is developing new digital service products and businessesprovides file-based services in areas such as digital imaging, digital vault, distribution services and interactive media.media to new and existing distribution platforms.
 
OurThe 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 fiber, satellite and the Internet. The group’s revenue is also driven by 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. This operating segment also includes the operations of AccentHealth, which operates an advertising-supported captive audience television network in doctor office waiting rooms nationwide. Approximately 60%44% of the network services group’s revenue relates to AccentHealth, broadcast services, satellite operations and fiber services that are earned monthly under long-term contracts ranging generally from one to seven years. Additionally, approximately 40%56% of revenue relates to systems integration and engineering services that are provided on a project basis over terms generally ranging from three to twelve months.


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Corporate related items and expenses are reflected in Corporate and other, below. Cost of services and operating expenses consist primarily of production wages, facility costs and other direct costs and selling, general and administrative expenses.
 
                        
 Three Months Ended
 Nine Months Ended
  Three Months Ended
 
 September 30, September 30,  March 31, 
 2007 2006 2007 2006  2008 2007 
 amounts in thousands  amounts in thousands 
Segment Revenue                        
Creative Services group $99,959   101,567   316,401   303,498  $91,782   110,712 
Network Services group  77,954   68,309   212,614   185,735   97,523   63,170 
Corporate and other  —   —   —   —   —   — 
              
 $177,913   169,876   529,015   489,233  $189,305   173,882 
              
Segment Operating Cash Flow                        
Creative Services group $9,995   8,181   35,478   32,241  $3,817   14,284 
Network Services group  13,407   15,503   32,507   34,576   17,170   8,288 
Corporate and other  (7,248)  (7,868)  (21,753)  (27,003)  (10,948)  (7,210)
              
 $16,154   15,816   46,232   39,814  $10,039   15,362 
              
 
Revenue.  Total revenue increased $8,037,000$15,423,000 or 4.7% and $39,782,000 or 8.1%8.9% for the three and nine months ended September 30, 2007,March 31, 2008, as compared to the corresponding prior year periods.period. The creative services group revenue decreased $1,608,000$18,930,000 or 1.6% and increased $12,903,000 or 4.3%17.1% for the three and nine months ended September 30, 2007,March 31, 2008, respectively, as compared to the corresponding prior year periods.period. The decrease in creative services revenue for the three month period was mainly due to a $3,401,000 decrease in feature revenue driven by weakness in audio services, partially offset by growth in digital vaulting and digital distribution services. The increase in creative services revenue for the nine month period was due to (i) an increasea decrease of $6,569,000 in commercial revenue driven primarily by strong worldwide demand in the first quarter, (ii) an increase of $4,171,000 in media services driven by growth in digital vaulting and digital distribution services, offset by lower traditional lab and DVD services and (iii) favorable changes in foreign currency exchange rates of $5,134,000, offset by a decrease$10,742,000 in television post production services in the U.S. driven primarily by the Writers Guild strike, (ii) lower feature revenue of $4,210,000 driven by smaller feature sound projects, (iii) a decrease of $2,573,000 in commercial revenue driven by strong worldwide demand in the prior year period and (iv) a decrease of $857,000 in U.K. television revenue driven by declines in the broadcast work.
 
The network services group revenue increased $9,645,000$34,353,000 or 14.1% and $26,879,000 or 14.5%54.4% for the three and nine months ended September 30, 2007,March 31, 2008, as compared to the corresponding prior year periods.period. The increase in revenue for the three month period was due to (i) an increase of $12,678,000$29,180,000 in system integration services revenue due to the timing of and increase in the number of large projects, and (ii) an increase of $3,179,000$3,071,000 in content distribution revenue in the U.S. and Singapore. These increases in revenue were partially offset by a decrease of $5,937,000 primarily due to the termination of certain distribution contracts in the U.K. The increase in revenue for the nine month period was due to (i) an increase of $32,047,000 in system integration services revenue due to the timing of and increase in the number of projects, (ii) an increase of $4,699,000 in content distribution revenue in the U.S. and Singapore, (iii) an increase of $3,131,000$2,382,000 driven by AccentHealth which was acquired in February 2006 and (vi) favorable changes in foreign currency exchange rates of $3,314,000. These increases in revenue were partially offset by (i) a decrease of $10,200,000 primarily due to the termination of certain distribution contractscontinued growth in the U.K. and (ii) a decrease of $4,794,000 due to a one-time project in 2006.digital network.
 
Cost of Services.  Cost of services increased $11,036,000 or 9.9% and $43,449,000$16,518,000 or 13.6% for the three and nine months ended September 30, 2007,March 31, 2008, as compared to the corresponding prior year periods. Theperiod. A significant portion of the increase for the three month period was attributable to higher costs across the network services group primarily in production material resulting from increased volumes in system integration services. The increase for the nine month period was across creative services and network services resulting from higher volumes of system integration services, commercial and feature revenue, and new digital media revenue. Additionally, changeswhich have a higher percentage of equipment costs. The increase was partially offset by lower cost of services in foreign currency exchange rates resultedcreative services driven by decreases in an increase of $1,703,000 fortelevision production services impacted by the three month period and $5,616,000 for the nine month period.Writers Guild strike. As a percent of revenue, cost of services was 68.9%72.9% and 65.6%69.9% for the three month periods and was 68.5% and 65.1% for the nine months ended September 30,March 31, 2008 and 2007, and 2006, respectively. The percentage increase wasis a


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result of revenue mix primarily driven primarily by the higher production material costs for system integration projects, at the network services group and by higher labor intensive commercial and feature projects in thewhich have lower margins. Additionally, creative services group.labor costs decreased to a lesser degree than revenue during the period of the Writers Guild strike, with certain fixed costs remaining regardless of the decline in revenue.
 
Selling, General and Administrative.  Our selling, general and administrative expenses (“SG&A”), including corporate expenses of both DHC and Ascent Media but excluding stock-based compensation and accretion expense on asset retirement obligations, decreased $3,337,000increased $4,228,000 or 7.8% and $10,085,000 or 7.7%11.4% for the three and nine months ended September 30, 2007March 31, 2008 as compared to the corresponding prior year periods.period. The decline for both periodsincrease was mainly driven by lower personnelDHC corporate expenses, which increased $3,227,000 over the corresponding prior year period as a result of legal and accounting costs resulting fromrelated to the Newhouse Transaction and Ascent Media’s restructuring in the third and fourth quarters of 2006, and lower professional fees.Spin Off. As a percent of revenue, SG&A was 22.0%21.8% and 25.1%21.3% for the three month periods and was 22.8% and 26.7% for the nine months ended September 30,March 31, 2008 and 2007, and 2006, respectively.


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Restructuring Charges.  During the ninethree months ended September 30, 2007,March 31, 2008, Ascent Media recorded restructuring charges of $192,000$1,257,000 related to severance and facility costs in conjunction with restructuring efforts within the U.S. and U.K. creative services business. Additional restructuringclosing its operations in Mexico. No such charges are expectedwere recorded in the fourth quarter of 2007. During the nine months ended September 30, 2006, Ascent Media recorded restructuring charges of $3,963,000 primarily related to severance. These restructuring activities were primarily in the Corporate and other group in the United States and United Kingdom.
 
Depreciation and Amortization.  The increase in depreciation and amortization expense for the three and nine months ended September 30, 2007March 31, 2008 is due to depreciation on new assets placed in service partially offset by assets becoming fully depreciated.
 
Stock-Based Compensation.  Stock-based compensation was a benefit of $116,000 and an expense of $966,000 for the three months ended March��31, 2008 and 2007, respectively. Effective August 3, 2006, Ascent Media adopted its 2006 Long-Term Incentive Plan (the “2006 Plan”). The 2006 Plan provides the terms and conditions for the grant of, and payment with respect to, Phantom Appreciation Rights (“PARs”) granted to certain officers and other key personnel of Ascent Media. The maximum number of PARs that may be granted under the 2006 Plan is 500,000, and there were 438,500483,500 PARs granted as of September 30, 2007.March 31, 2008. Ascent Media recorded 2006 Plan benefit of $276,000 and expense of $112,000 and $1,031,000$841,000 for the three and nine months ended September 30,March 31, 2008 and 2007, respectively.
On July 21, 2005, Liberty completed the spin off For Discovery Holding Company stock options held by certain of our capital stock. As a result of the Spin Off and related adjustments to Liberty’s stock incentive awards, options to acquire an aggregate of approximately 2.0 million shares of our Series A common stock and 3.0 million shares of our 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. SAR expense was a credit of $13,000 and anwe also recorded stock-based compensation expense of $12,000$160,000 and $137,000 for the ninethree months ended September 30,March 31, 2008 and 2007, and 2006, respectively. Pursuant to a reorganization agreement we entered into with Liberty in connection with the Spin Off, we are responsible for all stock options related to DHC common stock, and Liberty is responsible for all incentive awards related to Liberty common stock. We record stock-based compensation for all stock incentive awards held by our employees and our subsidiaries’ employees. Stock-based compensation expense was $634,000 and $1,188,000 for the nine months ended September 30, 2007 and 2006, respectively.
 
As of September 30, 2007,March 31, 2008, the total compensation cost related to unvested equity awards was $772,000.$379,000. Such amount will be recognized in our consolidated statements of operations over a weighted average period of approximately 1.1 years.
 
Share of Earnings of Discovery.  From January 1, 20062007 through May 14, 2007, we recorded our 50% share of the earnings of DCI. Subsequent to May 14, 2007, we recorded our 662/3% share of the earnings of Discovery. Our share of earnings of Discovery decreased $21,558,000 and increased $74,278,000$44,845,000 for the three and nine months ended September 30, 2007, respectively,March 31, 2008 as compared to the corresponding prior year periods.period. The three month decreaseincrease is mainly due to Discovery’s increased long-term incentive plan expenseperformance in the first quarter of 2008 as well as its increased interest expense resulting fromcompared to the debt incurred by Discovery in connection with the Cox Transaction.prior year period. The nine month increase also resulted from our $89,781,000 share of Discovery’s gain on the Cox Transaction, along with a $12,357,000 increase as the result of$17,536,000 impact from our ownership interest in Discovery increasing from 50% to 662/3%. These increases were partially offset
In connection with the Cox Transaction, we reallocated our excess basis related to our investment in Discovery. Such allocation process was completed in the first quarter of 2008 and resulted in approximately 48% of the excess basis created by Discovery incurring higher long-term incentive plan expensesthe Cox Transaction being allocated to intangible assets with determinable useful lives. Amortization of such intangible assets aggregated $3,744,000 (net of related taxes) for the three months ended March 31, 2008 and higher interest expense.is included in our share of earnings of Discovery.


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We have provided a more detailed discussion of Discovery’s results of operations below.
 
Other Income.  During the first quarter of 2007, our landlord terminated an operating lease for one of our production facilities in exchange for a cash payment. In connection with such termination we recorded a $6,992,000 gain, representing the cash we received less the net book value of leasehold improvements which were retired. No such transaction was recorded in 2008.
 
Income Taxes.  Our effective tax rate was 38.6%43.8% and 31.0% for the ninethree months ended September 30, 2007.March 31, 2008 and 2007, respectively. Our income tax expense for 20072008 was higher than the federal income tax rate of 35% due to state and foreign tax expense. For the nine months ended September 30, 2006, the effective tax rate was not meaningful because we recordedOur income tax expense for 2007 is lower than the federal income tax rate of $35,448,000, but had35% due to a net loss before taxes of $15,836,000. The net loss resulted from a $93,402,000 goodwill impairment charge recordedreduction in the thirdvaluation allowance from the usage of net operating loss carryforwards to offset taxable income in the first quarter of 2006, for which we receive no tax benefit.2007.
 
During the first quarter of 2008, Liberty reached an agreement with the IRS related to certain tax items that arose in periods prior to our spin off from Liberty on July 21, 2005. The agreement resulted in a reduction to the initial amount of federal and California net operating losses by $28,554,000 and $49,667,000, respectively, that Liberty allocated to DHC at the spin off date. However, since we had previously recorded a full valuation allowance against these net operating losses, the reversal of both the net operating losses and the corresponding valuation allowance resulted in no net impact to our condensed consolidated financial statements.


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Net Earnings (Loss).  Our net earnings (loss) increased from a loss of $51,284,000$20,464,000 for the ninethree months ended September 30, 2006March 31, 2007 to earnings of $102,188,000$33,991,000 for the ninethree months ended September 30, 2007.March 31, 2008. Such increase is due to the other aforementioned fluctuations in revenue, expenses and expenses.other income.
 
Liquidity and Capital Resources
 
Our primary sources of funds are cash on hand and cash flows from operating activities. During the ninethree months ended September 30, 2007,March 31, 2008, our primary use of cash was capital expenditures of $36,310,000. Of the foregoing 2007 capital expenditures, $11,300,000 relates$8,552,000 to the buildout of Ascent Media’s existing facilities for specific customer contracts. The remainder of our capital expenditures relate to purchases ofpurchase new equipment and the upgrade of existing facilities and equipment.equipment at Ascent Media and AccentHealth. We currently expect to spend up to an additional $33,000,000$40,000,000 for capital expenditures in 2007,2008, which we expect will be funded with Ascent Media’s and AccentHealth’s cash from operations and cash on hand. At September 30, 2007,March 31, 2008, we have approximately $152.5$223 million of corporate cash, and short-term investments. Forfor 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 any new investment opportunities, additional capital expenditures or our 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 makes a distribution with respect to its membership interests or makes other payments or advances to its members. Prior to May 14, 2007, DCI did not pay any dividends on its capital stock, and since that date, Discovery has not made any distributions to its members, and we do not have sufficient voting control to cause Discovery to make distributions or make other payments or advances to us.
 
Discovery
 
Effective May 15, 2007 and as a result of the Cox Transaction, our ownership interest in Discovery increased from 50% to 662/3%, and we continue to account for this investment using the equity method of accounting due to governance rights which restrict our ability to control Discovery. Accordingly, in our condensed consolidated financial statements we record our share of Discovery’s net income or loss available to members and reflect this activity in one line item in our condensed consolidated statement of operations as “Share of earnings of Discovery.” The following financial information of Discovery for the ninethree months ended September 30,March 31, 2008 and 2007 and 2006 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.


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The following discussion of Discovery’s results of operations is presented on a consolidated basis. In orderin two parts to provide aassist the reader in better understanding Discovery’s operations. The first section is an overall discussion of Discovery’s operations, we have also includedconsolidated operating results. The second section includes a summarized presentationmore detailed discussion of revenue and operating cash flow activity of Discovery’s three operating groups:divisions: Discovery networks U.S., or U.S. networks, Discovery networks international, or international networks, and Discovery commerce education and other.education.
 
U.S. networks is Discovery’s largest division, which owns and operates 11 cable and satellite channels, provides distribution and advertising sales services for Travel Channel and BBC America and provides distribution services for BBC World News. International networks manages a portfolio of channels, led by the Consolidated Results
Discovery Channel and Animal Planet brands, that are distributed in virtually every pay-television marketwas formed in the world via an infrastructure that includes major operational centers in London, Singapore, New Delhi and Miami. Discovery commerce has undergone a strategic review and has repositioned its operating approach from runningbrick-and-mortar physical retail locations to focusing on an increased reach of its products through retail partnerships and thee-commerce platform. On May 17, 2007, Discovery announced that it would close its 103 mall-based and stand-alone Discovery Channel stores, which closures were completed in the thirdsecond quarter of 2007. These stores had been2007 as part of Discovery’s commerce business. As a result ofrestructuring (the “DCI Restructuring”) completed by Discovery Communications, Inc. (“DCI”). In the store closures, the following Consolidated Results of Discovery have been prepared to reflect the retail store business as discontinued operations. Accordingly, the revenue, costs and expenses of the retail store business have been excluded from the respective captions in the Consolidated ResultsDCI Restructuring, DCI became a wholly-owned subsidiary of Discovery, and havethe former shareholders of DCI, including DHC, became members of Discovery. Discovery is the successor reporting entity to DCI. In connection with the DCI Restructuring, Discovery applied “pushdown” accounting and each shareholder’s basis in DCI as of May 14, 2007 has been reported under the headingpushed down to


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Discovery resulting in $4.3 billion of discontinued operations. Discovery’s education business will continue to focus on its direct-to-school distribution platform and its other premium direct-to-school subscription services.goodwill being recorded by Discovery. Since goodwill is not amortizable, there is no current income statement impact for this change in basis.
 
During 2007, Discovery undertook broad restructuring activities to better position its portfolio of assets and to facilitate growth and enhanced profitability. These activities resulted in additional operating expenses that impact the comparability of results from 2007 to 2008. The more significant items include fourth quarter 2007 content impairment charges of $129,091,000 at U.S. Networks and $9,976,000 at Education which both impacted content amortization expense when comparing expenses in the first quarter of 2008 to those in the corresponding prior year period. Additionally, a $10,999,000 restructuring charge was recorded in the first quarter of 2007, with no similar charge recorded in 2008.
Consolidated Results of Discovery
 
                
 Nine Months Ended
  Three Months Ended
 
 September 30,  March 31, 
 2007 2006  2008 2007 
 amounts in thousands  amounts in thousands 
Revenue:                
Advertising $968,087   887,627  $304,129   289,769 
Distribution  1,099,624   1,063,138   402,683   369,879 
Other  173,527   110,271   87,766   50,550 
          
Total revenue  2,241,238   2,061,036   794,578   710,198 
          
Expenses:                
Cost of revenue  (735,159)  (706,008)  (230,435)  (243,523)
Selling, general and administrative (“SG&A”) expense  (819,997)  (793,525)  (278,211)  (276,247)
          
Operating cash flow  686,082   561,503   285,932   190,428 
Restructuring and other charges  (15,798)  — 
Expenses arising from long-term incentive plans  (129,226)  (10,561)
Restructuring charges  —   (10,999)
Benefit (expense) arising from long-term incentive plans  35,857   (11,721)
Depreciation and amortization  (95,891)  (87,036)  (37,720)  (32,433)
Asset impairment  (26,174)  — 
Gain on sale of operating assets  134,671   — 
          
Operating income  553,664   463,906   284,069   135,275 
Other income (expense):                
Interest expense, net  (179,135)  (149,828)  (68,720)  (44,558)
Realized and unrealized gains from derivative instruments, net  2,507   11,562 
Unrealized gains (losses) from derivative instruments, net  (16,095)  1,065 
Minority interests in consolidated subsidiaries  (2,049)  3,077   (6,806)  (707)
Other  5,573   6,622   311   2,049 
          
Earnings before income taxes  380,560   335,339 
Income from continuing operations before income taxes  192,759   93,124 
Income tax expense  (73,938)  (143,727)  (87,541)  (41,710)
          
Earnings from continuing operations  306,622   191,612 
Income from continuing operations  105,218   51,414 
Loss from discontinued operations, net of income taxes  (60,532)  (24,473)  —   (8,300)
          
Net earnings $246,090   167,139 
Net income $105,218   43,114 
          


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Business Segment Results of Discovery
         
  Nine Months Ended
 
  September 30, 
  2007  2006 
  amounts in thousands 
 
Revenue:        
U.S. networks $1,468,061   1,391,520 
International networks  723,984   641,299 
Commerce, education and other  49,193   28,217 
         
Total revenue $2,241,238   2,061,036 
         
Operating Cash Flow:        
U.S. networks $595,123   541,393 
International networks  99,886   96,667 
Commerce, education and other  (8,927)  (76,557)
         
Total operating cash flow $686,082   561,503 
         
Note: Discovery commerce, education and other includes intercompany eliminations. In addition, prior year amounts have been reclassified for comparability with current year presentation.
The Cox Transaction was completed on May 14, 2007, and in connection therewith Discovery exchanged its subsidiary which held Travel Channel, travelchannel.com and approximately $1.3 billion in cash for Cox’s ownership interest in Discovery. Accordingly, Discovery’s 2007 results of operations do not include Travel Channel for the full nine months. In the following discussion of Discovery’s consolidated and the U.S. network’s revenue and expenses, the changes between the nine months ended September 30, 2007 and 2006 exclude the fluctuations due to the disposition of the Travel Channel. The disposal of Travel Channel does not meet the requirements for discontinued operations presentation.
 
Revenue.  Discovery’s consolidated revenue increased 11%12% for the ninethree months ended September 30,March 31, 2008, as compared to the corresponding prior year period, due to increases of 74% in other revenue, 9% in distribution revenue, and 5% in advertising revenue. Other revenue primarily increased as a result of (i) a $16,435,000 increase in ancillary revenue from a joint venture primarily due to an unprecedented level of seasonal sales driven by the success of the Planet Earth programming in 2007, which is not expected to continue at the same level, (ii) $8,688,000 earned by U.S. networks’ representation of Travel Channel, and (iii) the impact of the acquisition of HowStuffWorks in December 2007. Increased distribution revenue is primarily due to international networks subscriber growth and favorable exchange rates, combined with annual contract increases for the fully distributed


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U.S. networks, offset by the disposition of Travel Channel. Increases in advertising revenue were primarily due to higher viewership in Europe and the impact of favorable exchange rates, higher cash sellouts and higher scatter rates across most networks at the U.S. networks, offset by the disposition of Travel Channel. Program ratings are an indication of consumer acceptance and directly affect Discovery’s ability to generate revenue during the airing of its programs. If programs do not achieve sufficient acceptance, the revenue from advertising sales may decline.
Cost of revenue.  Cost of revenue, which includes content amortization and other production related expenses in addition to distribution and merchandising costs, decreased 5% for the three months ended March 31, 2008, as compared to the corresponding prior year period. Increased revenue was due toThe decrease is primarily a 5% increaseresult of (i) an $18,319,000 decrease from the disposition of Travel Channel and (ii) the effect of the $129,091,000 content impairment charge recorded in distribution revenue, a 14% increase in advertising revenue and a 47% increase in other revenue, including commerce and education revenue, during the same period.
Distribution revenue increased $21,425,000 or 4%2007 at the U.S. networks which decreased content amortization expense by $17,702,000 for the nine months ended September 30, 2007, asfirst quarter of 2008 compared to the corresponding prior year period, primarily dueperiod. Partially offsetting the decrease is the impact of International networks’ continued investment to support additional local feeds for growth in local ad sales, and the unfavorable impact of foreign currency exchange rates. As a 7% increaseresult of the foregoing fluctuations, cost of revenue as a percent of revenue decreased to 29% in average paying subscription units, principally2008 from networks carried on the digital tier, partially offset34% in 2007.
SG&A expenses.  SG&A expenses, which include personnel, marketing and other general and administrative expenses, increased by an increase in contra-revenue items. Contra-revenue items included in distribution revenue, such as launch amortization and marketing consideration, aggregated $70,966,000 and $62,768,0001% for the ninethree months ended September 30, 2007 and 2006, respectively. Many of Discovery’s domestic networks are currently distributed to substantially all of the cable television and direct broadcast satellite homes in the U.S. Accordingly, the rate of growth in U.S. distribution revenue in future periods is expected to be less than historical rates.
At the international networks, distribution revenue increased $31,464,000 or 8% for the nine months ended September 30, 2007,March 31, 2008, as compared to the corresponding prior year period. Such increase was principally comprised of combined revenue growth in Europe and Latin America of $44,698,000, revenue growth in Asia of $9,250,000 and a favorable foreign exchange impact in Europe and the U.K. of $15,518,000, offset by a $41,262,000 revenue decline in the U.K. The net increase in revenue resulted from a 13% increase in average paying subscription units combined with contractual rate increases in certain markets, partially offset by an increase in launch amortization. In January 2007 and in connection with the settlement of terms under a pre-existing distribution agreement, Discovery completed negotiations for the renewal of long-term distribution agreements for certain of its U.K. networks and paid a distributor $195.8 million. Most of the payment was attributed to the renewal period and is being amortized over a five year term. As a result, launch amortization at the international networks was $32,945,000 for the nine months ended September 30, 2007, as compared to $4,794,000 for the corresponding prior year period.


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Advertising revenue, which includes revenue from paid programming, increased $83,960,000 or 13% at the U.S. networks and increased $30,342,000 or 16% at the international networks, for the nine months ended September 30, 2007 as compared to the corresponding prior year period. The increase in advertising revenue at the U.S. networks was primarily due to improved advertising sell-out rates, better unit pricing and higher audience delivery on most channels, notably the Discovery Channel and TLC. 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, partially offset by a decline in advertising revenue in the U.K.
Commerce, Education and Other revenue increased $20,976,000 or 74% for the nine months ended September 30, 2007, as compared to the corresponding prior year period. The increase was driven by a surge in sales of Planet Earth DVDs following the series premiere in March 2007, as well as an increase in subscribers and improved pricing for Discovery’s direct-to-school education distribution platform.
Cost of Revenue.  Cost of revenue increased 9% for the nine months ended September 30, 2007, as compared to the corresponding prior year period. As a percent of revenue, cost of revenue was 33% for each of the nine month periods ended September 30, 2007 and 2006. The $55,599,000 increase over the prior year period primarily resulted from a $45,497,000 increase in content amortization expense due to continued investment in original productions, from 2006 acquisitions, and from accelerated amortization of certain programs. As announced on April 5, 2007, the Discovery Home channel will be re-branded as Discovery PlanetGreen during 2008, so additional accelerated amortization expenses on Discovery Home programs could be expected during the remainder of 2007 and early 2008. All programming portfolio assets will continue to be subject to evaluation in 2007 relative to reviews and strategic plans put in place for certain other channels by the new management. The increase in cost of revenue is also the result of several new networks launched in Europe, and a $4,517,000 impact of the German free-to-air channel branded as DMAX which was acquired in March 2006.
SG&A Expenses.  SG&A expenses increased 4% for the nine months ended September 30, 2007, as compared to the corresponding prior year period. This increase is comprised of $32,584,000 and $55,199,000 increases for U.S. networks and international networks, respectively, as compared to the corresponding prior year period, partially offset by a $43,944,000 decrease for the education business. In U.S. networks, the increase is due to compensation and benefit increases, small acquisition-related increases, and increases in general support costs, partially offset by a decrease in marketing expense. In international networks, the increase is primarily due to a $46,982,000 or 40%U.S. networks continued investment in digital media and an impact related to the expansion of network teams to support the re-branding strategies for Planet Green and Investigation Discovery, offset by the disposition of Travel Channel. Also contributing to the increase in personnel expense, resulting from 2006 acquisitions and infrastructure expansions in Europe which increased headcount and office locations, along withis the effectsimpact of unfavorable foreign currency exchange rates. In both U.S. networks and international networks, there was also an increase in corporate expenses allocated to these segments following the organizational and strategic changes which decreased allocations to commerce, education and other. In the education business, the decrease is primarily due to a $14,481,000 or 43% reduction in personnel expense as a result of business restructuring, combined with a $20,821,000 or 89% reduction in marketing expense as Discovery re-focuses the direction of the education business. As a percent of revenue, SG&A expense was 37%35% and 39% for the ninethree months ended September 30,March 31, 2008 and 2007, and 2006, respectively.
 
Restructuring Charges.  During the nine months ended September 30, 2007, Discovery recorded restructuring charges related to a number of organizational and strategic adjustments and consisting mainly of severance due to a reduction in headcount. The purpose of these adjustments was to better align Discovery’s organizational structure with the company’s new strategic priorities and to respond to continuing changes within the media industry. There was no restructuring charge in 2006.
Expenses Arisingarising from Long-term Incentive Plans.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. The value of units in the LTIP is indexed to the value of DHC Series A common stock and treated similar to a derivative by determining their fair value each reporting period.is calculated using the Black Scholes Model. The change in unit value of LTIP awards outstanding is recorded as compensation expense over the period outstanding. Upon redemption of the LTIP awards, participants receive a cash payment based on the changevalue of the award as described in market pricethe terms of DHC Series A common stock.the LTIP. In the third quarter of 2007, Discovery amended itsthe LTIP such that the redemption dates occur annually over a 4 year period instead of bi-annually over an 8 year period. This amendment will impact compensation expense recognized in 2007 and future


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periods, and also impactDue to the timing of cash payments. Compensation expense aggregated $129,226,000 for the nine months ended September 30, 2007 compared to $10,561,000 for the same period in 2006. The increase is primarily the result of increasesdecrease in the DHC Series A common stock price offset byduring the three months ended March 31, 2008, a decrease inbenefit of $40,510,000 was recorded to compensation expense compared to compensation expense of $11,721,000 for the three months ended March 31, 2007. Partially offsetting the benefit for the three months ended March 31, 2008 is $4,653,000 of compensation expense arising from a long-term incentive plan related to one of Discovery’s subsidiaries, for which there was no expense in the shortened redemption time period under the amended LTIP along with the difference in value accrued for units paid or forfeited during the quarter, largely as a result of the restructuring.corresponding prior year period. If the remaining vested LTIP awards at September 30, 2007March 31, 2008 were redeemed, the aggregate cash payments by Discovery would be approximately $105,308,000.$65,610,000.
Restructuring charges.  During the first quarter of 2007, Discovery recorded restructuring charges of $10,999,000 related to a number of organizational and strategic adjustments which consisted mainly of severance due to a reduction in headcount. The purpose of these adjustments was to better align Discovery’s organizational structure with the company’s new strategic priorities and to respond to continuing changes within the media industry. There was no similar restructuring charge in 2008.
 
Depreciation and Amortization.amortization.  The increase in depreciation and amortization for the ninethree months ended September 30, 2007March 31, 2008 is due to an increase in newintangible assets placedresulting from acquisitions combined with increases in service during 2006 and 2007.Discovery’s depreciable asset base resulting from capital expenditures.
 
Asset impairment.  During the second quarter of 2007, Discovery recorded an asset impairment which represents write-offs of education intangible assets related to its consumer business.
Gain on sale of operating assets.  Discovery recognized a gain on sale of operating assets of $134,671,000 in connection with the Cox Transaction.
Other Income and Expense
 
Interest Expense.expense.  On May 14, 2007, Discovery issuedentered into a new $1.5 billion term loan in connection with the Cox Transaction. The increase in interest expense for the ninethree months ended September 30, 2007March 31, 2008 as compared to the corresponding prior year period is primarily a result of the new term loan. The increase is also impacted by Discovery exercising its call rights in January 2007 to acquire mandatorily redeemable securities and reversing


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$4.5 million of accrued preferred returns. Preferred returns had been recorded as a component of interest expense based on a constant rate of return through the full term.
 
Realized and Unrealized Gainsgains from Derivative Instruments,derivative instruments, net.  Realized and unrealizedUnrealized 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 contractsinstruments include a combination of swaps, caps, collars and swaptions.other structured instruments. As a result of unrealized mark to market adjustments, Discovery recognized $2,507,000 and $11,562,000 in net gains on these instrumentsan unrealized loss of $16,095,000 during the ninethree months ended September 30, 2007March 31, 2008 and 2006, respectively.an unrealized gain of $1,065,000 for the three months ended March 31, 2007. 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 Interestsinterests in Consolidated Subsidiaries.consolidated subsidiaries.  Minority interest representsinterests primarily represent the portion of earnings of consolidated entities which are allocable to the minority partners as well as the increases and decreases in the estimated redemption value of mandatorily redeemable interests in subsidiaries which are initially recorded at fair value. The increase for the three months ended March 31, 2008 as compared to the corresponding prior year period is the result of increased profits earned by these consolidated subsidiaries, mainly driven by royalties on the Planet Earth DVD sales.
 
Other.  Other income in 20072008 and 20062007 relates primarily to Discovery’s equity share of earnings onof its joint ventures.
 
Income Taxes.taxes.  Discovery’s effective tax rate was 45% for income from continuing operations was 19% and 43% foreach of the ninethree months ended September 30, 2007March 31, 2008 and 2006, respectively.2007. Discovery’s effective tax rate differed from the federal income tax rate of 35% primarily due to the tax-free treatment of the disposition of the Travel Channel in 2007 and due to foreign and state taxestaxes.
Loss from discontinued operations.  Summarized financial information for the retail stores business included in 2006.discontinued operations is as follows (amounts in thousands):
     
  Three Months Ended
 
  March 31,
 
  2007 
 
Revenue $17,628 
Operating cash flow $(10,631)
Loss from discontinued operations before income taxes $(13,384)
Loss from discontinued operations, net of tax $(8,300)
 
Net Earnings.earnings.  Discovery’s net earnings were $246,090,000$105,218,000 and $167,139,000$43,114,000 for the ninethree months ended September 30,March 31, 2008 and 2007, and 2006, respectively. Such change isThe changes in net earnings are due to the other aforementioned fluctuations in revenue and expense.
Operating Division Results
As noted above, Discovery’s operations are divided into three groups: U.S. networks, international networks and commerce and education. Corporate expenses primarily consist of corporate functions, executive management and administrative support services. Corporate expenses are excluded from segment results to enable executive management to evaluate business segment performance based upon decisions made directly by business segment executives. Certain prior period amounts have been reclassified between segments to conform to Discovery’s 2008 operating structure.


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Discovery Consolidated
         
  Three Months Ended
 
  March 31, 
  2008  2007 
  amounts in thousands 
 
Revenue
        
U.S. networks $490,837   476,762 
International networks  266,885   216,647 
Commerce and education  24,510   23,131 
Corporate and eliminations  12,346   (6,342)
         
Total revenue $794,578   710,198 
         
Operating Cash Flow
        
U.S. networks $247,492   209,914 
International networks  69,307   27,415 
Commerce and education  44   (3,485)
Corporate and eliminations  (30,911)  (43,416)
         
Total operating cash flow $285,932   190,428 
         
Operating cash flow margin  36%  27%
         
U.S. Networks
         
  Three Months Ended
 
  March 31, 
  2008  2007 
  amounts in thousands 
 
Revenue
        
Advertising $238,792   234,611 
Distribution  223,996   225,905 
Other  28,049   16,246 
         
Total revenue  490,837   476,762 
Cost of revenue  (124,965)  (152,843)
SG&A expenses  (118,380)  (114,005)
         
Operating cash flow $247,492   209,914 
         
Operating cash flow margin  50%  44%
         
As noted above, in May 2007, Discovery exchanged its subsidiary holding the Travel Channel, travelchannel.com and approximately $1.3 billion in cash for Cox’s interest in Discovery. Accordingly, Discovery’s 2008 results of operations do not include Travel Channel. The disposal of Travel Channel does not meet the requirements for discontinued operations presentation. The following table presents U.S. networks results of operations excluding Travel Channel for all periods. This presentation is not in accordance with GAAP. However, Discovery


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believes this presentation provides a more meaningful comparison of the U.S. networks results of operations and allows the reader to better understand the U.S. networks ongoing operations.
U.S. Networks without Travel Channel
         
  Three Months Ended
 
  March 31, 
  2008  2007 
  amounts in thousands 
 
Revenue
        
Advertising $238,792   208,972 
Distribution  223,996   211,338 
Other  28,049   15,544 
         
Total revenue  490,837   435,854 
Cost of revenue  (124,965)  (134,524)
SG&A expenses  (118,380)  (101,079)
         
Operating cash flow $247,492   200,251 
         
Operating cash flow margin  50%  46%
         
The following discussion excludes the results of Travel Channel for all periods.
Revenue.  For the three months ended March 31, 2008, advertising revenue increased 14%, distribution revenue increased 6%, and other revenue increased 80%, as compared to the corresponding prior year period. The increase in advertising revenue at the U.S. networks was primarily due to higher cash sellouts and scatter market rate increases across most networks. Distribution revenue was driven by a 5% increase in average paying subscription units, principally from networks carried on the digital tier, combined with annual contractual rate increases for the fully distributed networks. Contra revenue items included in distribution revenue, such as launch amortization and marketing consideration, totaled $21,328,000 and $21,057,000 for the three months ended March 31, 2008 and 2007, respectively. U.S. networks is currently in negotiations to renew distribution agreements for carriage of its networks involving a substantial portion of its subscribers. A failure to secure a renewal or a renewal on less favorable terms may have a material adverse effect on U.S. networks results of operations and financial position. Other revenue increased primarily from Discovery’s representation of the Travel Channel and the acquisition of How Stuff Works in December 2007.
Cost of revenue.  For the three months ended March 31, 2008, cost of revenue decreased $9,559,000 or 7%, as compared to the corresponding prior year period, primarily due to a decrease in content amortization expense of $13,863,000. The decrease in content amortization expense was primarily a result of the effect of the $129,091,000 content impairment charge recorded in 2007 which drove a $17,702,000 decrease in content amortization expense for the three months ended March 31, 2008 as compared to the corresponding prior year period. Partially offsetting this reduction is new content amortization expense for programming that began to air during the three months ended March 31, 2008. Starting in the second quarter of 2008, additional content amortization expense is expected from the launch of new programming on most networks and the rebranding of certain networks.
SG&A expenses.  SG&A expenses increased $17,301,000 or 17% for the three months ended March 31, 2008, as compared to the corresponding prior year period. The increase is primarily driven by $10,812,000 of expenses related to the continued investment in digital media, including acquisitions from the third and fourth quarters of 2007, and a $3,690,000 impact related to the expansion of network teams to support the re-branding strategies for Planet Green and Investigation Discovery.
Digital Media Business.  U.S. networks digital media business revenue was $12,259,000 and $5,756,000 for the three months ended March 31, 2008 and 2007, respectively, and is included in total U.S. networks revenue. Operating expenses for these businesses were $22,241,000 and $8,926,000 for the three months ended March 31, 2008 and 2007, respectively. Discovery expects to continue to invest in digital media due to its recent acquisitions of


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PetFinder.com, TreeHugger.com and HowStuffWorks.com, as well as any future organic investments in this arena, with operating cash flow losses remaining below 5% of Discovery’s consolidated operating cash flow.
International Networks
         
  Three Months Ended
 
  March 31, 
  2008  2007 
  amounts in thousands 
 
Revenue
        
Advertising $65,295   55,067 
Distribution  178,687   143,974 
Other  22,903   17,606 
         
Total revenue  266,885   216,647 
Cost of revenue  (102,049)  (95,345)
SG&A expenses  (95,529)  (93,887)
         
Operating cash flow $69,307   27,415 
         
Operating cash flow margin  26%  13%
         
Revenue.  Distribution revenue increased 24%, or $34,713,000, for the three months ended March 31, 2008, as compared to the corresponding prior year period, principally comprised of combined revenue growth in Europe, Latin America and Asia of $22,063,000 and a favorable foreign exchange impact of $10,765,000. The increase in revenue resulted from increases in average paying subscription units of 15% primarily due to pay TV subscriber growth in many markets in Europe, combined with contractual rate increases in certain markets. Advertising revenue increased 19%, or $10,228,000, for the three months ended March 31, 2008, primarily due to higher viewership in Europe combined with an increased subscriber base in most markets worldwide and favorable foreign exchange impacts of $3,564,000. Other revenue increased 30%, or $5,297,000, primarily due to growth at Antenna Audio.
Cost of revenue.  Cost of revenue increased 7%, or $6,704,000, for the three months ended March 31, 2008, as compared to the corresponding prior year period, driven by an $8,907,000 increase in content amortization expense due to continued investment in original productions and language customization to support additional local feeds for growth in local ad sales. In addition, Discovery recognized $60,532,000transponder costs were $2,488,000 higher than the corresponding prior year period due to additional feeds in Europe. These increases were partially offset by reduced spending and $24,473,000efficiencies in production operations of net$4,711,000.
SG&A expenses.  SG&A expenses increased 2%, or $1,642,000, for the three months ended March 31, 2008, as compared to the corresponding prior year period. The increase is primarily due to an increase in personnel costs of $5,013,000 which includes an unfavorable foreign exchange impact of $2,040,000, offset by decreases in marketing and other general expenses.
For the three months ended March 31, 2008 and 2007, the international networks revenue and operating cash flow were impacted favorably by changes in the exchange rates of various foreign currencies. In the event the U.S. dollar strengthens against certain foreign currencies in the future, the international networks group’s revenue and operating cash flow will be negatively impacted. Had there been no impact from changes in exchange rates, international networks would have increased revenue by 15% instead of 23% and operating expenses would have remained relatively flat during the three months ended March 31, 2008, as compared to 2007.


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Commerce and Education
         
  Three Months Ended
 
  March 31, 
  2008  2007 
  amounts in thousands 
 
Revenue $24,510   23,131 
Cost of revenue  (12,336)  (12,560)
SG&A expenses  (12,130)  (14,056)
         
Operating Cash Flow $44   (3,485)
         
Operating cash flow margin  0%  (15)%
         
Revenue.  Commerce and education revenue increased 6% for the three months ended March 31, 2008, as compared to the corresponding prior year period, primarily due to an increase in commerce revenue which was driven by continued DVD sales of Planet Earth, along with other popular series such as Human Body, Body Atlas and Dirty Jobs. Education revenue improved slightly as a result of increased streaming and other revenue driven by further penetration of core streaming businesses and new products offset by a decrease in other non-digital services.
Cost of revenue.  Cost of revenue was relatively flat for the three months ended March 31, 2008, as compared to the corresponding prior year period, but decreased slightly as a percentage of revenue due to lower content amortization.
SG&A expenses.  SG&A expenses decreased $1,926,000 or 14% for the three months ended March 31, 2008, as compared to the corresponding prior year period, primarily due to a legal settlement occurring in the first quarter of 2007.
Corporate
Corporate operating cash flow losses decreased $12,505,000 or 29% for the three months ended March 31, 2008, as compared to the corresponding prior year period, primarily due to increased ancillary revenue from discontinued operations for eacha joint venture primarily due to an unprecedented level of seasonal sales driven by the success of the nine months ended September 30,Planet Earth programming in 2007, and 2006, respectively. The 2007 net loss contains $39,904,000which is not expected to continue at the same level. Corporate costs decreased 2% driven by a reduction in restructuring costs and $28,264,000 in asset impairment charges, along with normal business operations.headcount from corporate restructurings which occurred throughout 2007.
 
Liquidity and Capital Resources
 
Discovery’s principal sources of liquidity are cash flows from operations and borrowings under its credit facility, and its principal uses of cash are for capital expenditures, acquisitions, debt service requirements, and other obligations. Discovery provided $126,043,000anticipates that its operating cash flows, existing cash, cash equivalents and $270,606,000borrowing capacity under its revolving credit facility are sufficient to meet its anticipated cash requirements for at least the next 12 months.
During the three months ended March 31, 2008, Discovery’s primary uses of cash were principal payments under its bank facilities and senior notes totaling $190,500,000, capital expenditures of $13,955,000, and payments under its LTIP of $12,411,000. Discovery funded these investing and financing activities with cash from operations during the nine months ended September 30, 2007of $68,951,000 and 2006, respectively. Included in cash from operations was $209,289,000 and $33,729,000bank borrowings of deferred launch payments for the nine months ended September 30, 2007 and 2006, respectively, driving a significant use of cash during 2007.


I-24

During the nine months ended September 30, 2007, Discovery spent $55,317,000 on capital expenditures, $44,000,000 to acquire mandatorily redeemable securities related to minority interests in certain subsidiaries, and paid $1,321,544,000 in connection with the Cox Transaction. During the nine months ended September 30, 2006, Discovery paid $179,019,000 for business combinations, net of the cash acquired, paid $80,000,000 to acquire mandatorily redeemable securities related to minority interests in certain subsidiaries and spent $40,109,000 on capital expenditures.$165,500,000.
 
In addition to cash provided by operations, Discovery funds its activities with proceeds borrowed underDiscovery’s various debt facilities includinginclude two term loans, two revolving loan facilities and various senior notes payable. The second term loan was issuedentered into on May 14, 2007 for $1.5 billion in connection with the Cox Transaction. During the nine months ended September 30, 2007 and 2006, net borrowings under debt facilities were $1,331,909,000 and $71,909,000, respectively. Total commitments of these facilities were $5,590,000,000$5,445,000,000 at September 30, 2007.March 31, 2008. Debt outstanding on these facilities aggregated $3,946,300,000$4,078,501,000 at September 30, 2007,March 31, 2008, providing excess debt availability of $1,643,700,000.$1,366,499,000. 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.
 
TheDiscovery’s $1.5 billion term loan is secured by the assets of Discovery, excluding assets held by its subsidiaries. The remaining term andloan, revolving loans and senior notes are unsecured. The debt facilities contain


I-27

covenants that require the respective borrowers 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 that it iswas in compliance with all debt covenants at September 30, 2007.as of March 31, 2008.
 
During 2007,In 2008, including amounts discussed above, Discovery expects its uses of cash to spend up to $100,000,000be approximately $266,285,000 for debt repayments, $90,000,000 for capital expenditures $250,000,000and $260,000,000 for interest expenseexpense. Discovery will also be required to make payments under its current debt facilities,LTIP Plan. However, amounts expensed and payable under the LTIP are dependent on future annual calculations of unit values which are affected primarily by changes in DHC’s stock price, annual grants of additional units, redemptions of existing units, and changes to the plan. If the remaining vested LTIP awards at March 31, 2008 were redeemed, the aggregate cash payments by Discovery would be approximately $250,000,000 for the announced acquisition of HowStuffWorks.com and $85,000,000 to satisfy LTIP obligations.$65,610,000. Discovery believes that its cash flow from operations and borrowings available under its credit facilities will be sufficient to fund its working capital requirements.cash requirements, including LTIP obligations.
 
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.
Discovery is subject to a contractual agreement that may require Discovery to acquire the minority interest of certain of its subsidiaries. The right of the minority partner to put its interest back to Discovery for a value determined by a specified formula every three years commenced on December 31, 2002. Discovery accretes the mandatorily redeemable equity in a subsidiary to its estimated redemption value through the applicable redemption date. The most recent put right has been exercisable since December 2005. During 2006, Discovery was notified that the minority partner was evaluating whether to execute its rights under the agreement. As of September 30, 2007, the minority partner had not advised Discovery of its intention. Discovery is now accreting this minority interest to the December 2008 redemption date and estimates the redemption value to be $48 million as of September 30, 2007.
 
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.


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Item 4.Controls and Procedures
 
In accordance with Exchange ActRules 13a-15 and15d-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 September 30, 2007March 31, 2008 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 identified in connection with the evaluation described above that occurred during the ninethree months ended September 30, 2007March 31, 2008 that has materially affected, or is reasonably likely to materially affect, its internal controls over financial reporting.


I-26I-28

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 onForm 10-K, as amended, filed on February 28, 2007.15, 2008.
 
Item 6.Exhibits
 
(a)  Exhibits
(a) Exhibits
 
     
 10.1 Discovery Holding Company 2005 Incentive Plan (As Amended and Restated Effective August 15, 2007)*
 10.2 Discovery Holding Company 2005 Non-Employee Director Incentive Plan (As Amended and Restated Effective August 15, 2007)*
 10.3 Discovery Holding Company Transitional Stock Adjustment Plan (As Amended and Restated Effective August 15, 2007)*
 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*
     
 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**
 
 
*Filed herewith.
**Furnished herewith.


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: November 7, 2007May 8, 2008 By: 
/s/  John C. Malone

John C. Malone
Chief Executive Officer
     
Date: November 7, 2007May 8, 2008 By: 
/s/  David J.A. Flowers

David J.A. Flowers
Senior Vice President and Treasurer
(Principal Financial Officer)
     
Date: November 7, 2007May 8, 2008 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 ofRegulation S-K):
 
     
 10.1 Discovery Holding Company 2005 Incentive Plan (As Amended and Restated Effective August 15, 2007)*
 10.2 Discovery Holding Company 2005 Non-Employee Director Incentive Plan (As Amended and Restated Effective August 15, 2007)*
 10.3 Discovery Holding Company Transitional Stock Adjustment Plan (As Amended and Restated Effective August 15, 2007) *
 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*
     
 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**
 
 
*Filed herewith.
**Furnished herewith.