ITEM 1. BUSINESS.
(a) General Development of Business
Liberty Media Corporation is a holding company which, through its ownership of interests in subsidiaries and other companies, is primarily engaged in (i) electronic retailing, (ii) international cable television distribution, telephony and programming, and (iii) the production, acquisition and distribution through all available formats and media of branded entertainment, educational and informational programming and software. In addition, companies in which we own interests are engaged in, among other things, (i) interactive commerce via the Internet, television and telephone, (ii) domestic cable and satellite broadband distribution services, and (iii) wireless domestic telephony and other technology ventures. Through our affiliated companies we operate in the United States, Europe, South America and Asia. Our principal assets include interests in QVC, Inc., Starz Encore Group LLC, Ascent Media Group, Inc., Discovery Communications, Inc., UnitedGlobalCom, Inc., Jupiter Telecommunications Co., Ltd., Court Television Network, Game Show Network, InterActiveCorp and The News Corporation Limited.
From March 9, 1999 through August 9, 2001 we were a wholly-owned subsidiary of AT&T Corp. On March 9, 1999, AT&T acquired by merger our parent company at that time, the former Tele-Communications, Inc. ("TCI"), which was converted to a limited liability company and renamed AT&T Broadband, LLC. As part of that merger, AT&T issued its Class A and Class B Liberty Media Group tracking stock, which was designed to reflect the economic performance of the businesses and assets of AT&T attributed to its "Liberty Media Group." Our businesses and assets constituted all of the businesses and assets of Liberty Media Group.
Effective August 10, 2001, AT&T effected our split-off pursuant to which our common stock was recapitalized, and each share of AT&T Class A Liberty Media Group tracking stock was redeemed for one share of our Series A common stock, and each share of AT&T Class B Liberty Media Group tracking stock was redeemed for one share of our Series B common stock.
Following the split off, we are no longer a subsidiary of AT&T and no shares of AT&T Liberty Media Group tracking stock remain outstanding.
RECENT DEVELOPMENTS
In March and April of 2003, we issued an aggregate principal amount of $1,750 million of 0.75% Senior Exchangeable Debentures due 2023 for net cash proceeds of $1,715 million after expenses. Each $1,000 debenture is exchangeable at the holder's option for the value of 57.4079 shares of Time Warner Inc. common stock. We may, at our election, pay the exchange value in cash, Time Warner Inc. common stock, shares of our Series A common stock or a combination thereof. In addition, in April 2003, we issued $1,000 million principal amount of 5.70% Senior Notes due 2013 for net cash proceeds of $990 million.
During 2003, pursuant to contractual pre-emptive rights, we acquired approximately 48.7 million shares of InterActiveCorp for cash consideration of approximately $1,166 million. We also increased our economic and voting interest in News Corp. during 2003 and the first quarter of 2004. We now own 210.8 million non-voting News Corp. American Depository Shares and 48 million voting ADSs representing approximately 17% of News Corp.'s equity and a 9% voting interest.
On September 17, 2003, we completed our acquisition of Comcast Corporation's approximate 56.5% ownership interest in QVC, Inc for approximately $7.9 billion comprised of cash, Floating Rate Senior Notes and shares of our Series A common stock. QVC markets and sells a wide variety of consumer products and accessories primarily by means of televised shopping programs on the QVC network and via the Internet through QVC.com. Prior to this acquisition, we owned approximately 41.7% of QVC. The QVC management team continues to own the approximate 2% of QVC that we do not own.
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During the third and fourth quarters of 2003, we exchanged shares of our Series A common stock for all of the publicly held shares of the outstanding common stock of Ascent Media Group, Inc., Liberty Satellite & Technology, Inc., and On Command Corporation. The aggregate value, for accounting purposes, of the Series A common stock that we issued in these acquisitions was approximately $42 million.
In November 2003, we announced our intention to reduce our outstanding debt balance by approximately $4.5 billion over the next two years. We initiated the debt reduction plan during the fourth quarter of 2003 by using cash on hand and proceeds from the sale of certain non-strategic public holdings, including all of our shares of Vivendi Universal and Cendant Corporation, to (i) redeem $1.0 billion of floating rate notes that had been issued to Comcast, (ii) repay over $930 million of outstanding bank debt of our wholly-owned subsidiaries and (iii) retire approximately $578 million of other outstanding corporate indebtedness. We expect that the $2.0 billion reduction planned for the next two years ($1.0 billion in 2004 and $1.0 billion in 2005) will be funded with a combination of free cash flow from existing businesses, cash on hand, proceeds from equity collar expirations and dispositions of non-strategic assets.
On September 3, 2003, United Pan-Europe Communications N.V. (or UPC), a consolidated subsidiary of UnitedGlobalCom, Inc. (or UGC), completed a restructuring of its debt and emerged from bankruptcy. Under the terms of the restructuring, approximately $5.4 billion of UPC's debt was exchanged for equity of UGC Europe, Inc., a new holding company of UPC. Upon consummation of the restructuring, UGC received approximately 65.5% of UGC Europe's equity in exchange for UPC debt securities that it owned; third-party noteholders received approximately 32.5% of UGC Europe's equity, and existing preferred and ordinary shareholders, including UGC, received 2% of UGC Europe's equity.
On December 18, 2003, UGC completed its offer to exchange shares of its Class A common stock for the outstanding shares of UGC Europe common stock that it did not already own. Upon completion of the exchange offer, UGC owned 92.7% of the outstanding shares of UGC Europe common stock. On December 19, 2003, UGC effected a "short-form" merger with UGC Europe. In the short-form merger, each share of UGC Europe common stock not tendered in the exchange offer was converted into the right to receive the same consideration offered in UGC's earlier exchange offer, and UGC acquired the remaining 7.3% of UGC Europe.
On January 5, 2004, the holders of all of UGC's 8,198,016 outstanding shares of Class B common stock transferred their Class B shares to us in exchange for 12,576,968 shares of our Series A common stock and a cash payment of approximately $13 million. We refer to this transaction as the "founders transaction." The combination of the Class B shares acquired in the founders transaction with the shares of UGC's Class A and Class C common stock already owned by us, our recent exercise of preemptive rights to acquire additional shares of UGC's Class A common stock and our participation in UGC's recent rights offering results in our ownership of approximately 55% of UGC's outstanding common stock, which represents approximately 92% of the outstanding voting power of UGC. As a result of the founders transaction, the restrictions set forth in certain stockholders agreements and standstill agreements to which we were a party terminated, and we now have the power to elect all of the members of UGC's board of directors and, generally, to control UGC. In connection with the consummation of the founders transaction, we entered into a new standstill agreement with UGC that provides that we may not acquire more than 90% of UGC's outstanding common stock unless we make an offer or effect another transaction to acquire all of the outstanding common stock of UGC not already owned by us. Under certain circumstances, such an offer or transaction would require an independent appraisal to establish the price to be paid to stockholders unaffiliated with Liberty. In addition, we are entitled to preemptive rights with respect to certain issuances of UGC common stock.
Our Board of Directors has approved a resolution authorizing us to take the necessary actions to effect the spin-off of assets principally comprised of our International Group as a tax free distribution to our shareholders. The completion of this transaction is subject to, among other things, a final determination of the assets to be included in the spin-off, the receipt of a favorable tax opinion and regulatory and other third party approvals. Upon completion of this transaction, the International Group will be a separate publicly traded company.
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* * * * *
Certain statements in this Annual Report on Form 10-K constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. To the extent that statements in this Annual Report are not recitations of historical fact, such statements constitute forward-looking statements which, by definition, involve risks and uncertainties. In particular, statements under Item 1. "Business," Item 2.
ITEM 2. PROPERTIES
We own our corporate headquarters in Englewood, Colorado. All of our other real or personal property is owned or leased by our subsidiaries and business affiliates.
QVC owns its corporate headquarters and operations center in West Chester, Pennsylvania. It also owns call centers in San Antonio, Texas, Port St. Lucie, Florida, Chesapeake, Virginia and Bochum, Germany, as well as a call center and warehouse in Knowsley, United Kingdom. QVC owns a warehouse in Hucklehoven, Germany and distribution centers in Lancaster, Pennsylvania, Suffolk, Virginia and Rocky Mount, North Carolina. QVC leases outlet space throughout the United States and the United Kingdom, office space in London, Japan and Germany and a warehouse in Japan.
Starz Encore owns its corporate headquarters in Englewood, Colorado. In addition, Starz Encore leases office space for its sales staff at 10 locations throughout the United States.
Ascent Media owns or leases over 100 facilities. Domestically, Ascent Media leases facilities with approximately 975,000 square feet and owns facilities with approximately 360,000 square feet. Outside of the United States, Ascent Media leases facilities with approximately 250,000 square feet and owns facilities with 50,000 square feet. Nearly all of Ascent Media's facilities are built specifically for their technical and creative service operations.
On Command leases its corporate headquarters in Denver, Colorado; and has leased 77,000 square feet and 131,000 square feet of light manufacturing and storage space in Denver, Colorado and San Jose,
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California, respectively. On Command also has a number of small leases throughout the United States, Canada and Mexico.
Our other subsidiaries and business affiliates own or lease the fixed assets necessary for the operation of their respective businesses, including office space, transponder space, headends, cable television and telecommunications distribution equipment, telecommunications switches and customer equipment (including converter boxes). Our management believes that our current facilities are suitable and adequate for our business operations for the foreseeable future.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Klesch & Company Limited v. Liberty Media Corporation, John C. Malone and Robert R. Bennett. On September 4, 2001, we entered into agreements with Deutsche Telekom AG pursuant to which we would purchase its entire interest in six of nine regional cable television companies in Germany. In February 2002, we failed to receive regulatory approval for our proposed acquisition. On July 27, 2001, Klesch & Company Limited initiated a lawsuit against us, our chairman, John C. Malone, and our chief executive officer, Robert R. Bennett, in the United States District Court for the District of Colorado alleging, among other things, breach of fiduciary duty, fraud and breach of contract in connection with actions alleged to have been taken by us with respect to what then was a proposed transaction with Deutsche Telekom. Klesch is seeking damages in an unspecified amount. We believe all such claims to be without merit and, together with Messrs. Malone and Bennett, have filed an answer denying any liability to Klesch. We also have asserted counterclaims against Klesch seeking, among other things, a declaratory judgment to the effect that because Klesch has breached and repudiated an agreement that we entered into with Klesch in June 2001, we are relieved of any obligations that we might have to Klesch under that agreement. Those obligations would include, among other things, the obligation in certain events to pay to Klesch, as its sole compensation, fees equal to 3% of the value of specified assets acquired by us from Deutsche Telekom before the second anniversary of the date of that agreement, subject to an aggregate cap of Euro 165 million. Klesch has filed a reply denying all our counterclaims. In September 2002, we asserted counterclaims against Klesch's principal owner, A. Gary Klesch, alleging fraud and negligent misrepresentation. Mr. Klesch has filed a motion to dismiss the counterclaims, alleging lack of personal jurisdiction. The parties have completed their discovery, and a jury trial is scheduled to commence on September 7, 2004.
Liberty Digital, Inc. v. AT&T Broadband, LLC and Comcast Corporation. In November 1997, our subsidiary, Liberty Digital, Inc. (then known as TCI Music, Inc.), entered into an amended and restated contribution agreement with AT&T Broadband (then known as Tele-Communications, Inc.). That agreement, which was effective as of July 11, 1997, provides for the making of monthly payments by AT&T Broadband over a 20-year term, at the annual rate of $18 million, adjusted for increases in the consumer price index. The amended and restated agreement replaced a prior agreement that had been entered into in connection with Liberty Digital's acquisition of DMX Inc. In that acquisition, DMX shareholders received Liberty Digital shares and the right to require AT&T Broadband to purchase those shares upon satisfaction of specified conditions. In addition to granting those put rights, AT&T Broadband also agreed to cause its cable system subsidiaries to assign to Liberty Digital all revenue from the distribution of DMX music services to AT&T Broadband's customers. AT&T Broadband received 62.5 million shares of Liberty Digital common stock and a $40 million note payable by Liberty Digital in exchange for granting the put rights and causing its subsidiaries to make the revenue assignment.
The amended and restated contribution agreement modified the prior agreement in various respects, including, among others, limiting the category of revenue assigned by the TCI cable system subsidiaries to analog distribution revenue, imposing a requirement for payments in a fixed amount, subject to cost-of-living increases, and setting a term during which such payments would be required. The amended and restated agreement was entered into in connection with our acquisition of substantially all of AT&T Broadband's Liberty Digital stock in exchange for an $80 million promissory note and our agreement to assume AT&T Broadband's obligations with respect to the put rights granted to DMX shareholders, together with other agreements among the parties or their affiliates.
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AT&T Broadband made all the monthly payments required under the amended and restated contribution agreement until its combination with Comcast Corporation in November 2002, when it ceased to make any of the required payments. On January 8, 2003, Liberty Digital filed a lawsuit against AT&T Broadband and Comcast Corporation in district court in Arapahoe County, Colorado, seeking, among other things, damages for breach of contract, intentional interference with contractual relations and a declaratory judgment to the effect that the amended and restated contribution agreement is valid and binding. On March 5, 2003, the defendants filed an answer denying all of Liberty Digital's claims. The parties are engaged in discovery and the matter has been set for trial in June 2004.
Liberty Digital will vigorously prosecute its claims against AT&T Broadband and Comcast Corporation and believes that it will be successful in enforcing its rights under the amended and restated contribution agreement. There is, however, no assurance that Liberty Digital will achieve a favorable result in this litigation.
Dr. Leo Kirch, Individually and as assignee, KGL Pool GmBH, and International Television Trading Corp. v. Liberty Media Corporation, John Malone, Deutsche Bank, AG, and Dr. Rolf-Ernst Breuer. Dr. Kirch is the primary owner of KirchGroup, a German cable television and media conglomerate. In 2001 and 2002, a series of transactions led to the collapse of KirchGroup's control of much of the German cable market. On September 4, 2001, we entered into agreements with Deutsche Telekom AG pursuant to which we would purchase its entire interest in six of nine regional cable television companies in Germany. In February 2002, we failed to receive regulatory approval for our proposed acquisition and the transactions with Deutsche Telekom were never consummated. On January 14, 2004, Dr. Kirch, KGL Pool GBH, and International Television Trading Corp. added our company, and our chairman, John C. Malone, to a lawsuit they had initiated against Deutsche Bank and Dr. Breuer on February 3, 2003. The lawsuit, which is pending in the United States District Court for the Southern District of New York, is alleging, among other things, interference with contract, and interference with prospective economic advantage arising from an alleged conspiracy among our company, Dr. Malone, Deutsche Bank and Dr. Breuer pursuant to which we allegedly effected the transactions that led to the collapse of the KirchGroup's control of the German cable market in an effort to facilitate our agreements with Deutsche Telekom. Dr. Kirch, KGL Pool and International Television are seeking damages in an unspecified amount. We believe all such claims to be without merit and, together with Dr. Malone, have filed a motion to dismiss, on which the court has not yet ruled.
Liberty Media Corporation v. National Broadcasting Company. In 1988, Tele-Communications, Inc. (TCI) and its subsidiaries entered into a series of related agreements with National Broadcasting Company (NBC) regarding the Consumer News and Business Channel (CNBC), a programming service created and produced by NBC. Pursuant to the agreements, Satellite Services, Inc., a wholly-owned subsidiary of TCI, agreed to provide distribution of the CNBC service over cable systems controlled by TCI. In a separate agreement, NBC agreed to make quarterly payments to TCI equal to 6% of CNBC's annual gross revenues that exceed $80 million. NBC's payment obligations are conditioned on, among other things, carriage of the CNBC service by qualifying cable systems serving a minimum number of subscribers.
TCI assigned to us its rights to receive payments from NBC in 1995. In 1999, TCI merged with AT&T Corp. and we became a wholly-owned subsidiary of AT&T Broadband LLC, the successor to TCI. In 2001, we were split off by AT&T, taking with us the right to receive payments from NBC based on CNBC's gross revenues. TCI's distribution obligations remained with AT&T Broadband until November 2002, when AT&T Broadband combined with Comcast Corporation.
On February 14, 2003, NBC informed us that it would begin to reduce its quarterly payments with respect to the CNBC service. NBC alleged that Comcast Corporation had unlawfully repudiated the distribution agreement it had inherited from AT&T Broadband, and that this repudiation entitled NBC to reduce its payments to us. We are not aware of any legal action that NBC has taken to remedy Comcast Corporation's alleged repudiation of the distribution agreement.
On February 10, 2004, we filed a complaint in the Delaware Superior Court against NBC to vindicate our contractual rights. NBC is expected to respond to our complaint by March 25, 2004. We will vigorously
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prosecute our claims against NBC and believe that we will be successful in enforcing our rights. There is, however, no assurance that we will achieve a favorable result in this litigation.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
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PART II.
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
We have two series of common stock, Series A and Series B, which trade on the New York Stock Exchange under the symbols L and LMC.B, respectively. The following table sets forth the range of high and low sales prices of shares of our Series A and Series B common stock for the years ended December 31, 2003 and 2002.
As of January 30, 2004, there were approximately 12,000 and 400 record holders of our Series A common stock and Series B common stock, respectively (which amounts do not include the number of shareholders whose shares are held of record by banks, brokerage houses or other institutions, but include each such institution as one shareholder).
We have not paid any cash dividends on our Series A common stock and Series B common stock, and we have no present intention of so doing. Payment of cash dividends, if any, in the future will be determined by our Board of Directors in light of our earnings, financial condition and other relevant considerations.
On November 28, 2003, we acquired all of the outstanding stock of TP Investment, Inc. in exchange for 5,281,739 shares of our Series B Common Stock. TP Investment is a corporation that, prior to the acquisition, was wholly owned by a limited liability company in which the sole member is John C. Malone, the chairman of our board of directors. The agreed value of the TP Investment stock acquired was $60,740,000. We believe this transaction was exempt from the registration requirements of the Securities Act by virtue of Section 4(2) of the Securities Act since it was not a public offering.
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ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The following tables present selected historical information relating to our financial condition and results of operations for the past five years. The following data should be read in conjunction with our consolidated financial statements. We were a wholly-owned subsidiary of Tele-Communications, Inc. from August 1994 to March 9, 1999. On March 9, 1999, AT&T Corp. acquired TCI in a merger transaction. For financial reporting purposes, the AT&T Merger is deemed to have occurred on March 1, 1999. In connection with the merger, our assets and liabilities were adjusted to their respective fair values pursuant to the purchase method of accounting. Selected financial data for the two months ended February 28, 1999 has been excluded from the following table.
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(1) On September 17, 2003, we completed our acquisition of Comcast Corporation's approximate 56.5% ownership in QVC, Inc. for approximately $7.9 billion, comprised of cash, Floating Rate Senior Notes and shares of our Series A common stock. When combined with our previous ownership of approximately 41.7% of QVC, we owned 98.2% of QVC upon consummation of the transaction, which is deemed to have occurred on September 1, 2003, and we have consolidated QVC's financial position and results of operations since that date.
(2) Effective January 1, 2002, we adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, which among other matters, provides that goodwill and other indefinite-lived assets no longer be amortized. Amortization expense for such assets aggregated $627 million, $598 million and $438 million for the years ended December 31, 2001 and 2000 and the ten months ended December 31, 1999, respectively.
(3) Included in share of losses of affiliates are other-than-temporary declines in value aggregating $84 million, $148 million and $2,396 million for the years ended December 31, 2003, 2002, and 2001, respectively. In addition, share of losses of affiliates includes excess basis amortization of $798 million, $1,058 million and $463 million for the years ended December 31, 2001, 2000 and the ten months ended
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December 31, 1999, respectively. Pursuant to Statement 142, excess costs that are considered equity method goodwill are no longer amortized, but are evaluated for impairment under APB Opinion No. 18.
(4) The basic and diluted net earnings (loss) per common share for periods prior to August 10, 2001, the date of our split off from AT&T, is based upon 2,588 million shares of our Series A and Series B common stock issued upon consummation of the split off.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
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 consolidated financial statements and the notes thereto.
OVERVIEW
We are a holding company that owns majority and minority interests in a broad range of electronic retailing, video programming, broadband distribution and other communications companies. During the second half of 2003, we started changing our corporate focus to control more of our affiliated companies. The first step in this process was our September 2003 acquisition of Comcast Corporation's approximate 56% ownership interest in QVC, Inc., which when combined with our previous 42% ownership interest, gave us over 98% control of QVC, and we now consolidate the financial position and results of operations of QVC. In January 2004, we acquired all of the outstanding shares of Class B common stock of UnitedGlobalCom, Inc. from UGC's founding shareholders. Previously in December 2003, UGC completed the acquisition of all of the outstanding shares of UGC Europe, Inc. that it did not already own. As a result of these two transactions and our exercise of certain pre-emptive rights, UGC owns 100% of the outstanding common stock of UGC Europe and we own approximately 55% of the outstanding common stock of UGC representing approximately 92% of the voting power of UGC's shares. We began consolidating the operations of UGC effective January 1, 2004. In the fourth quarter of 2003, to further align our corporate structure with our operating assets, we organized our businesses into four Groups: Interactive Group, International Group, Networks Group and Corporate and Other. See "Business -- Narrative Description of Business" included in Part I of this Annual Report on Form 10-K for a description of the more significant businesses in each of these Groups.
Our primary businesses in the Interactive Group are QVC and Ascent Media Group, Inc. In addition, we own approximately 20% of InterActiveCorp, which we account for as an available-for-sale security. In evaluating the prospects and risks for QVC, our primary focus is currently on the following: potential opportunities to expand the QVC footprint in international markets, and new domestic marketing concepts to capitalize on the growing Internet market. During 2003, the growth in QVC's domestic revenue leveled off, as compared to recent years. During 2004, our goal will be to continue QVC's international expansion by increasing (1) the number of customers who have access to and use our service and (2) the average sales per customer. In addition we hope to find new opportunities for domestic growth, including Internet sales.
Our primary businesses in the International Group are UGC, which provides broadband services primarily in Europe; Jupiter Telecommunications ("J-COM"), which provides broadband services in Japan and Jupiter Programming ("JPC"), which provides video programming in Japan, all of which were equity affiliates at December 31, 2003. Our consolidated subsidiaries in the International Group at December 31, 2003 are Liberty Cablevision of Puerto Rico and Pramer S.C.A. We believe our primary opportunities in our international markets include continued growth in subscribers; increasing the average revenue per unit by continuing to rollout telephony, Internet and digital video; developing foreign programming businesses, including international expansion of our domestic networks, to distribute over our broadband systems; and maximizing operating efficiencies on a regional basis. Potential impediments to achieving these goals include increasing price competition for broadband services; alternative video technologies; and available capital to finance the proposed rollout of new services.
Our primary businesses in the Networks Group are Starz Encore Group LLC, Discovery Communications, Inc., Courtroom Television Network, LLC and GSN (formerly, Game Show Network). In addition we own approximately 18% of The News Corporation Limited, which we account for as an
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available-for-sale security. We view the development of digital and interactive services, our ability to expand these networks and increase distribution over our international distribution footprint, as mentioned above, and our ability to increase advertising rates relative to broadcast networks and other cable networks as key opportunities for growth in the coming months and years. We face several key obstacles in our attempt to meet these goals, including: continued consolidation in the broadband and satellite distribution industries; the impact on viewer habits of new technologies such as video on demand and personal video recorders; and alternative movie and programming sources.
Certain of our subsidiaries and affiliates are dependent on the entertainment industry for entertainment, educational and informational programming. In addition, a significant portion of the revenue of certain of our subsidiaries and affiliates is generated by the sale of advertising on their networks. A prolonged downturn in the economy has had and could continue to have a negative impact on the revenue and operating income of these businesses. A slow economy could reduce (i) the development of new television and motion picture programming, thereby adversely impacting their supply of service offerings; (ii) consumer disposable income and consumer demand for their products and services; and (iii) the amount of resources allocated for network and cable television advertising by major corporations.
Our businesses that operate in countries other than the United States are subject to a number of risks including fluctuations in currency exchange rates and political unrest. In addition, the economies in many of the regions where our international businesses operate have recently experienced moderate to severe recessionary conditions, including among others, Argentina, Chile, the United Kingdom, Germany and Japan. These recessionary conditions have strained consumer and corporate spending and financial systems and financial institutions in these areas. As a result, our affiliates have experienced a reduction in consumer spending and demand for services.
In addition to the businesses included in the foregoing Groups, we continue to maintain significant investments in public companies such as Time Warner Inc., Viacom, Inc. and Sprint Corporation, which are accounted for as available-for-sale ("AFS") securities. We view these holdings as financial assets that we can monetize and deploy the resulting proceeds into any of our operating Groups.
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SUMMARY OF OPERATIONS
To assist you in understanding and analyzing our business in the same manner we do, we have organized the following discussion of our results of operations into two parts: Consolidated Operating Results, and Operating Results by Business Group. The Operating Results by Business Group section includes a discussion of the more significant businesses within each Group.
CONSOLIDATED OPERATING RESULTS
Revenue. Our consolidated revenue increased 93.3% and 1.2% in 2003 and 2002, respectively, as compared to the corresponding prior year. The 2003 increase is due primarily to QVC, which recognized $1,973 million of revenue since our acquisition in September. In addition, revenue for the Interactive Group increased $45 million due to our acquisition of OpenTV Corp. in August 2002 and decreased $30 million at Ascent Media. The Networks Group revenue decreased due primarily to a reduction in rates in former AT&T Broadband systems resulting from the re-negotiation of Starz Encore's affiliation agreement with Comcast in 2003. The increase in consolidated revenue in 2002 was primarily the net result of a 9.5% increase in Starz Encore's revenue partially offset by a 9.3% decrease in Ascent Media's revenue. See "Operating Results by Business Group" below for a more complete discussion of these fluctuations.
Operating Cash Flow. We define Operating Cash Flow as revenue less cost of sales, operating expenses and selling, general and administrative ("SG&A") expenses (excluding stock compensation). Our chief operating decision maker and management team use this measure of performance in conjunction with other measures applied on a Group by Group basis to evaluate our businesses and make decisions about allocating resources among our businesses. We believe this is an important indicator of the operational strength and performance of our businesses, including the ability to service debt and fund capital expenditures. In addition, this measure allows us to view operating results, perform analytical comparisons and benchmarking between businesses and identify strategies to improve performance. This measure of performance excludes such costs as depreciation and amortization, stock compensation and impairments of long-lived assets that are included
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in the measurement of operating income pursuant to general accepted accounting principles ("GAAP"). Accordingly, Operating Cash Flow should be considered in addition to, but not as a substitute for, operating income, net income, cash flow provided by operating activities and other measures of financial performance prepared in accordance with GAAP. See footnote 18 to the accompanying consolidated financial statements for a reconciliation of Operating Cash Flow to Earnings Before Income Taxes and Minority Interest.
Consolidated Operating Cash Flow increased 96.2% and 12.5% in 2003 and 2002, respectively, as compared to the corresponding prior year. The increase in 2003 is due primarily to our acquisition of QVC, which contributed $434 million to our consolidated Operating Cash Flow. This increase was partially offset by a decrease in our Corporate and Other Group, which resulted from lower revenue from ancillary sources and higher legal and consulting expenses. The 2002 increase is primarily the net effect of a $58 million increase in Starz Encore's Operating Cash Flow and lower corporate SG&A expenses of $28 million, partially offset by a $44 million operating cash flow deficit at OpenTV, which was acquired in 2002. The decrease in corporate SG&A expenses in 2002 resulted from the sale of certain business units in 2002 and expenses incurred in 2001 related to our split-off from AT&T Corp.
Stock compensation. Stock compensation includes compensation related to (1) options and stock appreciation rights for shares of our common stock that are granted to certain of our officers and employees, (2) phantom stock appreciation rights ("PSARs") granted to officers and employees of certain of our subsidiaries pursuant to private equity plans and (3) amortization of restricted stock grants. In connection with our rights offering in the fourth quarter of 2002 and pursuant to the antidilution provisions of the stock incentive plans we administer, the number of shares and the applicable exercise prices of all of our options were adjusted as of October 31, 2002, the record date for the rights offering. As a result of these modifications, all of our outstanding options are now accounted for as variable plan awards. The amount of expense associated with stock compensation is generally based on the vesting of the related stock options and stock appreciation rights and the market price of the underlying common stock, as well as the vesting of PSARs and the equity value of the related subsidiary. The decrease in stock compensation in 2003 is primarily a result of a decrease in the equity value of Starz Encore. The expense reflected in the table is based on the market price of the underlying common stock as of the date of the financial statements and is subject to future adjustment based on market price fluctuations, vesting percentages and, ultimately, on the final determination of market value when the options are exercised.
Depreciation and Amortization. The increase in depreciation in 2003 is due to increases in our depreciable asset base resulting from (1) the acquisition of QVC and (2) capital expenditures. The increase in amortization in 2003 is due primarily to the acquisition of QVC and amortization of the related intangible assets. Effective January 1, 2002, Liberty and its subsidiaries adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets. Statement 142 provides that goodwill and indefinite lived intangibles are no longer amortized, but are evaluated periodically for impairment. The decrease in amortization in 2002 is due to the adoption of Statement 142 and the resulting elimination of goodwill amortization.
Impairment of Long-lived Assets. Starz Encore received an independent third party valuation in connection with its annual year-end evaluation of the recoverability of its goodwill. The result of this valuation, which was based on a discounted cash flow analysis of projections prepared by the management of Starz Encore, indicated that the fair value of this reporting unit was less than its carrying value including goodwill. This reporting unit fair value was then used to calculate an implied value of the goodwill related to Starz Encore. The $1,352 million excess of the carrying amount of the goodwill (including $1,195 million of allocated enterprise-level goodwill) over its implied value has been recorded as an impairment charge in the fourth quarter of 2003. Starz Encore's operating income includes $157 million of the foregoing impairment charge and $1,195 million is included in Corporate and Other. The reduction in the value of Starz Encore reflected in the third party valuation is believed to be attributable to a number of factors. Those factors include the reliance placed in that valuation on projections by management reflecting a lower rate of revenue growth compared to earlier projections based, among other things, on the possibility that revenue growth may be negatively affected by (1) a reduction in the rate of growth in total digital video subscribers and in the subscription video on demand business as a result of cable operators' increased focus on the marketing and II-6
sale of other services, such as high speed internet access and telephony, and the uncertainty as to the success of marketing efforts by distributors of Starz Encore's services and (2) lower per subscriber rates under the new affiliation agreement with Comcast, as compared to the payments required under the 1997 AT&T Broadband Affiliation Agreement (including the programming pass through provision).
During the years ended December 31, 2002 and 2001, we determined that the carrying value of certain of our subsidiaries' assets exceeded their respective fair values. Accordingly, in 2002 we recorded impairments of goodwill related to OpenTV ($92 million), Ascent Media ($84 million), our Latin American consolidated and equity investments ($46 million), DMX Music ($44 million) and On Command Corporation ($9 million). Such impairments were calculated as the difference between the carrying value and the estimated fair value of the related assets. In 2001, we recorded impairments of (1) Ascent Media's property and equipment and goodwill of $313 million and (2) goodwill of $75 million primarily related to the devaluation of the Argentine peso and the impact of such devaluation on Pramer, our wholly-owned Argentine programming subsidiary.
Operating Income (Loss). Consolidated operating loss increased $772 million in 2003 and decreased $943 million in 2002, as compared to the corresponding prior year. The increase in 2003 is due to the impairment of Starz Encore's goodwill partially offset by the operating income of QVC from the date of its acquisition. The decrease in 2002 is due primarily to (1) our adoption of Statement 142 and the resulting elimination of amortization on indefinite lived intangible assets and goodwill, (2) a decrease in stock compensation expense and (3) lower impairment charges.
Other Income and Expense
Interest expense. Interest expense was $539 million, $423 million and $525 million, for the years ended December 31, 2003, 2002 and 2001, respectively, including $61 million, $7 million and $6 million, respectively, of accretion of our exchangeable debentures. The remaining increase in interest expense in 2003 is due primarily to an increase in our debt balance in 2003. The decrease in 2002 is due to a lower average debt balance in 2002 and lower interest rates on certain variable-rate subsidiary and parent company bank debt.
Dividend and interest income. Dividend and interest income was $189 million, $209 million and $272 million for the years ended December 31, 2003, 2002 and 2001, respectively. The 2002 decrease is the net effect of lower interest rates on invested cash balances, offset by increases due to dividends from our Vivendi Universal and News Corp. investments. In 2001, we also earned interest on certain debt securities that we purchased in the second and third quarter of 2001. The majority of these debt securities were contributed to UGC in January 2002. Interest and dividend income for the year ended December 31, 2003 was comprised of interest income earned on invested cash ($61 million), dividends on News Corp. American Depository Shares ("ADSs") ($40 million), dividends on ABC Family Worldwide preferred stock ($31 million) and other ($57 million).
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Investments in Affiliates Accounted for Using the Equity Method. Our share of earnings (losses) of affiliates was $58 million, ($453) million and ($4,906) million during the years ended December 31, 2003, 2002 and 2001, respectively. A summary of our share of losses of affiliates, including nontemporary declines in value and excess cost amortization, is included below:
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* No longer an equity affiliate
At December 31, 2003, the aggregate carrying amount of our investments in affiliates exceeded our proportionate share of our affiliates' net assets by $7,021 million. Prior to the adoption of Statement 142, this excess basis was being amortized over estimated useful lives of up to 20 years based on the useful lives of the intangible assets represented by such excess costs. Such amortization was $798 million for the year ended December 31, 2001, and is included in our share of losses of affiliates. Upon adoption of Statement 142, we discontinued amortizing equity method excess costs in existence at the adoption date due to their characterization as equity method goodwill. Also included in share of losses for the years ended December 31, 2003, 2002 and 2001, are adjustments for nontemporary declines in value aggregating $84 million, $148 million and $2,396 million, respectively. See "Operating Results by Business Group" below for a discussion of our more significant equity method affiliates.
Nontemporary declines in fair value of investments. During 2003, 2002 and 2001, we determined that certain of our cost investments experienced other-than-temporary declines in value. As a result, the cost bases of such investments were adjusted to their respective fair values based primarily on quoted market prices at the balance sheet date. These adjustments are reflected as nontemporary declines in fair value of investments in the consolidated statements of operations. The following table identifies such adjustments attributable to each of the individual investments as follows:
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Gains (losses) on dispositions. Aggregate gains (losses) from dispositions during the years ended December 31, 2003, 2002 and 2001, are comprised of the following.
In all of the above exchange transactions, the gains or losses were calculated based upon the difference between the carrying value of the assets relinquished, as determined on an average cost basis, compared to the fair value of the assets received. See notes 5 and 6 to the accompanying consolidated financial statements for a discussion of the foregoing transactions.
Realized and unrealized gains (losses) on derivative instruments. Realized and unrealized gains (losses) on derivative instruments during the years ended December 31, 2003, 2002 and 2001 are comprised of the following:
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(1) Comprised primarily of forward foreign exchange contracts and interest rate swap agreements.
During 2001 and 2002, we had designated our equity collars as fair value hedges. Pursuant to Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," the equity collars were recorded on the balance sheet at fair value, and changes in the fair value of the equity collars and of the hedged security were recognized in earnings. Effective December 31, 2002, we elected to dedesignate our equity collars as fair value hedges. This election had no impact on our financial position at December 31, 2002 or our results of operations for the year ended December 31, 2002. Subsequent to December 31, 2002, changes in the fair value of our available-for-sale securities that previously had been reported in earnings due to the designation of equity collars as fair value hedges are now reported as a component of other comprehensive income on our balance sheet. Changes in the fair value of the equity collars continue to be reported in earnings.
Income taxes. Our effective tax rate was not meaningful in 2003 and was 33% and 36% for the years ended December 31, 2002 and 2001, respectively. Although we had a loss before tax expense for book purposes in 2003, we recorded tax expense of $374 million primarily due to our impairment of goodwill, which
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is not deductible for tax purposes. In addition, we incurred state and foreign taxes and an increase in our valuation allowance for losses of subsidiaries that we do not consolidate for tax purposes. The effective tax rates in 2002 and 2001 differed from the U.S. Federal income tax rate of 35% primarily due to state and local taxes and amortization for book purposes that is not deductible for income tax purposes.
Cumulative effect of accounting change. We and our subsidiaries adopted Statement 142 effective January 1, 2002. Upon adoption, we determined that the carrying value of certain of our reporting units (including allocated goodwill) was not recoverable. Accordingly, in the first quarter of 2002, we recorded an impairment loss of $1,869 million, net of related taxes, as the cumulative effect of a change in accounting principle. This transitional impairment loss includes an adjustment of $325 million for our proportionate share of transition adjustments that our equity method affiliates have recorded.
Effective January 1, 2001, we adopted Statement 133, which established accounting and reporting standards for derivative instruments. All derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value. If the derivative is designated as a fair value hedge, the changes in the fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings. If the derivative is not designated as a hedge, changes in the fair value of the derivative are recognized in earnings.
The adoption of Statement 133 on January 1, 2001, resulted in a cumulative increase in net earnings of $545 million (after tax expense of $356 million) and an increase in other comprehensive loss of $87 million. The increase in net earnings was mostly attributable to separately recording the fair value of our embedded call option obligations associated with our senior exchangeable debentures. The increase in other comprehensive loss relates primarily to changes in the fair value of our warrants and options to purchase certain available-for-sale securities.
OPERATING RESULTS BY BUSINESS GROUP
The tables in this section present 100% of each business' revenue, operating cash flow and operating income even though we own less than 100% of many of these businesses. These amounts are combined on an unconsolidated basis and are then adjusted to remove the effects of the equity method investments to arrive at the consolidated amounts for each group. This presentation is designed to reflect the manner in which management reviews the operating performance of individual businesses within each group regardless of whether the investment is accounted for as a consolidated subsidiary or an equity investment. It should be noted, however, that this presentation is not in accordance with GAAP since the results of operations of equity method investments are required to be reported on a net basis. Further, we could not, among other things, cause any noncontrolled affiliate to distribute to us our proportionate share of the revenue or operating cash flow of such affiliate.
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The financial information presented below for equity method affiliates was obtained directly from those affiliates. We do not control the decision-making process or business management practices of our equity affiliates. Accordingly, we rely on the management of these affiliates and their independent auditors to provide us with financial information prepared in accordance with GAAP. As a result, we make no representations as to whether such information has been prepared in accordance with GAAP. We are not aware, however, of any errors in or possible misstatements of the financial information provided by our equity affiliates that would have a material effect on our consolidated financial statements.
Interactive Group
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(1) QVC was an equity method affiliate until September 2003 when it became a consolidated subsidiary.
QVC. QVC is a retailer of a wide range of consumer products, which are marketed and sold primarily by merchandise-focused televised shopping programs. In the United States, the programs are aired through its nationally televised shopping network -- 24 hours a day, 7 days a week ("QVC-US"). Internationally, QVC has electronic retailing program services based in the United Kingdom ("QVC-England"), Germany ("QVC-Deutschland") and Japan ("QVC-Japan"). As more fully described in note 4 to the accompanying consolidated financial statements, we acquired a controlling interest in QVC on September 17, 2003. For financial reporting purposes, the acquisition is deemed to have occurred on September 1, 2003, and we have
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consolidated QVC's results of operations since that date. Accordingly, increases in the Interactive Group's revenue and expenses for the year ended December 31, 2003 are primarily the result of the September 2003 acquisition of QVC.
The following discussion describes QVC's results of operations for the full years ended December 31, 2003, 2002 and 2001. Depreciation and amortization for periods prior and subsequent to Liberty's acquisition of Comcast's interest in QVC are not comparable as a result of the effects of purchase accounting. However, in order to provide a more meaningful basis for comparing the 2003, 2002 and 2001 periods, the operating results of QVC for the four months ended December 31, 2003 have been combined with the eight months ended August 31, 2003 in the following table and discussion. The combining of predecessor and successor accounting periods is not permitted by GAAP.
Net revenue for the years ended December 31, 2003, 2002 and 2001 includes the following revenue by geographical area:
QVC's consolidated net revenue increased 12.1% during the year ended December 31, 2003 as compared to the year ended December 31, 2002. Such increase is due primarily to increases in average sales per customer for both QVC-Deutschland and QVC-Japan of 48.4% and 73.0%, respectively. In addition, the number of homes receiving the QVC-Deutschland and QVC-Japan service increased 5.6% and 64.6%, respectively, from December 31, 2002 to December 31, 2003. Additional increases in net revenue were due to a 2.8% and a 6.3% increase in net sales per customer in the U.S. and the U.K., respectively. QVC's net revenue increased 12.0% for the year ended December 31, 2002, as compared to 2001. Such increase was due to a 3.6% increase in the average number of U.S. homes receiving the QVC service and a 5.3% increase in net sales to existing U.S. subscribers. Additional increases in net revenues were due to a 252.7% and 29.1% increase in net sales per customer for QVC-Japan and QVC-Deutschland, respectively. As the QVC service is already received by substantially all of the cable television and direct broadcast satellite homes in the U.S., future growth in U.S. sales will depend on continued additions of new customers from homes already receiving the QVC service and continued growth in sales to existing customers. QVC's future sales may also be affected by the willingness of cable and satellite distributors to continue to carry QVC's programming service as well as general economic conditions.
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During the years ended December 31, 2003, 2002 and 2001 the increases in revenue were also impacted by changes in the exchange rates for the UK pound sterling, the euro and the Japanese yen. The percentage increase in revenue for each of QVC's geographic areas in dollars and in local currency is as follows:
Gross profit increased from 35.7% of net revenue for the year ended December 31, 2001 to 36.2% for the year ended December 31, 2002 and to 36.4% for 2003. The 2003 increase in gross profit percentage is primarily the result of a higher product margin due to a shift in the product mix from lower margin home products to higher margin apparel and accessory categories. In addition, QVC had a lower inventory obsolescence provision in 2003. The increase in the 2002 gross profit percentage is primarily the result of increased product margin.
QVC's operating expenses are comprised of commissions and license fees, order processing and customer service, provision for doubtful accounts, and credit card processing fees. Operating expenses increased 8.2% and 7.8% for the years ended December 31, 2003 and 2002, respectively, as compared to the corresponding prior year period. These increases are primarily due to the increases in sales volume. As a percentage of net revenue, operating expenses were 9.1%, 9.5% and 9.8% for 2003, 2002 and 2001, respectively. As a percent of net revenue, commissions and license fees decreased in 2003, as compared to 2002, and remained constant over the 2002 and 2001 periods. The 2003 decrease is due to an increase in Internet sales, for which lower commissions are required to be paid. In addition, commissions and license fee expense decreased as a percentage of net revenue in 2003 for QVC-Japan where certain distributors receive payments based on number of subscribers rather than sales volume. As a percent of net revenue, order processing and customer service expenses remained constant in 2003 and decreased in each geographical segment in 2002. Such decrease is a result of reduced personnel expense due to increased Internet sales, increased use of QVC's automated telephone system and operator efficiencies in call handling and staffing. Credit card processing fees remained constant at 1.4% of net revenue for the years ended December 31, 2003, 2002 and 2001.
QVC's SG&A expenses increased 5.9% and 6.3% during the years ended December 31, 2003 and 2002, respectively, as compared to the corresponding prior year periods. The 2003 increase is primarily the net result of increases in personnel, transponder and occupancy costs, partially offset by decreases in advertising and marketing costs. Personnel cost increases reflect the addition of personnel to support the increased sales of the foreign operations. The increase in transponder fees is primarily the result of QVC-UK purchasing greater band-width as well as incurring a full year of digital transmission fees. Occupancy costs increased primarily as the result of higher costs for expanded office space in QVC-Japan. Decreases in advertising and marketing were primarily due to decreased domestic spending related to U.S. infomercial ventures as well as lower payments to affiliates for short-term carriage and incentive programs. The increase in SG&A in 2002 is due primarily to higher personnel costs due to the expansion of the international businesses.
QVC's depreciation and amortization expense increased for the year ended December 31, 2003 due to the amortization of intangible assets recorded in connection with our purchase of QVC.
Ascent Media. Ascent Media provides sound, video and ancillary post production and distribution services to the motion picture and television industries in the United States, Europe, Asia and Mexico. Accordingly, Ascent Media is dependent on the television and movie production industries and the commercial advertising market for a substantial portion of its revenue.
Ascent Media's revenue decreased 5.6% and 9.3% during the years ended December 31, 2003 and 2002, respectively, as compared to the corresponding prior year. The 2003 decrease is due primarily to a decrease in
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revenue for Ascent Media's Networks Group ($29 million) due to the sale of a business unit in December 2002 and the re-negotiation of certain contracts resulting in lower rates for services. The 2002 decrease is the net effect of decreases due to reduced television and motion picture production activity and lower television advertising production, which were partially offset by an increase due to acquisitions in the second half of 2001.
Ascent Media's operating expenses decreased $21 million or 6.5% and $48 million or 13.0% during the years ended December 31, 2003 and 2002, respectively, as compared to the corresponding prior year. These decreases are due to decreases in variable expenses such as personnel and material costs. In addition, the 2003 decrease is due to the sale of the Networks Group business unit referred to above.
Ascent Media's general and administrative expenses were relatively comparable over the 2001, 2002 and 2003 periods.
Ascent Media's depreciation and amortization increased 4.8% and decreased 47.7% in 2003 and 2002, respectively. The decrease in depreciation and amortization in 2002 is due primarily to the adoption of Statement 142 and the resulting elimination of goodwill amortization.
In connection with its 2002 Statement 142 impairment analysis, Ascent Media recorded an $84 million charge to write off a portion of the goodwill related to its Entertainment Television reporting unit. As a result of the weakness in the economy and in the entertainment and advertising industries during 2001, Ascent Media did not meet its 2001 operating objectives and reduced its 2002 expectations. Accordingly, at December 31, 2001, Ascent Media assessed the recoverability of its property and equipment and intangible assets and determined that an impairment adjustment was necessary. In addition, in the fourth quarter of 2001, Ascent Media made the decision to consolidate its operations and close certain facilities. In connection with these initiatives, Ascent Media recorded a restructuring charge related to lease cancellation fees and an additional impairment charge related to its property and equipment. All of the foregoing charges are included in impairment of long-lived assets in our statement of operations for the year ended December 31, 2001. No significant impairments were recorded by Ascent Media in 2003.
Other. Consolidated subsidiaries included in the Interactive Group are On Command, which provides in-room, on demand video entertainment and information services to hotels, motels and resorts; TruePosition, Inc., which provides equipment and technology that deliver location-based services to wireless users; and OpenTV, which provides interactive television solutions, including operating middleware, web browser software, interactive applications, and consulting and support services. Other consolidated subsidiary revenue increased $61 million in 2003 due primarily to the operations of OpenTV ($46 million), which we acquired in August 2002 and True Position ($20 million), which began deploying its networks in 2003. The improvements in operating cash flow and operating income in 2003 are due to the same factors. The increase in other consolidated subsidiary revenue in 2002 is due to our acquisition of OpenTV. The changes in operating cash flow and operating income in 2002 are due to improvements in the operations of On Command and True Position, offset by OpenTV losses.
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International Group
The following table includes information regarding our equity method affiliates, which presentation is not in accordance with GAAP. See -- "Operating Results by Business Group" above.
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(1) Represents an equity method affiliate. Equity ownership percentages for significant equity affiliates at December 31, 2003 are as follows:
Consolidated Subsidiaries. Our international consolidated subsidiaries are Liberty Cablevision of Puerto Rico, Inc., which provides cable television and other broadband services in Puerto Rico, and Pramer, which owns and distributes programming services throughout Latin America. Consolidated International Group revenue, operating cash flow and operating income was relatively consistent from 2002 to 2003. The decrease
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in revenue and operating cash flow from 2001 to 2002 is due to the devaluation of the Argentine peso during 2002.
UGC. UGC's revenue increased 24.9% and decreased 3.0% for the years ended December 31, 2003 and 2002, respectively. The increase in 2003 is due primarily to an increase in subscribers, revenue per subscriber and the strengthening of the euro against the U.S. dollar (approximately 16.1%). The decrease in 2002 is due to the sale of UGC's Australian operations partially offset by increases in Europe and Chile. UGC's operating expenses decreased $4 million or less than 1% in 2003 and $290 million or 27.3% in 2002. These decreases are due primarily to cost control initiatives, including restructurings. The 2002 expenses were also impacted by the sale of UGC's Australian operations. UGC's SG&A expenses increased $48 million or 10.7% in 2003 and decreased $244 million or 35.4% in 2002. The 2003 increase is due primarily to the strengthening of the euro against the U.S. dollar. The 2002 decrease is the result of cost control initiatives and the sale of UGC's Australian operations.
Also included in UGC's operating losses are (i) impairments of long-lived assets of $1,321 million in 2001, compared to $436 million in 2002 and $402 million in 2003, and (ii) restructuring charges of $204 million in 2001, compared to $1 million in 2002 and $36 million in 2003.
J-COM. J-COM's revenue increased 32.5% and 48.0% for the years ended December 31, 2003 and 2002, respectively, as compared to the corresponding prior year. The increase in revenue in 2003 was due to a 10.3% increase in the number of homes receiving at least one service, a 8.4% increase in the average number of services per home and a 9.6% increase in the average revenue per household receiving at least one service ("ARPH"). Revenue increased in 2002 due to a 23.2% increase in homes receiving at least one service, a 11.7% increase in average number of services per home and a 9.2% increase in ARPH. In addition, changes in the exchange rate also positively impacted revenue in 2003 and 2002. On a local currency basis, J-COM's revenue increased 22.7% and 52.3% in 2003 and 2002, respectively.
J-COM's operating expenses increased 17.0% and 22.2% in 2003 and 2002, respectively. These increases are due to the increase in subscribers and growth of J-COM's business. As a percent of revenue, operating expenses decreased from 40.3% in 2002 to 35.5% in 2003 due to the realization of economies of scale from the growth of the business. SG&A expenses increased 6.2% and 30.1% in 2003 and 2002, respectively. The increase in SG&A expenses are due to the growth of the business in 2002 and exchange rate fluctuations in 2003.
JPC. JPC's revenue increased 50.4% and 32.2% for the years ended December 31, 2003 and 2002, respectively, as compared to the corresponding prior years. The increase in 2003 was largely due to increases in revenue for Shop Channel, which experienced an 17.5% increase in full time equivalent homes ("FTE's") and a 14% increase in sales per FTE. In 2002, Shop Channel had a 30.4% increase in FTE's and a 8.2% increase in sales per FTE. Affiliate revenue and advertising revenue at JPC's other networks also contributed to the overall revenue increase in both years due to continued subscriber growth at those networks. Shop Channel revenue accounted for 81%, 80% and 78% of JPC's revenue in 2003, 2002 and 2001, respectively. In addition, changes in the exchange rate also positively impacted revenue in 2003 and 2002. On a local currency basis, JPC's revenue increased 39.4% and 36.1% in 2003 and 2002, respectively.
JPC's operating expenses increased 50.5% and 43.0% in 2003 and 2002, respectively. These increases are primarily due to higher cost of goods sold at Shop Channel resulting from revenue increases of 41.3% and 38.9% during 2003 and 2002, respectively. JPC's SG&A expenses increased 29.8% and 25.1% in 2003 and 2002, respectively. The increases in SG&A were due to growth in the business resulting from additional sales volume at Shop Channel and additional channel offerings.
Other Equity Method Affiliates. The decreases in revenue, operating cash flow and operating income in 2002 are due primarily to the devaluation of the Argentine peso and the resulting impact on the financial results of Cablevision S.A., which provides broadband services in Argentina.
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Networks Group
The following table includes information regarding our equity method affiliates, which presentation is not in accordance with GAAP. See "-- Operating Results by Business Group" above.
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(1) Represents an equity method affiliate. Equity ownership percentages for significant equity affiliates at December 31, 2003 are as follows:
Starz Encore. Starz Encore provides premium programming distributed by cable operators, direct-to-home satellite providers and other distributors throughout the United States. The majority of Starz Encore's revenue is derived from the delivery of movies to subscribers under affiliation agreements with these video programming distributors. Prior to 2001, Starz Encore had entered into an affiliation agreement with AT&T Broadband LLC (previously known as Tele-Communications, Inc.), which provided for AT&T Broadband's
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unlimited access to all of the existing Encore and STARZ! services in exchange for fixed monthly payments to Starz Encore (the "1997 Affiliation Agreement"). The payment from AT&T Broadband was to be adjusted if AT&T acquired or disposed of cable systems, or if Starz Encore's cash programming costs increased or decreased, as the case may be, above or below amounts specified in the agreement. In such cases, AT&T Broadband's payments under the 1997 Affiliation Agreement would have been increased or decreased in an amount equal to a proportion of the excess or shortfall.
In November 2002, AT&T Broadband completed a transaction with Comcast Corporation and Comcast Holdings Corporation in which AT&T Broadband and Comcast Holdings became wholly-owned subsidiaries of Comcast, and AT&T Broadband was renamed Comcast Cable Holdings, LLC. Upon completion of this transaction, Comcast challenged the validity and enforceability of the 1997 Affiliation Agreement. In September 2003, Starz Encore and Comcast entered into a seven-year agreement (the "2003 Comcast Affiliation Agreement") for the carriage of the STARZ! and Encore movie services on all Comcast owned and operated cable systems (including those of Comcast Cable Holdings). This agreement resolved all of the disputes and litigation that were pending between Starz Encore and Comcast with respect to the 1997 Affiliation Agreement.
Pursuant to the terms of the 2003 Comcast Affiliation Agreement, Comcast made payments to Starz Encore for Comcast Cable Holdings subscribers for the period from November 2002 to December 31, 2003 based on the per-subscriber rates included in the Comcast consignment agreement that was in effect prior to the execution of the 2003 Comcast Affiliation Agreement. The 2003 Comcast Affiliation Agreement also includes provisions for the distribution of new Starz Encore products in select Comcast systems and provisions for co-operative marketing efforts between Comcast and Starz Encore. Unlike the 1997 Affiliation Agreement, the 2003 Comcast Affiliation Agreement does not include any provision permitting Starz Encore to pass through a portion of its programming costs.
Starz Encore's revenue decreased 4.1% and increased 9.5% for the years ended December 31, 2003 and 2002, respectively, as compared to the corresponding prior years. The 2003 decrease is primarily the net effect of a $77 million reduction in revenue from Comcast Cable Holdings partially offset by a $35 million increase in revenue from other distributors resulting from a 13.6% increase in the number of average subscription units to Starz Encore's services. Substantially all of the increase in the average number of subscription units is attributable to Starz Encore's Thematic Multiplex service, which has lower subscription rates than the other Starz Encore services. The reduction in revenue from Comcast Cable Holdings is the result of a lower effective per-subscriber fee under the Comcast consignment agreement and a decrease in STARZ! subscription units in the Comcast Cable Holdings system partially offset by an increase in subscription units to Starz Encore's other services. The decrease in STARZ! subscription units in these systems is due to the negative effects of changes in marketing efforts and packaging of STARZ! that Comcast implemented prior to the execution of the 2003 Comcast Affiliation Agreement. Comcast, DirecTV and Echostar Communications generated 24.2%, 23.3% and 11.0%, respectively, of Starz Encore's revenue for the year ended December 31, 2003. The 2002 increase in revenue is primarily due to a 24.7% increase in average subscription units from all forms of distribution. Subscription units grew at a faster rate than revenue primarily due to a disproportionate increase in units of Thematic Multiplex channels.
Starz Encore's average subscription units increased at a slower rate in 2003 as compared to 2002. This trend reflects the impact of the dispute with Comcast described above, as well as the impact of promotional efforts on the part of certain other DTH and cable operators to sell other premium movie services to their customers instead of Starz Encore's offerings. During the third and fourth quarters of 2003, Starz Encore entered into new affiliation agreements with certain multichannel video program distributors, including Comcast and Charter Communications. Under these new affiliation agreements, Starz Encore has obtained more favorable positioning and increased co-operative marketing commitments. Starz Encore is negotiating with its other multichannel video programming distributors to obtain similar positioning and increased co- operative marketing commitments. However, no assurance can be given that these negotiations will be successful.
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Starz Encore's subscription units at December 31, 2003, 2002 and 2001 are presented in the table below. Subscription units for December 31, 2002 reflect certain minor adjustments to conform with the policy adopted by Starz Encore in 2003 of only presenting paying subscription units. Prior to 2003, Starz Encore had included certain of its subscribers receiving the services during free promotional campaigns.
At December 31, 2003, cable, direct broadcast satellite, and other distribution represented 65.5%, 33.7% and 0.8%, respectively, of Starz Encore's total subscription units.
Starz Encore's operating expenses increased $22 million or 5.4% and $5 million or 1.2% for the years ended December 31, 2003 and 2002, respectively, as compared to the corresponding prior year. Such increases are due primarily to increases in programming costs, which increased from $358 million in 2002 to $398 million in 2003. In the first quarter of 2003, Starz Encore entered into a settlement agreement regarding the payment of certain music license fees, which resulted in the reversal of a related accrual in the amount of $8 million. This reversal partially offset the programming cost increase in 2003. In 2002, Starz Encore's uplink costs decreased $5 million as a result of the completion of Starz Encore's new uplink facility. This decrease partially offset the increase in programming costs.
Starz Encore estimates that its 2004 programming expense will increase between $170 million and $190 million over amounts expensed in 2003. In addition, Starz Encore expects that programming costs in 2005 will exceed the 2004 costs by approximately $125 million to $175 million. Such increases are based on increases in the expected box office performance of movie titles that will become available to Starz Encore during these periods through its output arrangements with various movie studios. In addition, Starz Encore expects a higher cost per title due to a new rate card for movie titles under certain of its license agreements that will be effective for movies made available to Starz Encore in 2004 and thereafter and amortization of deposits previously made under the output agreements. The portion of increased programming costs that would otherwise have been eligible to be passed through under the 1997 Affiliation Agreement cannot be passed through under the 2003 Comcast Affiliation Agreement. In 2004, Starz Encore is not expected to generate increases in revenue or reductions in other costs in 2004 sufficient to fully offset these cost increases. Accordingly, these increased programming costs are expected to result in a direct reduction to Starz Encore's operating income in 2004. These estimates are subject to a number of assumptions that could change depending on the number of movie titles actually becoming available to Starz Encore and their ultimate box office performance. Accordingly, the actual amount of cost increases experienced by Starz Encore may differ from the amounts noted above.
Starz Encore's selling, general and administrative expenses decreased $58 million or 35.0% and increased $19 million or 12.7% during 2003 and 2002, respectively, as compared to the corresponding prior year. The decrease in 2003 is due primarily to a $57 million decrease in sales and marketing expenses and a $7 million decrease in bad debt expense. The decrease in sales and marketing expenses is due to the reduced number of co-operative promotions by certain multichannel television distributors discussed above and the reversal of an accrual recorded in prior years. As noted above, during the third and fourth quarters of 2003, Starz Encore entered into new affiliation agreements with certain multichannel television distributors, including Comcast and Charter Communications. Consequently, Starz Encore anticipates that its co-operative promotions and its sales and marketing expenses will increase in 2004. The higher bad debt expense in 2002 resulted from the
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bankruptcy filing of Adelphia Communications Corporation. The increase in SG&A expenses in 2002 is due primarily to increases in marketing support, salaries and related payroll expenses, and bad debt expense.
The decrease in Starz Encore's depreciation and amortization in 2002 is due to the adoption of Statement 142 and the resulting elimination of goodwill amortization.
Starz Encore has granted phantom stock appreciation rights to certain of its officers and employees. Compensation relating to the phantom stock appreciation rights has been recorded based upon the fair value of Starz Encore as determined by a third-party appraisal. The amount of expense associated with the phantom stock appreciation rights is generally based on the vesting of such rights and the change in the fair value of Starz Encore. Starz Encore's stock compensation decreased in 2003 as a result of a decrease in the estimated equity value of Starz Encore.
As more fully described above under "-- Consolidated Operating Results -- Impairment of Long-lived Assets," we recorded a $1,352 million impairment charge in 2003 related to Starz Encore, of which $1,195 million relates to enterprise-level goodwill and is included in Corporate and Other.
Discovery. Discovery's revenue increased 16.2% and 13.2% for the years ended December 31, 2003 and 2002, respectively, as compared to the corresponding prior year. The 2003 revenue increase was driven by a 22.8% increase in gross advertising revenue and a 11.9% increase in gross affiliate revenue. The increase in advertising revenue in 2003 was primarily due to increased audience delivery in the United States and Europe due to improved ratings and an increase in overall subscribers. Affiliate revenue increased due to the overall subscriber growth combined with subscribers moving from free preview status to paying subscribers at the developing domestic networks. The revenue increase in 2002 was due to a 10.9% increase in gross advertising revenue and a 14.0% increase in gross affiliate revenue. The growth in advertising revenue was caused by an increase in audience delivery both domestically and in Europe combined with an increase in the percentage of advertising spots that were sold. Affiliate revenue grew due to the conversion of free preview subscribers to paying subscribers at various developing networks.
Discovery's operating expenses increased 7.4% and 13.1% in 2003 and 2002, respectively. Such increases were due primarily to 11.9% and 18.5% increases in programming costs, respectively, as the company continues to invest in newer and more dramatic programming. Discovery's SG&A expenses increased 15.1% and 4.3% in 2003 and 2002, respectively. The increase in 2003 was primarily driven by increased personnel and general and administrative expense domestically, combined with increased marketing and sales related expenses. The 2002 increase was due to growth in personnel and administrative expenses combined with higher domestic sales related expenses.
Court TV. Court TV's revenue increased 30.4% and 25.4% for the years ended December 31, 2003 and 2002, respectively, as compared to the corresponding prior year. The 2003 increase is due to a 26.8% increase in affiliate revenue and a 45.4% increase in advertising revenue. Advertising revenue increased as a result of a 13.0% increase in primetime ratings combined with a 7.5% increase in subscribers, which also drove the increase in affiliate revenue. The revenue increase in 2002 was due to a 3.7% and 44.2% increase in affiliate and advertising revenue, respectively. The increase in advertising revenue was mainly due to a 6.3% increase in subscribers and a 16.7% increase in primetime ratings.
Court TV's operating expenses, which are comprised primarily of programming costs, decreased 11.8% in 2003 and increased 32.9% in 2002. The increase in operating costs in 2002 was due to increased programming investments. Operating costs decreased in 2003 due to a reduction in various acquired programming costs combined with a delay in the release of certain original programming. Court TV's SG&A expenses increased 11.0% and 15.6% in 2003 and 2002, respectively. The increases in Court TV's expenses are due to the growth of the business. As a percent of revenue, SG&A expenses decreased from 49.9% in 2002 to 42.5% in 2003 as the company's size is creating more economies of scale.
GSN. GSN's revenue increased 43.4% and 43.2% for the years ended December 31, 2003 and 2002, respectively, as compared to the corresponding prior year. These increases are due to 30.8% and 30.8% increases in advertising revenue and 60.7% and 71.9% increases in net affiliate revenue. Affiliate revenue increased in both years due to 13.2% and 25.8% growth in subscribers combined with modest rate increases II-20
and a decrease in amortized subscriber launch costs. Advertising revenue increased due to an improved audience delivery, stemming from subscriber growth and improved delivery of key demographics, as well as improved sales efforts yielding an increased percentage of inventory sold to advertisers.
GSN's operating expenses, which are comprised primarily of programming costs, increased 46.7% and 14.8% in 2003 and 2002, respectively, and represented 46.6% and 45.0% of revenue. The increase in operating costs in both years is due to continued investments in programming and interactive functionality. GSN's SG&A expenses decreased 1.1% in 2003 and increased 57.5% in 2002, as compared to the corresponding prior year. As a percent of revenue, SG&A expenses decreased from 75.4% in 2002 to 52.6% in 2003. The increase in SG&A in 2002 was due primarily to increased marketing costs associated with branding the business combined with an increase in general and administrative costs related to the growth in the business.
Other. Included in the Networks Group consolidated subsidiaries is Maxide Acquisition, Inc. (d/b/a DMX Music), which is principally engaged in programming, distributing, and marketing digital and analog music services to homes and businesses. Operating results for our other Networks consolidated subsidiaries were fairly consistent during the three years presented. The higher operating loss in 2002 is due primarily to a $44 million impairment of long-lived assets related to DMX Music.
LIQUIDITY AND CAPITAL RESOURCES
CORPORATE
Although our sources of funds include our available cash balances, net cash from operating activities, and dividend and interest receipts, historically we have been dependent upon our financing activities, proceeds from asset sales and monetization of our public investment portfolio, including derivative instruments, to generate sufficient cash resources to meet our future cash requirements and planned commitments. During 2003, we issued $1,750 million principal amount of 0.75% Senior Exchangeable Debentures due 2023. Each $1,000 debenture is exchangeable at the holder's option for the value of 57.4079 shares of Time Warner common stock. We received cash proceeds of $1,715 million upon issuance of the exchangeable debentures after related offering costs. In addition, during 2003 we (i) issued $1,000 million face amount of senior notes with an interest rate of 5.70% for net cash proceeds of approximately $990 million, (ii) received cash proceeds of $3,629 million upon the sale of assets and the settlement of financial instruments related to certain of our available-for-sale securities and (iii) received premium proceeds of $783 million from the origination of financial instruments.
Our uses of cash in recent years include investments in and advances to affiliates and debt repayments. In this regard, our investments in and advances to cost and equity method affiliates aggregated $2,593 million and $458 million, respectively, during the year ended December 31, 2003. Included in the foregoing amounts is $1,166 million invested in InterActiveCorp pursuant to contractual pre-emptive rights and $388 million invested in J-COM. Other uses of cash in 2003 include debt repayments of $3,508 million, cash paid for acquisitions of $711 million and stock repurchases of $437 million.
In November 2003, we announced our intention to reduce our outstanding consolidated debt balance by approximately $4.5 billion by the end of 2005. We initiated the debt reduction plan during the fourth quarter of 2003 by (i) redeeming $1.0 billion of floating rate notes that had been issued to Comcast, (ii) repaying $934 million of outstanding bank debt of our wholly-owned subsidiaries, and (iii) retiring approximately $578 million of other outstanding corporate indebtedness.
Our liquidity needs in 2004 include an approximate $1.0 billion reduction in our corporate indebtedness pursuant to our debt reduction plan, as well as continued funding of our existing investees as they develop and expand their businesses. We currently anticipate such cash investments to aggregate $1,400 million to $1,700 million in 2004. Included in the foregoing estimate is approximately $600 million that we invested in UGC in the first quarter of 2004 to (1) exercise our pre-emptive rights and (2) participate in UGC's rights offering and approximately $450 million that we invested in News Corp. We may also invest additional amounts in new or existing ventures. However, we are unable to quantify such investments at this time. We
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also expect our subsidiaries to spend approximately $340 million for capital expenditures in 2004, including $180 million by QVC, which amounts we expect to be funded by the cash flows of the respective subsidiary.
We expect that these investing and financing activities will be funded with a combination of cash on hand, cash provided by operating activities, proceeds from equity collar expirations and dispositions of non-strategic assets. In this regard, we expect to receive cash proceeds of $547 million in 2004, $1,311 million in 2005, $744 million in 2006, $389 million in 2007, $405 million in 2008, and $4,267 million thereafter upon settlement of our AFS Derivatives. The foregoing amounts assume we physically settle all derivatives and exclude any provision for income taxes. With the repayment of the bank debt of our wholly-owned subsidiaries and our acquisition of the controlling interest in QVC, we also expect to have access to the cash generated by the operating activities of our subsidiaries to the extent such cash exceeds the working capital needs of the subsidiaries and is not otherwise restricted.
Prior to the maturity of our equity collars, the terms of certain of our equity and narrow-band collars allow us to borrow funds equal to the present value of future put option proceeds (which we refer to as the PV Amount) at a rate equal to LIBOR at the time of borrowing. As of December 31, 2003, such amount aggregated approximately $3,922 million. We may also borrow the difference between the PV Amount and future put option proceeds at a rate equal to LIBOR plus our applicable credit spread at the time of borrowing. As of December 31, 2003, this amount aggregated approximately $936 million.
Subsequent to our November 2003 announcement regarding our intention to reduce our outstanding indebtedness, Standard and Poor's Securities, Inc., Fitch Investors Service, L.P. and Moody's Investors Service, Inc. each affirmed its respective rating for our senior debt at the lowest level of investment grade with a stable outlook. None of our existing indebtedness includes any covenant under which a default could occur as a result of a downgrade in our credit rating. However, any such downgrade could adversely affect our access to the public debt markets and our overall cost of future borrowings.
Based on currently available information, we expect to receive approximately $100 million in dividend and interest income during the year ended December 31, 2004. Based on current debt levels and current interest rates, we expect to make interest payments of approximately $470 million during the year ended December 31, 2004, primarily all of which relates to parent company debt.
SUBSIDIARIES
At December 31, 2003, Starz Encore had no amounts outstanding and $325 million available pursuant to its bank credit facility. This bank credit facility contains provisions which limit additional indebtedness, sale of assets, liens, guarantees, and distributions by Starz Encore. At December 31, 2003, our subsidiary that operates the DMX Music service was not in compliance with three covenants contained in its bank loan agreement. The subsidiary and the participating banks have entered into a forbearance agreement whereby the banks have agreed to forbear from exercising certain default-related remedies against the subsidiary through March 31, 2004. The subsidiary will not be able to repay its debt when the forbearance agreement expires and is currently considering its financing options. The outstanding balance of the subsidiary's bank facility was $89 million at December 31, 2003. All other consolidated subsidiaries were in compliance with their debt covenants at December 31, 2003. Starz Encore's ability to borrow the unused capacity noted above is dependent on its continuing compliance with its covenants at the time of, and after giving effect to, a requested borrowing.
EQUITY AFFILIATES
Various partnerships and other affiliates of ours accounted for using the equity method finance a substantial portion of their acquisitions and capital expenditures through borrowings under their own credit facilities and net cash provided by their operating activities. Notwithstanding the foregoing, certain of our affiliates may require additional capital to finance their operating or investing activities. In the event our affiliates require additional financing and we fail to meet a capital call, or other commitment to provide capital or loans to a particular company, such failure may have adverse consequences to us. These consequences may include, among others, the dilution of our equity interest in that company, the forfeiture of our right to vote or II-22
exercise other rights, the right of the other stockholders or partners to force us to sell our interest at less than fair value, the forced dissolution of the company to which we have made the commitment or, in some instances, a breach of contract action for damages against us. Our ability to meet capital calls or other capital or loan commitments is subject to our ability to access cash.
UGC. UGC and its significant operating subsidiaries have incurred losses since their formation, as they have attempted to expand and develop their businesses and introduce new services.
On September 3, 2003, United Pan-Europe Communications N.V. ("UPC"), a consolidated subsidiary of UGC, completed a restructuring of its debt instruments and emerged from bankruptcy. Under the terms of the restructuring, approximately $5.4 billion of UPC's debt was exchanged for equity of UGC Europe, Inc., a new holding company of UPC. Upon consummation, UGC received approximately 65.5% of UGC Europe's equity in exchange for UPC debt securities that it owned; third-party noteholders received approximately 32.5% of UGC Europe's equity; and existing preferred and ordinary shareholders, including UGC, received 2% of UGC Europe's equity. In January 2004, UGC also amended the E3,500 million bank facility of UGC Europe to, among other things, adjust certain financial covenants which require UGC Europe to maintain specified minimum or maximum financial ratios, reschedule payment maturities, reset interest rates on various tranches of indebtedness and to permit additional borrowings in certain instances. At December 31, 2003 there was approximately E2,900 million outstanding on this facility.
On December 18, 2003, UGC completed its offer to exchange shares of its Class A common stock for 13 million outstanding shares of UGC Europe common stock that it did not already own. Upon completion of the exchange offer, UGC owned 92.7% of the outstanding shares of UGC Europe common stock. On December 19, 2003, UGC effected a "short-form" merger with UGC Europe. In the short-form merger each share of UGC Europe common stock not tendered in the exchange offer was converted into the right to receive the same consideration offered in the exchange offer, and UGC acquired the remaining 7.3% of UGC Europe.
At December 31, 2003, we owned approximately 307 million shares of UGC common stock, which represents an approximate 52% economic interest and a 90% voting interest in UGC. Due to certain voting and standstill arrangements, we were unable to exercise control of UGC, and accordingly, we used the equity method of accounting for our investment.
On January 5, 2004, we completed a transaction pursuant to which UGC's founding shareholders (the "Founders") transferred 8.2 million shares of UGC Class B common stock to us in exchange for 12.6 million shares of our Series A common stock and a cash payment of approximately $13 million. Upon closing of the exchange, the restrictions on the exercise by us of our voting power with respect to UGC terminated, and we gained voting control of UGC. Accordingly, UGC will be included in our consolidated financial position and results of operations beginning January 2004. We have entered into a new Standstill Agreement with UGC that limits our ownership of UGC common stock to 90 percent of the outstanding common stock unless we make an offer or effect another transaction to acquire all outstanding UGC common stock. Under certain circumstances, such an offer or transaction would require an independent appraisal to establish the price to be paid to stockholders unaffiliated with us.
In January 2004, we also purchased an additional 18.3 million shares of UGC Class A common stock pursuant to certain pre-emptive rights granted to us pursuant to our standstill agreement with UGC. The $140 million purchase price for such shares was comprised of (1) the cancellation of indebtedness due from subsidiaries of UGC to certain of our subsidiaries in the amount of $104 million (including accrued interest) and (2) $36 million in cash.
Also in January 2004, UGC initiated a rights offering pursuant to which holders of each of UGC's Class A, Class B and Class C common stock received .28 transferable subscription rights to purchase a like class of common stock for each share of common stock owned by them on January 21, 2004. The rights offering originally expired on February 6, 2004, but was subsequently extended to February 12, 2004. UGC received cash proceeds of approximately $1.02 billion from the rights offering and expects to use such cash proceeds for working capital and general corporate purposes, including future acquisitions and repayment of
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outstanding indebtedness. As a holder of UGC Class A, Class B and Class C common stock, we participated in the rights offering and exercised our rights to purchase 94.1 million shares for a total cash purchase price of $565 million. Subsequent to the foregoing transactions, we own approximately 55% of UGC's common stock representing approximately 92% of the voting power of UGC's shares.
OFF-BALANCE SHEET ARRANGEMENTS AND AGGREGATE CONTRACTUAL OBLIGATIONS
Starz Encore has entered into agreements with a number of motion picture producers which obligate Starz Encore to pay fees for the rights to exhibit certain films that are released by these producers. The unpaid balance under agreements for film rights related to films that were available at December 31, 2003 is reflected as a liability in the accompanying consolidated balance sheet. The balance due as of December 31, 2003 is payable as follows: $177 million in 2004 and $48 million in 2005.
Starz Encore has also contracted to pay fees for the rights to exhibit films that have been released theatrically, but are not available for exhibition by Starz Encore until some future date. These amounts have not been accrued at December 31, 2003. Starz Encore's estimate of amounts payable under these agreements is as follows: $558 million in 2004; $231 million in 2005; $140 million in 2006; $112 million in 2007; $108 million in 2008 and $233 million thereafter.
Starz Encore is also obligated to pay fees for films that are released by certain producers through 2010 when these films meet certain criteria described in the studio output agreements. The actual contractual amount to be paid under these agreements is not known at this time. However, such amounts are expected to be significant. Starz Encore's total film rights expense aggregated $398 million, $358 million and $354 million for the years ended December 31, 2003, 2002 and 2001, respectively.
In addition to the foregoing contractual film obligations, two motion picture studios that have output contracts with Starz Encore through 2006 and 2010, respectively, have the right to extend their contracts for an additional three years. If the first studio elects to extend its contract, Starz Encore has agreed to pay the studio $60 million within five days of the studio's notice to extend. The studio is required to exercise its option by December 31, 2004. If the second studio elects to extend its contract, Starz Encore has agreed to pay the studio a total of $190 million in four annual installments. The studio is required to exercise this option by December 31, 2007. If made, Starz Encore's payments to the studios would be amortized ratably over the term of the respective output agreement extension.
Liberty guarantees Starz Encore's film licensing obligations under certain of its studio output agreements. At December 31, 2003, Liberty's guarantee for studio output obligations for films released by such date aggregated $799 million. While the guarantee amount for films not yet released is not determinable, such amount is expected to be significant. As noted above, Starz Encore has recognized the liability for a portion of its obligations under the output agreements. As this represents a commitment of Starz Encore, a consolidated subsidiary of ours, we have not recorded a separate liability for our guarantee of these obligations.
At December 31, 2003, Liberty guaranteed Y14.4 billion ($134 million) of the bank debt of J-COM, an equity affiliate that provides broadband services in Japan. Liberty's guarantees expire as the underlying debt matures and is repaid. The debt maturity dates range from 2004 to 2018. In addition, Liberty has agreed to fund up to Y10 billion ($93 million at December 31, 2003) to J-COM in the event J-COM's cash flow (as defined in its bank loan agreement) does not meet certain targets. In the event J-COM meets certain performance criteria, this commitment expires on September 30, 2004.
We have also guaranteed various leases, loans, notes payable, letters of credit and other obligations (the "Guaranteed Obligations") of certain other affiliates. At December 31, 2003, the Guaranteed Obligations aggregated approximately $160 million and are not reflected in our balance sheet at December 31, 2003. Currently, we are not certain of the likelihood of being required to perform under such guarantees.
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Information concerning the amount and timing of required payments under our contractual obligations is summarized below:
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(1) Includes all debt instruments, including the call option feature related to our exchangeable debentures. Amounts are stated at the face amount at maturity and may differ from the amounts stated in our consolidated balance sheet to the extent debt instruments (i) were issued at a discount or premium or (ii) are reported at fair value in our consolidated balance sheet. Also includes capital lease obligations.
Pursuant to a tax sharing agreement between us and AT&T when we were a subsidiary of AT&T, we received a cash payment from AT&T in periods when we generated taxable losses and such taxable losses were utilized by AT&T to reduce the consolidated income tax liability. To the extent such losses were not utilized by AT&T, such amounts were available to reduce federal taxable income generated by us in future periods, similar to a net operating loss carryforward. During the period from March 10, 1999 to December 31, 2002, we received cash payments from AT&T aggregating $555 million as payment for our taxable losses that AT&T utilized to reduce its income tax liability. In the event AT&T generates ordinary losses in 2003 or capital losses in 2003 or 2004 and is able to carry back such losses to offset taxable income previously offset by our losses, we may be required to refund as much as $333 million of these cash payments. We are currently unable to determine the likelihood that we will be required to make any refund payments to AT&T.
AT&T, as the successor to TCI, was the subject of an Internal Revenue Service ("IRS") audit for the 1993-1999 tax years. The IRS notified AT&T and us that it was proposing income adjustments and assessing certain penalties in connection with TCI's 1994 tax return. The IRS, AT&T and we have reached an agreement whereby AT&T will recognize additional income of $94 million with respect to this matter, and no penalties will be assessed. Pursuant to the tax sharing agreement between us and AT&T, we may be obligated to reimburse AT&T for any tax that is ultimately assessed as a result of this agreement. We are currently unable to estimate any such tax liability and resulting reimbursement, but we believe that any such reimbursement will not be material to our financial position.
In connection with agreements for the sale of certain assets, we typically retain liabilities that relate to events occurring prior to the sale, such as tax, environmental, litigation and employment matters. We generally indemnify the purchaser in the event that a third party asserts a claim against the purchaser that relates to a liability retained by us. These types of indemnification guarantees typically extend for a number of years. We are unable to estimate the maximum potential liability for these types of indemnification guarantees as the sale agreements typically do not specify a maximum amount and the amounts are dependent upon the outcome of future contingent events, the nature and likelihood of which cannot be determined at this time. Historically, we have not made any significant indemnification payments under such agreements and no amount has been accrued in the accompanying consolidated financial statements with respect to these indemnification guarantees.
We have contingent liabilities related to legal and tax proceedings and other matters arising in the ordinary course of business. Although it is reasonably possible we may incur losses upon conclusion of such matters, an estimate of any loss or range of loss cannot be made. In the opinion of management, it is expected
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that amounts, if any, which may be required to satisfy such contingencies will not be material in relation to the accompanying consolidated financial statements.
CRITICAL ACCOUNTING POLICIES
The preparation of our financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Listed below are the accounting policies that we believe are critical to our financial statements due to the degree of uncertainty regarding the estimates or assumptions involved and the magnitude of the asset, liability, revenue or expense being reported. All of these accounting policies, estimates and assumptions, as well as the resulting impact to our financial statements, have been discussed with our audit committee.
Carrying Value of Investments. Our cost and equity method investments comprise 36.9% and 9.9%, respectively, of our total assets at December 31, 2003 and 36.2% and 18.6%, respectively, at December 31, 2002. We account for these investments pursuant to Statement of Financial Accounting Standards No. 115, Statement of Financial Accounting Standards No. 142 and Accounting Principles Board Opinion No. 18. These accounting principles require us to periodically evaluate our investments to determine if decreases in fair value below our cost bases are other than temporary or "nontemporary." If a decline in fair value is determined to be nontemporary, we are required to reflect such decline in our statement of operations. Nontemporary declines in fair value of our cost investments are recognized on a separate line in our statement of operations, and nontemporary declines in fair value of our equity method investments are included in share of losses of affiliates in our statement of operations.
The primary factors we consider in our determination of whether declines in fair value are nontemporary are the length of time that the fair value of the investment is below our carrying value; and the financial condition, operating performance and near term prospects of the investee. In addition, we consider the reason for the decline in fair value, be it general market conditions, industry specific or investee specific; analysts' ratings and estimates of 12 month share price targets for the investee; changes in stock price or valuation subsequent to the balance sheet date; and our intent and ability to hold the investment for a period of time sufficient to allow for a recovery in fair value. Fair value of our publicly traded investments is based on the market price of the security at the balance sheet date. We estimate the fair value of our other cost and equity investments using a variety of methodologies, including cash flow multiples, discounted cash flow, per subscriber values, or values of comparable public or private businesses. Impairments are calculated as the difference between our carrying value and our estimate of fair value. As our assessment of the fair value of our investments and any resulting impairment losses requires a high degree of judgment and includes significant estimates and assumptions, actual results could differ materially from our estimates and assumptions.
Our evaluation of the fair value of our investments and any resulting impairment charges are determined as of the most recent balance sheet date. Changes in fair value subsequent to the balance sheet date due to the factors described above are possible. Subsequent decreases in fair value will be recognized in our statement of operations in the period in which they occur to the extent such decreases are deemed to be nontemporary. Subsequent increases in fair value will be recognized in our statement of operations only upon our ultimate disposition of the investment.
At December 31, 2003, we had no unrealized losses related to our available-for-sale securities.
Accounting for Acquisitions. We acquired QVC in 2003 and OpenTV in 2002. We account for all acquisitions of companies such as these pursuant to Statement of Financial Accounting Standards No. 141, "Business Combinations," which prescribes the purchase method of accounting for business combinations. Pursuant to Statement 141, the purchase price is allocated to all of the assets and liabilities of the acquired company, based on their respective fair values. Any excess purchase price over the estimated fair value of the net assets is recorded as goodwill.
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In determining fair value, we are required to make estimates and assumptions that affect the recorded amounts. To assist in this process, we often engage third party valuation specialists to value certain of the assets and liabilities. Estimates used in these valuations may include expected future cash flows (including timing thereof), market rate assumptions for contractual obligations, expected useful lives of tangible and intangible assets and appropriate discount rates. Our estimates of fair value are based on assumptions believed to be reasonable, but which are inherently uncertain.
The allocation of the purchase price to tangible and intangible assets impacts our statement of operations due to the amortization of these assets. With respect to the acquisition of QVC, the total purchase price of $7.9 billion was allocated to QVC's net assets based on their estimated fair values as determined by an independent valuation firm. QVC's more significant intangible assets included customer relationships and cable and satellite distribution rights, which are amortized over their respective useful lives, and trademarks, which have an indefinite useful life and are not amortized. We also allocated a portion of the purchase price to goodwill, which is not amortized. We estimate that amortization expense related to the amortizable intangible assets will be $312 million annually. If the allocation to QVC's amortizable assets had been 10% or $436 million more and the allocation to tradmarks and goodwill had been $436 million less, our annual amortization expense would be $31 million higher.
Accounting for Derivative Instruments. We use various derivative instruments, including equity collars, narrow-band collars, put spread collars, written put and call options, interest rate swaps and foreign exchange contracts, to manage fair value and cash flow risk associated with many of our investments, some of our debt and transactions denominated in foreign currencies. We account for these derivative instruments pursuant to Statement 133 and Statement of Financial Accounting Standards No. 149 "Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities." Statement 133 and Statement 149 require that all derivative instruments be recorded on the balance sheet at fair value. Changes in derivatives designated as cash flow hedges are recorded in other comprehensive income. Changes in derivatives designated as fair value hedges and changes in derivatives not designated as hedges are included in realized and unrealized gains (losses) on derivative instruments in our statement of operations.
We use the Black-Scholes model to estimate the fair value of our derivative instruments that we use to manage market risk related to certain of our available-for-sale securities. The Black-Scholes model incorporates a number of variables in determining such fair values, including expected volatility of the underlying security and an appropriate discount rate. We obtain volatility rates from independent sources based on the expected volatility of the underlying security over the term of the derivative instrument. The volatility assumption is evaluated annually to determine if it should be adjusted, or more often if there are indications that it should be adjusted. We obtain a discount rate at the inception of the derivative instrument and update such rate each reporting period based on our estimate of the discount rate at which we could currently settle the derivative instrument. At December 31, 2003, the expected volatilities used to value our AFS Derivatives generally ranged from 25% to 56% and the discount rates ranged from 1.46% to 4.86%. Considerable management judgment is required in estimating the Black-Scholes variables. Actual results upon settlement or unwinding of our derivative instruments may differ materially from these estimates.
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Changes in our assumptions regarding (1) the discount rate and (2) the volatility rates of the underlying securities that are used in the Black-Scholes model would have the most significant impact on the valuation of our AFS Derivatives. The table below summarizes changes in these assumptions and the resulting impacts on our estimate of fair value.
Utilization of the Equity Method of Accounting for our Investment in UGC. At December 31, 2003, we owned approximately 52% of UGC's outstanding equity representing approximately 90% of the voting power of UGC's common stock. UGC's operating and financial decisions are controlled by its Board of Directors. We held substantially all of our voting interest in UGC through Class C common shares of which we were the only Class C shareholder. Under UGC's certificate of incorporation, the Class C shareholders are entitled to elect only 4 of the 12 directors. The UGC Founders had effective control to elect the remaining 8 directors through their ownership of UGC's Class B shares. Our ability to convert our Class C shares into Class B shares and to elect a majority of UGC's Board of Directors following such conversion was limited by the terms of such shares and by a standstill agreement which was in effect until June 2010. While an earlier termination of the standstill agreement was possible in the event that the UGC Founders reduce their interests in Class B shares below certain specified levels, it was outside our control to effect such an early termination. The Class C shares had approval rights over certain material transactions and related party matters which were considered protective in nature.
As a result of the aforementioned governance arrangements, we determined that our voting interest was not sufficient to allow us to control UGC and therefore apply consolidation accounting with respect to our investment in UGC. We did consider our Class C shareholder rights sufficient to exert significant influence over the financial and operating policies of UGC, and accordingly, we applied the equity method of accounting for this investment.
On January 5, 2004, we completed a transaction pursuant to which the UGC Founders transferred 8.2 million shares of UGC Class B common stock to us in exchange for 12.6 million shares of our Series A common stock and a cash payment of approximately $13 million. Upon closing of the exchange, the restrictions on our right to exercise our voting power with respect to UGC were terminated, and we gained voting control of UGC. Accordingly, we will begin consolidating UGC's results of operations and financial position in January 2004. We are currently in the process of quantifying the appropriate purchase accounting and consolidation adjustments related to UGC, and we expect the application of consolidation accounting for UGC will have a significant effect on our financial position and results of operations.
Carrying Value of Long-lived Assets. Our property and equipment, intangible assets and goodwill (collectively, our "long-lived assets") also comprise a significant portion of our total assets at December 31, 2003 and 2002. We account for our long-lived assets pursuant to Statement of Financial Accounting Standards No. 142 and Statement of Financial Accounting Standards No. 144. These accounting standards require that we periodically, or upon the occurrence of certain triggering events, assess the recoverability of our long-lived assets. If the carrying value of our long-lived assets exceeds their estimated fair value, we are required to write the carrying value down to fair value. Any such writedown is included in impairment of long-lived assets in our consolidated statement of operations. A high degree of judgment is required to estimate the fair value of our long-lived assets. We may use quoted market prices, prices for similar assets, present value techniques and other valuation techniques to prepare these estimates. In addition, we may obtain independent appraisals in certain circumstances. We may need to make estimates of future cash flows and discount rates as
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well as other assumptions in order to implement these valuation techniques. Accordingly, any value ultimately derived from our long-lived assets may differ from our estimate of fair value. As each of our operating segments has long-lived assets, this critical accounting policy affects the financial position and results of operations of each segment.
Starz Encore received an independent third party valuation in connection with its annual year-end evaluation of the recoverability of its goodwill. The result of this valuation, which was based on a discounted cash flow analysis of projections prepared by the management of Starz Encore, indicated that the fair value of this reporting unit was less than its carrying value including goodwill. This reporting unit fair value was then used to calculate an implied value of the goodwill related to Starz Encore. The $1,352 million excess of the carrying amount of the goodwill (including $1,195 million of allocated enterprise-level goodwill) over its implied value has been recorded as an impairment charge in the fourth quarter of 2003. The reduction in the value of Starz Encore reflected in the third party valuation is believed to be attributable to a number of factors. Those factors include the reliance placed in that valuation on projections by management reflecting a lower rate of revenue growth compared to earlier projections based, among other things, on the possibility that revenue growth may be negatively affected by (1) a reduction in the rate of growth in total digital video subscribers and in the subscription video on demand business as a result of cable operators' increased focus on the marketing and sale of other services, such as high speed internet access and telephony, and the uncertainty as to the success of marketing efforts by distributors of Starz Encore's services and (2) lower per subscriber rates under the new affiliation agreement with Comcast, as compared to the payments required under the 1997 AT&T Broadband Affiliation Agreement (including the programming pass through provision).
Due to the slow-down in the movie and television industries in 2002 and 2001, Ascent Media recorded long-lived asset impairment charges of $84 million and $313 million, respectively. In 2002 and 2001, we also recorded impairment charges of $99 million and $75 million, respectively, the majority of which is due to adverse economic conditions that affected our subsidiaries and affiliates in South America; and we recorded a $92 million impairment charge in 2002 related to OpenTV Corp due to slower than expected growth in the interactive television industry and cutbacks in capital expenditures by broadband service providers.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
We are exposed to market risk in the normal course of business due to our ongoing investing and financial activities and our investments in different foreign countries. Market risk refers to the risk of loss arising from adverse changes in stock prices, interest rates and foreign currency exchange rates. The risk of loss can be assessed from the perspective of adverse changes in fair values, cash flows and future earnings. We have established policies, procedures and internal processes governing our management of market risks and the use of financial instruments to manage our exposure to such risks.
We are exposed to changes in interest rates primarily as a result of our borrowing and investment activities, which include investments in fixed and floating rate debt instruments and borrowings used to maintain liquidity and to fund business operations. The nature and amount of our long-term and short-term debt are expected to vary as a result of future requirements, market conditions and other factors. We manage our exposure to interest rates by maintaining what we believe is an appropriate mix of fixed and variable rate debt. We believe this best protects us from interest rate risk. We have achieved this mix by (i) issuing fixed rate debt that we believe has a low stated interest rate and significant term to maturity and (ii) issuing short-term variable rate debt to take advantage of historically low short-term interest rates. As of December 31, 2003, the face amount of our fixed rate debt (considering the effects of interest rate swap agreements) was $8,168 million, which had a weighted average stated interest rate of 4.68%. Our variable rate debt of $3,807 million had a weighted average interest rate of 2.31% at December 31, 2003. Had market interest rates been 100 basis points higher (representing an approximate 43% increase over our variable rate debt effective cost of borrowing) throughout the year ended December 31, 2003, we would have recognized approximately $27 million of additional interest expense. Had the estimated value of the call option obligations associated with our senior exchangeable debentures been 10% higher during the year ended December 31, 2003, we would have recognized an additional unrealized loss on derivative instruments of $99 million. For additional
II-29
information regarding the impacts of changes in discount rates and volatilities on our derivative instruments, see "Critical Accounting Policies-Accounting for Derivatives."
We are exposed to changes in stock prices primarily as a result of our significant holdings in publicly traded securities. We continually monitor changes in stock markets, in general, and changes in the stock prices of our holdings, specifically. We believe that changes in stock prices can be expected to vary as a result of general market conditions, technological changes, specific industry changes and other factors. We use equity collars, put spread collars, narrow-band collars, written put and call options and other financial instruments to manage market risk associated with certain investment positions. These instruments are recorded at fair value based on option pricing models. Equity collars provide us with a put option that gives us the right to require the counterparty to purchase a specified number of shares of the underlying security at a specified price (the "Company Put Price") at a specified date in the future. Equity collars also provide the counterparty with a call option that gives the counterparty the right to purchase the same securities at a specified price at a specified date in the future. The put option and the call option generally are equally priced at the time of origination resulting in no cash receipts or payments. Narrow-band collars are equity collars in which the put and call prices are set so that the call option has a relatively higher fair value than the put option at the time of origination. In these cases we receive cash equal to the difference between such fair values.
Put spread collars provide us and the counterparty with put and call options similar to equity collars. In addition, put spread collars provide the counterparty with a put option that gives it the right to require us to purchase the underlying securities at a price that is lower than the Company Put Price. The inclusion of the secondary put option allows us to secure a higher call option price while maintaining net zero cost to enter into the collar. However, the inclusion of the secondary put exposes us to market risk if the underlying security trades below the put spread price.
Among other factors, changes in the market prices of the securities underlying the AFS Derivatives affect the fair market value of the AFS Derivatives. The following table illustrates the impact that changes in the market price of the securities underlying Liberty's AFS Derivatives would have on the fair market value of such derivatives. Such changes in fair market value would be included in realized and unrealized gains (losses) on financial instruments in the accompanying consolidated statement of operations.
- ---------------
(1) Includes narrow-band collars.
At December 31, 2003, the fair value of our available-for-sale securities was $19,875 million. Had the market price of such securities been 10% lower at December 31, 2003, the aggregate value of such securities would have been $1,988 million lower resulting in an increase to unrealized losses in other comprehensive earnings. Such decrease would be partially offset by an increase in the value of our AFS Derivatives as noted in the table above. Had the stock price of our publicly traded investments accounted for using the equity method been 10% lower at December 31, 2003, there would have been no impact on the carrying value of such investments assuming that the decline in value is deemed to be temporary.
Investments in and advances to our foreign affiliates are denominated in foreign currencies. Therefore, we are exposed to changes in foreign currency exchange rates. We do not hedge the majority of our foreign currency exchange risk because of the long-term nature of our interests in foreign affiliates. However, in order to reduce our foreign currency exchange risk related to our recent investment in J-COM, we have entered into
II-30
forward sale contracts with respect to Y20,802 million ($194 million at December 31, 2003). In addition to the forward sale contracts, we entered into collar agreements with respect to Y28,785 million ($268 million at ]December 31, 2003). These collar agreements have a remaining term of approximately one year, an average call price of 108 yen/U.S. dollar and an average put price of 125 yen/U.S. dollar. During 2003, we had unrealized losses of $23 million related to our yen contracts. We continually evaluate our foreign currency exposure based on current market conditions and the business environment in each country in which we operate.
From time to time we enter into total return debt swaps in connection with our purchase of our own or third-party public and private indebtedness. Under these arrangements, we direct a counterparty to purchase a specified amount of the underlying debt security for our benefit. We initially post collateral with the counterparty equal to 10% of the value of the purchased securities. We earn interest income based upon the face amount and stated interest rate of the underlying debt securities, and we pay interest expense at market rates on the amount funded by the counterparty. In the event the fair value of the underlying debt securities declines 10%, we are required to post cash collateral for the decline, and we record an unrealized loss on financial instruments. The cash collateral is further adjusted up or down for subsequent changes in fair value of the underlying debt security. At December 31, 2003, the aggregate purchase price of debt securities underlying total return debt swap arrangements was $314 million ($200 million of which related to our senior notes and debentures). As of such date, we had posted cash collateral equal to $35 million. In the event the fair value of the purchased debt securities were to fall to zero, we would be required to post additional cash collateral of $279 million.
We periodically assess the effectiveness of our derivative financial instruments. With regard to interest rate swaps, we monitor the fair value of interest rate swaps as well as the effective interest rate the interest rate swap yields, in comparison to historical interest rate trends. We believe that any losses incurred with regard to interest rate swaps would be offset by the effects of interest rate movements on the underlying debt facilities. With regard to equity collars, we monitor historical market trends relative to values currently present in the market. We believe that any unrealized losses incurred with regard to equity collars and swaps would be offset by the effects of fair value changes on the underlying assets. These measures allow our management to measure the success of its use of derivative instruments and to determine when to enter into or exit from derivative instruments.
Our derivative instruments are executed with counterparties who are well known major financial institutions with high credit ratings. While we believe these derivative instruments effectively manage the risks highlighted above, they are subject to counterparty credit risk. Counterparty credit risk is the risk that the counterparty is unable to perform under the terms of the derivative instrument upon settlement of the derivative instrument. To protect ourselves against credit risk associated with these counterparties we generally:
- execute our derivative instruments with several different counterparties, and
- execute equity derivative instrument agreements which contain a provision that requires the counterparty to post the "in the money" portion of the derivative instrument into a cash collateral account for our benefit, if the respective counterparty's credit rating for its senior secured debt were to reach certain levels, generally a rating that is below Standard & Poor's rating of A- and/or Moody's rating of A3.
Due to the importance of these derivative instruments to our risk management strategy, we actively monitor the creditworthiness of each of these counterparties. Based on our analysis, we currently consider nonperformance by any of our counterparties to be unlikely.
II-31
Our counterparty credit risk by financial institution is summarized below:
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The consolidated financial statements of Liberty Media Corporation are filed under this Item, beginning on Page II-33. The financial statement schedules required by Regulation S-X are filed under Item 15 of this Annual Report on Form 10-K.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES.
In accordance with Exchange Act Rules 13a-15 and 15d-15, the Company carried out an evaluation, under the supervision and with the participation of management, including its chief executive officer, principal accounting officer and principal financial officer (the "Executives"), of the effectiveness of its disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Executives concluded that the Company's disclosure controls and procedures were effective as of December 31, 2003 to provide reasonable assurance that information required to be disclosed in its reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms.
There has been no change in the Company's internal controls over financial reporting that occurred during the three months ended December 31, 2003 that has materially affected, or is reasonably likely to materially affect, its internal controls over financial reporting.
II-32
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders Liberty Media Corporation:
We have audited the accompanying consolidated balance sheets of Liberty Media Corporation and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of operations, comprehensive earnings (loss), stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2003. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Liberty Media Corporation and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.
As discussed in note 2 to the consolidated financial statements, the Company changed its method of accounting for intangible assets in 2002 and for derivative financial instruments in 2001.
KPMG LLP
Denver, Colorado March 12, 2004
II-33
LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS DECEMBER 31, 2003 AND 2002
See accompanying notes to consolidated financial statements. II-34
LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
See accompanying notes to consolidated financial statements. II-35
LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE EARNINGS (LOSS) YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
See accompanying notes to consolidated financial statements. II-36
LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
See accompanying notes to consolidated financial statements. II-37
LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
See accompanying notes to consolidated financial statements. II-38
LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003, 2002 AND 2001
(1) BASIS OF PRESENTATION
The accompanying consolidated financial statements include the accounts of Liberty Media Corporation and its controlled subsidiaries ("Liberty" or the "Company," unless the context otherwise requires). All significant intercompany accounts and transactions have been eliminated in consolidation.
Liberty is a holding company which, through its majority and minority ownership of interests in subsidiaries and other companies, is primarily engaged in (i) electronic retailing, (ii) international cable television distribution, telephony and programming, and (iii) the production, acquisition and distribution through all available formats and media of branded entertainment, educational and informational programming and software. In addition, companies in which Liberty owns interests are engaged in, among other things, (i) interactive commerce via the Internet, television and telephone, (ii) domestic cable and satellite broadband distribution services, and (iii) wireless domestic telephony and other technology ventures. Liberty, through its affiliated companies, operates in the United States, Europe, South America and Asia.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CASH AND CASH EQUIVALENTS
Cash equivalents consist of investments which are readily convertible into cash and have maturities of three months or less at the time of acquisition.
RECEIVABLES
Receivables are reflected net of an allowance for doubtful accounts. Such allowance aggregated $109 million and $45 million at December 31, 2003 and 2002, respectively. A summary of activity in the allowance for doubtful accounts is as follows:
INVENTORY
Inventory, consisting primarily of products held for sale, is stated at the lower of cost or market. Cost is determined by the average cost method, which approximates the first-in, first-out method.
PROGRAM RIGHTS
Prepaid program rights are amortized on a film-by-film basis over the anticipated number of exhibitions. Committed program rights and program rights payable are recorded at the estimated cost of the programs when the film is available for airing less prepayments. These amounts are amortized on a film-by-film basis over the anticipated number of exhibitions.
INVESTMENTS
All marketable equity and debt securities held by the Company are classified as available-for-sale and are carried at fair value ("AFS Securities"). Unrealized holding gains and losses on AFS Securities are carried
II-39
LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
net of taxes as a component of accumulated other comprehensive earnings in stockholders' equity. Realized gains and losses are determined on an average cost basis. Other investments in which the Company's ownership interest is less than 20% and are not considered marketable securities are carried at cost.
For those investments in affiliates in which the Company has the ability to exercise significant influence, the equity method of accounting is used. Under this method, the investment, originally recorded at cost, is adjusted to recognize the Company's share of net earnings or losses of the affiliates as they occur rather then as dividends or other distributions are received, limited to the extent of the Company's investment in, advances to and commitments for the investee. If the Company's investment in the common stock of an affiliate is reduced to zero as a result of recording its share of the affiliate's net losses, and the Company holds investments in other more senior securities of the affiliate, the Company would continue to record losses from the affiliate to the extent of these additional investments. The amount of additional losses recorded would be determined based on changes in the hypothetical amount of proceeds that would be received by the Company if the affiliate were to experience a liquidation of its assets at their current book values. Prior to the Company's January 1, 2002 adoption of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets ("Statement 142"), the Company's share of net earnings or losses of affiliates included the amortization of the difference between the Company's investment and its share of the net assets of the investee. Upon adoption of Statement 142, the portion of excess costs on equity method investments that represents goodwill ("equity method goodwill") is no longer amortized, but continues to be considered for impairment under Accounting Principles Board Opinion No. 18. The Company's share of net earnings or loss of affiliates also includes any other-than-temporary declines in fair value recognized during the period.
Changes in the Company's proportionate share of the underlying equity of a subsidiary or equity method investee, which result from the issuance of additional equity securities by such subsidiary or equity investee, are recognized as increases or decreases in stockholders' equity.
The Company continually reviews its investments to determine whether a decline in fair value below the cost basis is other than temporary ("nontemporary"). The primary factors the Company considers in its determination are the length of time that the fair value of the investment is below the Company's carrying value; and the financial condition, operating performance and near term prospects of the investee. In addition, the Company considers the reason for the decline in fair value, be it general market conditions, industry specific or investee specific; analysts' ratings and estimates of 12 month share price targets for the investee; changes in stock price or valuation subsequent to the balance sheet date; and the Company's intent and ability to hold the investment for a period of time sufficient to allow for a recovery in fair value. If the decline in fair value is deemed to be nontemporary, the cost basis of the security is written down to fair value. In situations where the fair value of an investment is not evident due to a lack of a public market price or other factors, the Company uses its best estimates and assumptions to arrive at the estimated fair value of such investment. The Company's assessment of the foregoing factors involves a high degree of judgment and accordingly, actual results may differ materially from the Company's estimates and judgments. Writedowns for cost investments and AFS Securities are included in the consolidated statements of operations as nontemporary declines in fair values of investments. Writedowns for equity method investments are included in share of earnings (losses) of affiliates.
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The Company uses various derivative instruments including equity collars, narrow-band collars, put spread collars, written put and call options, bond swaps, interest rate swaps and foreign exchange contracts to manage fair value and cash flow risk associated with many of its investments, some of its variable rate debt and transactions denominated in foreign currencies. Liberty's derivative instruments are executed with counterparties who are well known major financial institutions. While Liberty believes these derivative instruments effectively manage the risks highlighted above, they are subject to counterparty credit risk.
II-40
LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Counterparty credit risk is the risk that the counterparty is unable to perform under the terms of the derivative instrument upon settlement of the derivative instrument. To protect itself against credit risk associated with these counterparties the Company generally:
- executes its derivative instruments with several different counterparties, and
- executes equity derivative instrument agreements which contain a provision that requires the counterparty to post the "in the money" portion of the derivative instrument into a cash collateral account for the Company's benefit, if the respective counterparty's credit rating for its senior unsecured debt were to reach certain levels, generally a rating that is below Standard & Poor's rating of A- and/or Moody's rating of A3.
Due to the importance of these derivative instruments to its risk management strategy, Liberty actively monitors the creditworthiness of each of its counterparties. Based on its analysis, the Company currently considers nonperformance by any of its counterparties to be unlikely.
Effective January 1, 2001, Liberty adopted Statement of Financial Accounting Standards No. 133 "Accounting for Derivative Instruments and Hedging Activities" ("Statement 133"). All derivatives, whether designated in hedging relationships or not, are recorded on the balance sheet at fair value. If the derivative is designated as a fair value hedge, the changes in the fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings. If the derivative is designated as a cash flow hedge, the effective portions of changes in the fair value of the derivative are recorded in other comprehensive earnings. Ineffective portions of changes in the fair value of cash flow hedges are recognized in earnings. If the derivative is not designated as a hedge, changes in the fair value of the derivative are recognized in earnings.
During 2001 and 2002, the only derivative instruments designated as hedges were the Company's equity collars, which were designated as fair value hedges. Effective December 31, 2002, the Company elected to dedesignate its equity collars as fair value hedges. Such election had no effect on the Company's financial position at December 31, 2002 or its results of operations for the year ended December 31, 2002. Subsequent to December 31, 2002, changes in the fair value of the Company's AFS Securities that previously had been reported in earnings due to the designation of equity collars as fair value hedges are reported as a component of other comprehensive earnings (loss) on the Company's consolidated balance sheet. Changes in the fair value of the equity collars continue to be reported in earnings.
The fair value of derivative instruments is estimated using third party estimates or the Black-Scholes model. The Black-Scholes model incorporates a number of variables in determining such fair values, including expected volatility of the underlying security and an appropriate discount rate. The Company obtains volatility rates from independent sources based on the expected volatility of the underlying security over the term of the derivative instrument. The volatility assumption is evaluated annually to determine if it should be adjusted, or more often if there are indications that it should be adjusted. A discount rate is obtained at the inception of the derivative instrument and updated each reporting period based on the Company's estimate of the discount rate at which it could currently settle the derivative instrument. Considerable management judgment is required in estimating the Black-Scholes variables. Actual results upon settlement or unwinding of derivative instruments may differ materially from these estimates.
The adoption of Statement 133 on January 1, 2001, resulted in a cumulative increase in net earnings of $545 million, or $0.21 per common share (after tax expense of $356 million), and an increase in other comprehensive loss of $87 million. The increase in net earnings was mostly attributable to separately recording the fair value of the embedded call option obligations associated with the Company's senior exchangeable debentures. The increase in other comprehensive loss relates primarily to changes in the fair value of the Company's warrants and options to purchase certain AFS Securities.
II-41
LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Company assesses the effectiveness of equity collars by comparing changes in the intrinsic value of the equity collar to changes in the fair value of the underlying security. For derivatives designated as fair value hedges, changes in the time value of the derivatives, which are excluded from the assessment of hedge effectiveness, are recognized currently in earnings as a component of realized and unrealized gains (losses) on derivative instruments. Hedge ineffectiveness, determined in accordance with Statement 133, had no impact on earnings for the years ended December 31, 2002 and 2001.
PROPERTY AND EQUIPMENT
Property and equipment, including significant improvements, is stated at cost. Depreciation is computed using the straight-line method using estimated useful lives of 3 to 20 years for support equipment and 10 to 40 years for buildings and improvements.
INTANGIBLE ASSETS
Effective January 1, 2002, the Company adopted Statement 142. Statement 142 requires that goodwill and other intangible assets with indefinite useful lives (collectively, "indefinite lived intangible assets") no longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of Statement 142. Equity method goodwill is also no longer amortized, but continues to be considered for impairment under Accounting Principles Board Opinion No. 18. Statement 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("Statement 144").
Statement 142 required the Company to perform an assessment of whether there was an indication that goodwill was impaired as of the date of adoption. To accomplish this, the Company identified its reporting units and determined the carrying value of each reporting unit by assigning the assets and liabilities, including the existing goodwill and intangible assets, to those reporting units as of the date of adoption. Statement 142 requires the Company to consider equity method affiliates as separate reporting units. As a result, a portion of the Company's enterprise-level goodwill balance was allocated to various reporting units which included a single equity method investment as its only asset. For example, goodwill was allocated to a separate reporting unit which included only the Company's investment in Discovery Communications, Inc. 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 which is part of a reporting unit containing allocated goodwill 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.
The Company determined the fair value of its reporting units using independent appraisals, public trading prices and other means. The Company then compared the fair value of each reporting unit to the reporting unit's carrying amount. To the extent a reporting unit's carrying amount exceeded its fair value, the Company performed the second step of the transitional impairment test. In the second step, the Company compared the implied fair value of the reporting unit's goodwill, determined by allocating the reporting unit's fair value to all of its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation, to its carrying amount, both of which were measured as of the date of adoption.
In situations where the implied fair value of a reporting unit's goodwill was less than its carrying value, Liberty recorded a transition impairment charge. In total, the Company recognized a $1,869 million transitional impairment loss, net of taxes of $127 million, as the cumulative effect of a change in accounting principle in 2002. The foregoing transitional impairment loss includes an adjustment of $325 million for the Company's proportionate share of transition adjustments that its equity method affiliates recorded.
II-42
LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
As noted above, indefinite lived intangible assets are no longer amortized. Adjusted net loss and loss per common share, exclusive of amortization expense related to goodwill, franchise costs and equity method goodwill, for periods prior to the adoption of Statement 142 are as follows (amounts in millions, except per share amounts):
Amortization of intangible assets with finite useful lives was $285 million and $191 million for the years ended December 31, 2003 and 2002, respectively. Based on its current amortizable intangible assets, Liberty expects that amortization expense will be as follows for the next five years (amounts in millions):
Changes in the carrying amount of goodwill for the year ended December 31, 2003 are as follows:
- ---------------
(1) During the year ended December 31, 2003 and excluding the acquisition of QVC, Inc. ("QVC"), Liberty completed several small acquisitions for aggregate consideration of $167 million. In connection with these
II-43
LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
acquisitions, Liberty recorded additional goodwill of $88 million, which represents the excess of the purchase price over the estimated fair value of tangible and identifiable intangible assets acquired.
(2) Starz Encore Group LLC ("Starz Encore") received an independent third party valuation in connection with its annual year-end evaluation of the recoverability of its goodwill. The result of this valuation, which was based on a discounted cash flow analysis of projections prepared by the management of Starz Encore, indicated that the fair value of this reporting unit was less than its carrying value including goodwill. This reporting unit fair value was then used to calculate an implied value of the goodwill (including $1,195 of allocated enterprise-level goodwill) related to Starz Encore. The $1,352 million excess of the carrying amount of the goodwill over its implied value has been recorded as an impairment charge in the fourth quarter of 2003. The reduction in the value of Starz Encore reflected in the third party valuation is believed to be attributable to a number of factors. Those factors include the reliance placed in that valuation on projections by management reflecting a lower rate of revenue growth compared to earlier projections based, among other things, on the possibility that revenue growth may be negatively affected by (1) a reduction in the rate of growth in total digital video subscribers and in the subscription video on demand business as a result of cable operators' increased focus on the marketing and sale of other services, such as high speed internet access and telephony, and the uncertainty as to the success of marketing efforts by distributors of Starz Encore's services and (2) lower per subscriber rates under the new affiliation agreement with Comcast, as compared to the payments required under the 1997 AT&T Broadband Affiliation Agreement (including the programming pass through provision).
(3) As noted above, the Company's enterprise-level goodwill is allocable to reporting units, whether they are consolidated subsidiaries or equity method investments. The following table summarizes these allocations at December 31, 2003 (amounts in millions).
In August 2002, Liberty purchased 38% of the common equity and 85% of the voting power of OpenTV Corp. ("OpenTV"), which when combined with Liberty's previous ownership interest in OpenTV, brought Liberty's total ownership to 41% of the equity and 86% of the voting power of OpenTV. During the period between the execution of the purchase agreement in May 2002 and the consummation of the acquisition in August 2002, OpenTV disclosed that it was lowering its revenue and cash flow projections for 2002 and extending the time before it would be cash flow positive. As a result, OpenTV wrote off all of its separately recorded goodwill. In light of the announcement by OpenTV and the adverse impact on its stock price, as well as other negative factors arising in its industry sector, Liberty determined that the goodwill initially recorded in purchase accounting ($92 million) was not recoverable. This assessment is supported by an appraisal performed by an independent third party. Accordingly, Liberty recorded an impairment charge for the entire amount of the goodwill during the third quarter of 2002.
II-44
LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
In addition to the goodwill impairment related to OpenTV, the Company recorded 2002 impairments of $84 million related to Ascent Media and $99 million primarily related to its equity method affiliates in South America.
IMPAIRMENT OF LONG-LIVED ASSETS
Statement 144 requires that the Company periodically review the carrying amounts of its property and equipment and its intangible assets (other than goodwill) to determine whether current events or circumstances indicate that such carrying amounts may not be recoverable. If the carrying amount of the asset is greater than the expected undiscounted cash flows to be generated by such asset, an impairment adjustment is to be recognized. Such adjustment is measured by the amount that the carrying value of such assets exceeds their fair value. The Company generally measures fair value by considering sale prices for similar assets or by discounting estimated future cash flows using an appropriate discount rate. Considerable management judgment is necessary to estimate the fair value of assets. Accordingly, actual results could vary significantly from such estimates. Assets to be disposed of are carried at the lower of their financial statement carrying amount or fair value less costs to sell.
As a result of the weakness in the economy in 2001 certain subsidiaries of the Company did not meet their 2001 operating objectives and reduced their 2002 expectations. Accordingly, the subsidiaries assessed the recoverability of their property and equipment and intangible assets and determined that impairment adjustments were necessary. In addition, in the fourth quarter of 2001, a subsidiary made the decision to consolidate its operations and close certain facilities. In connection with these initiatives, the subsidiary recorded a restructuring charge related to lease cancellation fees and an additional impairment charge related to its property and equipment. All of the foregoing charges are included in impairment of long-lived assets in the Company's statement of operations.
MINORITY INTERESTS
Recognition of minority interests' share of losses of subsidiaries is generally limited to the amount of such minority interests' allocable portion of the common equity of those subsidiaries. Further, the minority interests' share of losses is not recognized if the minority holders of common equity of subsidiaries have the right to cause the Company to repurchase such holders' common equity.
FOREIGN CURRENCY TRANSLATION
The functional currency of the Company is the United States ("U.S.") dollar. The functional currency of the Company's foreign operations generally is the applicable local currency for each foreign subsidiary and foreign equity method investee. Assets and liabilities of foreign subsidiaries and foreign equity investees are translated at the spot rate in effect at the applicable reporting date, and the consolidated statements of operations and the Company's share of the results of operations of its foreign equity affiliates are translated at the average exchange rates in effect during the applicable period. The resulting unrealized cumulative translation adjustment, net of applicable income taxes, is recorded as a component of accumulated other comprehensive earnings in stockholders' equity.
Transactions denominated in currencies other than the functional currency are recorded based on exchange rates at the time such transactions arise. Subsequent changes in exchange rates result in transaction gains and losses which are reflected in the accompanying consolidated statements of operations and comprehensive loss as unrealized (based on the applicable period-end exchange rate) or realized upon settlement of the transactions.
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LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
REVENUE RECOGNITION
Revenue is recognized as follows:
- Revenue from electronic retail sales is recognized at the time of shipment to customers. An allowance for returned merchandise is provided as a percentage of sales based on historical experience. The total reduction in sales due to returns for the four months ended December 31, 2003 aggregated $340 million.
- Programming revenue is recognized in the period during which programming is provided, pursuant to affiliation agreements.
- Advertising revenue is recognized, net of agency commissions, in the period during which underlying advertisements are broadcast.
- Revenue from post-production services is recognized in the period the services are rendered.
- Revenue from sales and licensing of software and related service and maintenance is recognized pursuant to Statement of Position No. 97-2 "Software Revenue Recognition." For multiple element contracts with vendor specific objective evidence, the Company recognizes revenue for each specific element when the earnings process is complete. If vendor specific objective evidence does not exist, revenue is deferred and recognized on a straight-line basis over the term of the maintenance period.
- Cable and other distribution revenue is recognized in the period that services are rendered. Cable installation revenue is recognized in the period the related services are provided to the extent of direct selling costs. Any remaining amount is deferred and recognized over the estimated average period that customers are expected to remain connected to the cable distribution system.
COST OF SALES-ELECTRONIC RETAILING
Cost of sales primarily includes actual product cost, provision for obsolete inventory, buying allowances received from suppliers, shipping and handling costs and warehouse costs.
ADVERTISING COSTS
Advertising costs generally are expensed as incurred. Advertising expense aggregated $26 million, $43 million and $43 million for the years ended December 31, 2003, 2002 and 2001, respectively. Co-operative marketing costs are recognized as advertising expense to the extent an identifiable benefit is received and fair value of the benefit can be reasonably measured. Otherwise, such costs are recorded as a reduction of revenue.
STOCK BASED COMPENSATION
As more fully described in note 13, the Company has granted to its employees options, stock appreciation rights ("SARs") and options with tandem SARs to purchase shares of Liberty Series A and Series B common stock. The Company accounts for these grants pursuant to the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB Opinion No. 25"). Under these provisions, options are accounted for as fixed plan awards and no compensation expense is recognized because the exercise price is equal to the market price of the underlying common stock on the date of grant; whereas options with tandem SARs are accounted for as variable plan awards unless there is a significant disincentive for employees to exercise the SAR feature. Compensation for variable plan awards is recognized based upon the percentage of the options that are vested and the difference between the market price of the underlying common stock and the exercise price of the options at the balance sheet date. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, "Accounting for
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Stock-Based Compensation," ("Statement 123") to its options. Compensation expense for options with tandem SARs is the same under APB Opinion No. 25 and Statement 123.
Agreements that require Liberty to reacquire interests in subsidiaries held by officers and employees in the future are marked-to-market at the end of each reporting period with corresponding adjustments being recorded to stock compensation expense.
EARNINGS (LOSS) PER COMMON SHARE
Basic earnings (loss) per common share is computed by dividing net earnings (loss) by the number of common shares outstanding. The number of outstanding common shares for periods prior to the Company's August 2001 split off from AT&T Corp. is based upon the number of shares of Series A and Series B Liberty common stock issued upon consummation of the Split Off Transaction. Diluted earnings (loss) per common share 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. Excluded from diluted earnings per share for the years ended December 31, 2003, 2002 and 2001, are 84 million, 78 million and 76 million potential common shares because their inclusion would be anti-dilutive.
RECLASSIFICATIONS
Certain prior period amounts have been reclassified for comparability with the 2003 presentation.
ESTIMATES
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Liberty considers the fair value of its derivative instruments and its assessment of nontemporary declines in value of its investments to be its most significant estimates.
Liberty holds a significant number of investments that are accounted for using the equity method. Liberty does not control the decision making process or business management practices of these affiliates. Accordingly, Liberty relies on management of these affiliates and their independent accountants to provide it with accurate financial information prepared in accordance with GAAP that Liberty uses in the application of the equity method. The Company is not aware, however, of any errors in or possible misstatements of the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
financial information provided by its equity affiliates that would have a material effect on Liberty's consolidated financial statements.
(3) SUPPLEMENTAL DISCLOSURES TO CONSOLIDATED STATEMENTS OF CASH FLOWS
(4) ACQUISITION OF CONTROLLING INTEREST IN QVC, INC.
On September 17, 2003, Liberty completed its acquisition of Comcast Corporation's ("Comcast") approximate 56.5% ownership interest in QVC for an aggregate purchase price of approximately $7.9 billion. QVC markets and sells a wide variety of consumer products in the U.S. and several foreign countries primarily by means of televised shopping programs on the QVC networks and via the Internet through its domestic and international websites. Prior to the closing, Liberty owned approximately 41.7% of QVC. Subsequent to the closing, Liberty owned approximately 98% of QVC's outstanding shares, and the remaining shares of QVC are held by members of the QVC management team.
Liberty's purchase price for QVC was comprised of 217.7 million shares of Liberty's Series A common stock valued, for accounting purposes, at $2,555 million, Floating Rate Senior Notes due 2006 in an aggregate principal amount of $4,000 million (the "Floating Rate Notes") and approximately $1,358 million in cash (including acquisition costs). The foregoing value of the Series A common stock issued was based on the average closing price for such stock for the five days surrounding July 3, 2003, which was the date that Liberty announced that it had reached an agreement with Comcast to acquire Comcast's interest in QVC. Substantially all of the cash component of the purchase price was funded with the proceeds from the Company's issuance of its 3.50% Senior Notes due 2006 in the aggregate principal amount of $1.35 billion.
Subsequent to the closing, QVC is a consolidated subsidiary of Liberty. For financial reporting purposes, the acquisition is deemed to have occurred on September 1, 2003, and since that date QVC's results of operations have been consolidated with Liberty's. Prior to its acquisition of Comcast's interest, Liberty accounted for its investment in QVC using the equity method of accounting. Liberty has recorded the acquisition of QVC as a step acquisition, and accordingly, QVC's assets and liabilities have been recorded at amounts equal to (1) 56.5% of estimated fair value at the date of acquisition plus (2) 43.5% of historical cost. The $2,048 million excess of the purchase price over the estimated fair value of 56.5% of QVC's assets and liabilities combined with Liberty's historical equity method goodwill of $1,848 million has been recorded as goodwill in the accompanying condensed consolidated balance sheet. The excess of the purchase price for Comcast's interest in QVC over the estimated fair value of QVC's assets and liabilities is attributable to the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
following: (i) QVC's position as a market leader in its industry, (ii) QVC's ability to generate significant cash from operations and Liberty's ability to obtain access to such cash, and (iii) QVC's perceived significant international growth opportunities.
Liberty's total investment in QVC of $10,717 million is comprised of $2,804 million attributable to its historical equity method investment and $7,913 million representing the purchase price for Comcast's interest. This total investment has been allocated based on a third party appraisal to QVC's assets and liabilities as follows (amounts in millions):
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(1) Customer relationships are being amortized over 10-14 years. Cable and satellite television distribution rights are being amortized primarily over 14 years.
The following unaudited pro forma information for Liberty and its consolidated subsidiaries for the years ended December 31, 2003 and 2002 was prepared assuming the acquisition of QVC occurred on January 1, 2002. These pro forma amounts are not necessarily indicative of operating results that would have occurred if the QVC acquisition had occurred on January 1, 2002.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(5) INVESTMENTS IN AFFILIATES ACCOUNTED FOR USING THE EQUITY METHOD
Liberty has various investments accounted for using the equity method. The following table includes Liberty's carrying amount and percentage ownership of the more significant investments in affiliates at December 31, 2003 and the carrying amount at December 31, 2002:
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* A consolidated subsidiary since September 2003.
The following table reflects Liberty's share of earnings (losses) of affiliates including excess basis amortization in 2001 and nontemporary declines in value:
UGC
UGC is a global broadband communications provider of video, voice and data services with operations in over 25 countries throughout the world. On January 30, 2002, the Company and UGC completed a transaction (the "UGC Transaction") pursuant to which UGC was formed to own UGC Holdings, Inc. ("UGC Holdings"). Upon consummation of the UGC Transaction, all shares of UGC Holdings common stock were exchanged for shares of common stock of UGC. In addition, the Company contributed (i) cash consideration of $200 million; (ii) a note receivable from Belmarken Holding B.V., a subsidiary of UGC Holdings, with an accreted value of $892 million and a carrying value of $496 million (the "Belmarken Loan") and (iii) Senior Notes and Senior Discount Notes of United-Pan Europe Communications N.V. ("UPC"), a subsidiary of UGC Holdings, with an aggregate carrying amount of $270 million to UGC in exchange for 281.3 million shares of UGC Class C common stock with a fair value of $1,406 million. Liberty has accounted for the UGC Transaction as the acquisition of an additional noncontrolling interest in UGC in exchange for monetary
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
financial instruments. Accordingly, Liberty calculated a $440 million gain on the transaction based on the difference between the estimated fair value of the financial instruments and their carrying value. Due to its continuing indirect ownership in the assets contributed to UGC, Liberty limited the amount of gain it recognized to the minority shareholders' attributable share (approximately 28%) of such assets or $123 million (before deferred tax expense of $48 million).
Because Liberty had no commitment to make additional capital contributions to UGC, Liberty suspended recording its share of UGC's losses when its carrying value was reduced to zero in 2002.
At December 31, 2003, Liberty owned approximately 307 million shares of UGC common stock, or an approximate 52% economic interest and a 90% voting interest in UGC. The closing price of UGC's Class A common stock was $8.48 on December 31, 2003. Pursuant to certain voting and standstill arrangements, Liberty was unable to exercise control of UGC, and accordingly, Liberty used the equity method of accounting for its investment through December 31, 2003.
On September 3, 2003, UPC completed a restructuring of its debt instruments and emerged from bankruptcy. Under the terms of the restructuring, approximately $5.4 billion of UPC's debt was exchanged for equity of UGC Europe, Inc., a new holding company of UPC ("UGC Europe"). Upon consummation, UGC receive approximately 65.5% of UGC Europe's equity in exchange for UPC debt securities that it owned; third-party noteholders received approximately 32.5% of UGC Europe's equity; and existing preferred and ordinary shareholders, including UGC, received 2% of UGC Europe's equity.
On December 18, 2003, UGC completed its offer to exchange its Class A common stock for the outstanding shares of UGC Europe common stock that it did not already own. Upon completion of the exchange offer, UGC owned 92.7% of the outstanding shares of UGC Europe common stock. On December 19, 2003, UGC effected a "short-form" merger with UGC Europe. In the short-form merger, each share of UGC Europe common stock not tendered in the exchange offer was converted into the right to receive the same consideration offered in the exchange offer, and UGC acquired the remaining 7.3% of UGC Europe. In connection with UGC's acquisition of the minority interest in UGC Europe, Liberty calculated a $680 million gain due to the dilutive effect on its investment in UGC and the implied per share value of the exchange offer. However, as Liberty had suspended recording losses of UGC in 2002 and these suspended losses exceeded the aforementioned gain, Liberty did not recognized the gain in its consolidated financial statements.
On January 5, 2004, Liberty completed a transaction pursuant to which UGC's founding shareholders (the "Founders") transferred 8.2 million shares of UGC Class B common stock to Liberty in exchange for 12.6 million shares of Liberty Series A common stock and a cash payment of approximately $13 million. Upon closing of the transaction with the Founders, the restrictions on the exercise by Liberty of its voting power with respect to UGC terminated, and Liberty gained voting control of UGC. Accordingly, UGC will be included in Liberty's consolidated financial position and results of operations beginning January 2004. Liberty has entered into a new Standstill Agreement with UGC that limits Liberty's ownership of UGC common stock to 90 percent of the outstanding common stock unless it makes an offer or effects another transaction to acquire all outstanding UGC common stock. Under certain circumstances, such an offer or transaction would require an independent appraisal to establish the price to be paid to stockholders unaffiliated with Liberty.
In January 2004, Liberty also purchased an additional 18.3 million shares of UGC Class A common stock pursuant to certain pre-emptive rights granted to it pursuant to a standstill agreement with UGC. The $140 million purchase price for such shares was comprised of (1) the cancellation of indebtedness due from subsidiaries of UGC to certain subsidiaries of Liberty in the amount of $104 million (including accrued interest) and (2) $36 million in cash.
Also in January 2004, UGC initiated a rights offering pursuant to which holders of each of UGC's Class A, Class B and Class C common stock received .28 transferable subscription rights to purchase a like II-51
LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
class of common stock for each share of common stock owned by them on January 21, 2004. The rights offering originally expired on February 6, 2004, but was subsequently extended to February 12, 2004. UGC received cash proceeds of approximately $1.02 billion from the rights offering and expects to use such cash proceeds for working capital and general corporate purposes, including future acquisitions and repayment of outstanding indebtedness. As a holder of UGC Class A, Class B and Class C common stock, Liberty participated in the rights offering and exercised its rights to purchase 94.1 million shares for a total cash purchase price of $565 million. Subsequent to the foregoing transactions, Liberty owns approximately 55% of UGC's common stock representing approximately 92% of the voting power of UGC's shares.
TELEWEST
Telewest operates cable television and telephone systems in the United Kingdom, and develops and sells a variety of television programming also in the U.K.
Telewest has disclosed that it has reached an agreement in principle, subject to certain conditions, relating to a restructuring of a significant portion of its notes and debentures. The agreement provides for the cancellation of all outstanding notes and debentures issued by Telewest and one of its subsidiaries, as well as certain other unsecured foreign exchange contracts, in exchange for new ordinary shares representing 98.5% of the issued share capital of a new holding company immediately after the restructuring. Existing shareholders will receive a 1.5% interest in the new holding company under the proposed restructuring. As a result of Telewest's proposed restructuring, which Liberty expects will reduce its ownership in Telewest to below 10%, Liberty determined that beginning in 2003 it no longer has the ability to exercise significant influence over the operations of Telewest. In addition, Liberty has removed its representatives from the Telewest board of directors. Accordingly, effective January 1, 2003, Liberty no longer accounts for its investment in Telewest using the equity method.
At December 31, 2003, Liberty's accumulated other comprehensive earnings includes $287 million (before related deferred taxes) of unrealized foreign currency losses related to its investment in the equity of Telewest. These unrealized foreign currency losses will only be recognized by Liberty upon the sale of its Telewest investment.
During the year ended December 31, 2001, Liberty determined that its investment in Telewest experienced a nontemporary decline in value. As a result, the carrying value of Telewest was adjusted to its estimated fair value, and the Company recognized a charge of $1,801 million. Such charge is included in share of losses of affiliates.
CABLEVISION
Cablevision provides cable television and high speed data services in Argentina. At December 31, 2003, the Company has a 39% economic ownership in Cablevision. As a result of deteriorating economic conditions and the devaluation of the Argentine peso, Cablevision recorded foreign currency translation losses of $393 million in the fourth quarter of 2001. At December 31, 2001, the Company determined that its investment in Cablevision had experienced a nontemporary decline in value, and accordingly, recorded an impairment charge of $195 million. Such charge is included in share of losses of affiliates. The Company's share of losses in 2001, when combined with foreign currency translation losses recorded in other comprehensive loss at December 31, 2001, reduced the carrying value of its investment in Cablevision to zero as of December 31, 2001. Included in accumulated other comprehensive earnings at December 31, 2003 is $201 million (before related deferred taxes) of unrealized foreign currency translation losses related to the Company's investment in Cablevision. These unrealized foreign currency losses will only be recognized by Liberty upon the sale of its Cablevision investment.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
ASTROLINK
Astrolink originally intended to build a global telecom network using Ka-band geostationary satellites to provide broadband data communications services. Astrolink's original business plan required significant additional financing over the next several years. During the fourth quarter of 2001, two of the members of Astrolink informed Astrolink that they did not intend to provide any of Astrolink's required financing. Based on an assessment of Astrolink's remaining sources of liquidity and Astrolink's inability to obtain financing for its business plan, the Company concluded that the carrying value of its investment in Astrolink should be reduced to reflect a fair value that assumed the liquidation of Astrolink. Accordingly, the Company wrote-off all of its remaining investment in Astrolink during the fourth quarter of 2001. Including such fourth quarter amount, the Company recorded losses and charges relating to its investment in Astrolink aggregating $417 million during the year ended December 31, 2001. As Liberty had no obligation to make additional contributions to Astrolink, its share of losses in 2002 was limited to amounts advanced to Astrolink by Liberty. Liberty sold its interest in Astrolink in the fourth quarter of 2003 for cash proceeds of $5 million.
OTHER
In April 2002, Liberty sold its 40% interest in Telemundo Communications Group for cash proceeds of $679 million, and recognized a gain of $344 million (before related tax expense of $134 million) based upon the difference between the cash proceeds and Liberty's basis in Telemundo, including allocated goodwill of $25 million.
During the years ended December 31, 2003, 2002 and 2001, Liberty recorded nontemporary declines in fair value aggregating $84 million, $148 million and $2,396 million, respectively, related to certain of its other equity method investments. Such amounts are included in share of losses of affiliates.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(6) INVESTMENTS IN AVAILABLE-FOR-SALE SECURITIES AND OTHER COST INVESTMENTS
Investments in available-for-sale securities, which are recorded at their respective fair market values, and other cost investments are summarized as follows:
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(1) Includes $533 million of shares pledged as collateral for share borrowing arrangements at December 31, 2003.
(2) At December 31, 2003, other available-for-sale securities include $493 million of investments in certain third-party marketable debt securities held by Liberty parent and $26 million of such securities held by Liberty subsidiaries. At December 31, 2002, such investments aggregated $622 million and $49 million, respectively.
NEWS CORP.
During the year ended December 31, 2003, Liberty increased its economic and voting interest in News Corp. Effective October 14, 2003, pursuant to a put/call arrangement with News Corp., Liberty acquired $500 million of American Depository Shares ("ADSs") for News Corp. preferred limited voting shares at $21.50 per ADR. In addition during 2003, Liberty sold certain of its News Corp. non-voting ADSs in the open market and purchased voting New Corp. ADSs in the open market. Liberty recognized a gain of $236 million (before related tax expense of $92 million) on the sale of its non-voting ADSs. Subsequent to December 31, 2003, Liberty purchased additional voting ADSs and sold additional non-voting ADSs in the open market. Subsequent to these transactions, Liberty owns 210.8 million non-voting News Corp. ADSs and 48 million voting ADSs. On a net basis, Liberty effectively exchanged 21.2 million non-voting ADSs and $693 million in cash for the 48 million voting ADSs, taking into account proceeds from sales of, and unwinding of collars on, non-voting News Corp. ADSs.
In May 2001, Liberty consummated a transaction with News Corp. whereby Liberty exchanged 70.7 million shares of Gemstar-TV Guide International, Inc. ("Gemstar") for 121.5 million News Corp. ADSs. Included in losses on dispositions in the accompanying consolidated statement of operations for the year ended December 31, 2001 is a loss of $764 million recognized in connection with this transaction based on the difference between the fair value of the securities received by Liberty and the carrying value of the
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Gemstar shares. In December 2001, Liberty exchanged its remaining Gemstar shares for 28.8 million additional News Corp. ADSs and recorded an additional loss of $201 million. Liberty accounts for its investment in News Corp. as an available-for-sale security.
VIVENDI AND INTERACTIVECORP
Prior to May 7, 2002, Liberty held 74.4 million shares of IAC's common stock and shares and other equity interests in certain subsidiaries of IAC that were exchangeable for an aggregate of 79.0 million shares of IAC common stock. On an "as-converted basis," Liberty owned an approximate 20% voting interest in IAC and applied the equity method of accounting for its investment. IAC owned and operated businesses in television production, electronic retailing, ticketing operations and Internet services.
On May 7, 2002, Liberty, IAC, and Vivendi consummated the following transactions. Liberty exchanged 7.1 million shares of USANi LLC (a subsidiary of IAC) for a like number of shares of IAC common stock. Vivendi then acquired from Liberty 25 million shares of IAC common stock, approximately 38.7 million shares of USANi LLC, and Liberty's approximate 30% interest in multiThematiques S.A., together with certain liabilities with respect thereto, in exchange for 37.4 million Vivendi ordinary shares, which at the date of the transaction had an aggregate fair value of $1,013 million. Liberty recognized a loss of $817 million based on the difference between the fair value of the Vivendi shares received and the carrying value of the assets relinquished, including goodwill of $514 million which was allocated to the reporting unit holding the IAC interests. Following this exchange, IAC contributed substantially all of its entertainment assets to Vivendi Universal Entertainment ("VUE"), a partnership controlled by Vivendi, in exchange for, among other consideration, common and preferred interests in VUE. After this contribution, Liberty exchanged its remaining equity interests in subsidiaries of IAC for 33.2 million shares of common stock of IAC.
During the year ended December 31, 2003 and pursuant to contractual pre-emptive rights, Liberty acquired an aggregate 48.7 million shares of IAC for cash consideration of $1,166 million. At December 31, 2003, Liberty owns approximately 20% of IAC common stock representing an approximate 47% voting interest. However, due to certain governance arrangements which limit its ability to exert significant influence over IAC, Liberty accounts for such investment as an available-for-sale security. Liberty also owned approximately 3% of Vivendi and accounted for such investment as an available-for-sale security. During the fourth quarter of 2003, Liberty sold all of its shares of Vivendi common stock in the open market for aggregate cash proceeds of $838 million and recognized a $262 million gain (before tax expense of $102 million).
TIME WARNER
On January 11, 2001, America Online, Inc. completed its merger with Time Warner to form AOL Time Warner (now known as Time Warner Inc.). In connection with the merger, each share of Time Warner common stock held by Liberty was converted into 1.5 shares of an identical series of AOL Time Warner stock. Liberty recognized a $253 million gain (before deferred tax expense of $100 million) based upon the difference between the carrying value of Liberty's interest in Time Warner and the fair value of the AOL Time Warner securities received.
VIACOM
On January 23, 2001, BET Holdings II, Inc. ("BET") was acquired by Viacom in exchange for shares of Class B common stock of Viacom. As a result of the merger, Liberty received 15.2 million shares of Viacom's Class B common stock (less than 1% of Viacom's common equity) in exchange for its 35% ownership interest in BET, which investment had been accounted for using the equity method. Liberty accounts for its investment in Viacom as an available-for-sale security. Liberty recognized a gain of $559 million (before deferred tax expense of $221 million) in 2001 based upon the difference between the carrying value of Liberty's interest in BET and the value of the Viacom securities received. II-55
LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NONTEMPORARY DECLINES IN FAIR VALUE OF INVESTMENTS
During the years ended December 31, 2003, 2002 and 2001, Liberty determined that certain of its AFS Securities and cost investments experienced nontemporary declines in value. The primary factors considered by Liberty in determining the timing of the recognition for the majority of these impairments was the length of time the investments traded below Liberty's cost bases and the lack of near-term prospects for recovery in the stock prices. As a result, the carrying amounts of such investments were adjusted to their respective fair values based primarily on quoted market prices at the balance sheet date. These adjustments are reflected as nontemporary declines in fair value of investments in the consolidated statements of operations.
The following table identifies the realized losses attributable to each of the individual investments as follows:
UNREALIZED HOLDINGS GAINS AND LOSSES
Unrealized holding gains and losses related to investments in available-for-sale securities that are included in accumulated other comprehensive earnings are summarized below.
Management estimates that the fair market value of all of its other cost investments approximated $497 million and $342 million at December 31, 2003 and 2002, respectively. Management calculates market values of its other cost investments using a variety of approaches including multiple of cash flow, per subscriber value, or a value of comparable public or private businesses. No independent appraisals were conducted for those cost investment assets.
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(7) DERIVATIVE INSTRUMENTS
The Company's derivative instruments are summarized as follows:
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(1) Includes narrow-band collars.
EQUITY COLLARS, NARROW-BAND COLLARS, PUT SPREAD COLLARS AND PUT OPTIONS
The Company has entered into equity collars, narrow-band collars, put spread collars, written put options and other financial instruments to manage market risk associated with its investments in certain marketable securities. These instruments are recorded at fair value based on option pricing models. Equity collars provide the Company with a put option that gives the Company the right to require the counterparty to purchase a specified number of shares of the underlying security at a specified price (the "Company Put Price") at a specified date in the future. Equity collars also provide the counterparty with a call option that gives the counterparty the right to purchase the same securities at a specified price at a specified date in the future. The put option and the call option generally are equally priced at the time of origination resulting in no cash receipts or payments. Narrow-band collars are equity collars in which the put and call prices are set so that the call option has a relatively higher fair value than the put option at the time of origination. In these cases the Company receives cash equal to the difference between such fair values.
Put spread collars provide the Company and the counterparty with put and call options similar to equity collars. In addition, put spread collars provide the counterparty with a put option that gives it the right to require the Company to purchase the underlying securities at a price that is lower than the Company Put Price. The inclusion of the secondary put option allows the Company to secure a higher call option price while maintaining net zero cost to enter into the collar. However, the inclusion of the secondary put exposes the Company to market risk if the underlying security trades below the put spread price.
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EXCHANGEABLE DEBENTURE CALL OPTION OBLIGATIONS
Liberty has issued senior exchangeable debentures which are exchangeable for the value of a specified number of shares of Sprint PCS Group common stock, Motorola common stock, Viacom Class B common stock or Time Warner common stock, as applicable. (See note 9 for a more complete description of the exchangeable debentures.)
Prior to the adoption of Statement 133, the exchangeable debenture call option feature and the long-term debt were reported together in the Company's consolidated balance sheet. Under Statement 133, the call option feature of the exchangeable debentures is reported separately in the consolidated balance sheet at fair value. Accordingly, at January 1, 2001, Liberty recorded a transition adjustment to reflect the call option obligations at fair value ($459 million) and to recognize in net earnings the difference between the fair value of the call option obligations at issuance and the fair value of the call option obligations at January 1, 2001. Such adjustment to net earnings aggregated $757 million (before tax expense of $299 million) and is included in cumulative effect of accounting change. Changes in the fair value of the call option obligations subsequent to January 1, 2001 are recognized as unrealized gains (losses) on derivative instruments in Liberty's consolidated statements of operations.
REALIZED AND UNREALIZED GAINS ON DERIVATIVE INSTRUMENTS
Realized and unrealized gains (losses) on derivative instruments during the years ended December 31, 2003, 2002 and 2001 are comprised of the following:
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(1) Comprised primarily of forward foreign exchange contracts and interest rate swap agreements.
(8) AT&T OWNERSHIP OF LIBERTY
On March 9, 1999, AT&T Corp. ("AT&T") acquired Tele-Communications, Inc. ("TCI"), the former parent company of Liberty, in a merger transaction (the "AT&T Merger").
From March 9, 1999 through August 9, 2001, AT&T owned 100% of the outstanding common stock of Liberty. During such time, the AT&T Class A Liberty Media Group common stock and the AT&T Class B Liberty Media Group common stock were tracking stocks of AT&T designed to reflect the economic performance of the businesses and assets of AT&T attributed to the Liberty Media Group, which was comprised of the businesses and assets of Liberty and its subsidiaries.
Effective August 10, 2001, AT&T effected the split-off of Liberty pursuant to which Liberty's common stock was recapitalized, and each outstanding share of AT&T Liberty Media Group tracking stock was redeemed for one share of Liberty common stock (the "Split Off Transaction"). Subsequent to the Split Off Transaction which was accounted for at historical cost, Liberty is no longer a subsidiary of AT&T.
In connection with the Split Off Transaction, Liberty was also deconsolidated from AT&T for federal income tax purposes. Pursuant to an agreement entered into at the time of the AT&T Merger, AT&T was
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
required to pay Liberty an amount equal to 35% of the amount of the net operating loss carryforward reflected in TCI's final federal income tax return that had not been used as an offset to Liberty's obligations under a tax sharing agreement and that had been, or was reasonably expected to be, utilized by AT&T. The $803 million payment was received by Liberty prior to the Split Off Transaction and has been reflected as an increase to additional paid-in-capital in the accompanying consolidated statement of stockholders' equity. In addition, certain deferred intercompany gains were includible in AT&T's taxable income as a result of the Split Off Transaction, and AT&T was entitled to reimbursement from Liberty for the resulting tax liability of approximately $115 million. Such tax liability has been reflected as a reduction in additional paid-in-capital in the accompanying consolidated statement of stockholders' equity.
(9) LONG-TERM DEBT
Debt is summarized as follows:
SENIOR NOTES AND DEBENTURES
In September 2003, Liberty issued $1,350 million principal amount of 3.5% senior notes due 2006 for net cash proceeds of $1,347 million. Liberty used the proceeds from this offering to partially finance its purchase of Comcast's interest in QVC. See note 4.
Also as part of the consideration for QVC, Liberty issued $4,000 million of Floating Rate Notes due 2006 to Comcast. The Floating Rate Notes accrue interest at LIBOR plus a margin. The margin on the $2,500 million principal amount of Floating Rate Notes sold by Comcast on September 24, 2003 is fixed at 1.5%. On September 24, 2003 and December 12, 2003, Liberty repurchased from subsidiaries of Comcast $500 million and $1,000 million, respectively, principal amount of the Floating Rate Notes at a purchase price equal to 100% of the principal amount plus accrued interest.
During the second quarter of 2003, Liberty issued $1,000 million principal amount of senior notes due 2013 with an interest rate of 5.70% for cash proceeds of $990 million net of offering discount and underwriting fees.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
In prior years, Liberty issued $750 million of 7 7/8% Senior Notes due 2009, $237.8 million of 7 3/4% Senior Notes due 2009, $500 million of 8 1/2% Senior Debentures due 2029, and $1 billion of 8 1/4% Senior Debentures due 2030. Interest on these obligations is payable semi-annually.
The senior notes and senior debentures are stated net of an aggregate unamortized discount of $24 million and $19 million at December 31, 2003 and 2002, respectively, which is being amortized to interest expense in the accompanying consolidated statements of operations.
SENIOR EXCHANGEABLE DEBENTURES
In November 1999, Liberty issued $869 million of 4% Senior Exchangeable Debentures due 2029. Each $1,000 debenture is exchangeable at the holder's option for the value of 22.9486 shares of Sprint PCS Group stock. After the date Liberty's ownership level of Sprint PCS Group common stock falls below 10%, Liberty may, at its election, pay the exchange value in cash, Sprint PCS Group stock or a combination thereof. Prior to such time, the exchange value must be paid in cash. Liberty's ownership in Sprint PCS was approximately 17% at December 31, 2003. Liberty, at its option, may redeem the debentures, in whole or in part, for cash.
In February and March 2000, Liberty issued an aggregate of $810 million of 3 3/4% Senior Exchangeable Debentures due 2030. Each $1,000 debenture is exchangeable at the holder's option for the value of 16.7764 shares of Sprint PCS Group stock. After the date Liberty's ownership level of Sprint PCS Group stock falls below 10%, Liberty may, at its election, pay the exchange value in cash, Sprint PCS Group stock or a combination thereof. Prior to such time, the exchange value must be paid in cash. Liberty, at its option, may redeem the debentures, in whole or in part, for cash.
In January 2001, Liberty issued $600 million of 3 1/2% Senior Exchangeable Debentures due 2031. Each $1,000 debenture is exchangeable at the holder's option for the value of 36.8189 shares of Motorola common stock. Such exchange value is payable, at Liberty's option, in cash, Motorola stock or a combination thereof. On or after January 15, 2006, Liberty, at its option, may redeem the debentures, in whole or in part, for cash.
In March 2001, Liberty issued $817.7 million of 3 1/4% Senior Exchangeable Debentures due 2031. Each $1,000 debenture is exchangeable at the holder's option for the value of 18.5666 shares of Viacom Class B common stock. After January 23, 2003, such exchange value is payable at Liberty's option in cash, Viacom stock or a combination thereof. Prior to such date, the exchange value must be paid in cash. On or after March 15, 2006, Liberty, at its option, may redeem the debentures, in whole or in part, for cash.
In March and April 2003, Liberty issued an aggregate principal amount of $1,750 million of 0.75% Senior Exchangeable Debentures due 2023 and received net cash proceeds of $1,715 million after expenses. Each $1,000 debenture is exchangeable at the holder's option for the value of 57.4079 shares of Time Warner common stock. Liberty may, at its election, pay the exchange value in cash, Time Warner common stock, shares of Liberty Series A common stock or a combination thereof. On or after April 5, 2008, Liberty, at its option, may redeem the debentures, in whole or in part, for shares of Time Warner common stock, cash or any combination thereof. On March 30, 2008, March 30, 2013 or March 30, 2018, each holder may cause Liberty to purchase its exchangeable debentures, and Liberty, at its election, may pay the purchase price in shares of Time Warner common stock, cash, Liberty Series A common stock, or any combination thereof.
Interest on the Company's exchangeable debentures is payable semi-annually based on the date of issuance. At maturity, all of the Company's exchangeable debentures are payable in cash.
In accordance with Statement 133, the call option feature of the exchangeable debentures is reported at fair value and separately from the long-term debt in the consolidated balance sheet.
The reported amount of the long-term debt portion of the exchangeable debentures is calculated as the difference between the face amount of the debentures and the fair value of the call option feature on the date of issuance. The fair value of the call option obligations related to the $1,750 million of exchangeable II-60
LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
debentures issued during the year ended December 31, 2003, aggregated $406 million on the date of issuance. Accordingly, the long-term debt portion was recorded at $1,344 million. The long-term debt is accreted to its face amount over the expected term of the debenture using the effective interest method. Accretion related to all of the Company's exchangeable debentures aggregated $61 million, $7 million and $6 million during the years ended December 31, 2003, 2002 and 2001, respectively, and is included in interest expense in the accompanying consolidated statements of operations.
SUBSIDIARY BANK CREDIT FACILITIES
At December 31, 2003, Starz Encore had no amounts outstanding and $325 million available pursuant to its bank credit facility. The bank credit facility contains restrictive covenants which require, among other things, the maintenance of certain financial ratios, and include limitations on indebtedness, liens, encumbrances, acquisitions, dispositions, guarantees and dividends. Additionally, the bank credit facility requires the payment of fees of .2% per annum on the average unborrowed portion of the total commitment. Such fees were not significant in 2003, 2002 and 2001. Starz Encore's ability to borrow the unused capacity noted above is dependent on its continuing compliance with its covenants at the time of, and after giving effect to, a requested borrowing.
At December 31, 2003, the subsidiary of Liberty that operates the DMX Music service was not in compliance with three covenants contained in its bank loan agreement. The subsidiary and the participating banks have entered into a forbearance agreement whereby the banks have agreed to forbear from exercising certain default-related remedies against the subsidiary through March 31, 2004. The subsidiary will not be able to repay its debt when the forbearance agreement expires and is currently considering its financing options. The outstanding balance of the subsidiary's bank facility was $89 million at December 31, 2003, all of which is included in current portion of debt. All other consolidated borrowers were in compliance with their debt covenants at December 31, 2003.
FIVE YEAR MATURITIES
The U.S. dollar equivalent of the annual maturities of Liberty's debt for each of the next five years is as follows (amounts in millions):
FAIR VALUE OF DEBT
Liberty estimates the fair value of its debt based on the quoted market prices for the same or similar issues or on the current rate offered to Liberty for debt of the same remaining maturities. The fair value of Liberty's publicly traded debt at December 31, 2003 is as follows (amounts in millions):
Liberty believes that the carrying amount of its subsidiary debt approximated fair value at December 31, 2003.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
A reconciliation of the carrying value of the Company's debt to the face amount at maturity is as follows (amounts in millions):
(10) INCOME TAXES
During the period from March 9, 1999 to August 10, 2001, Liberty was included in the consolidated federal income tax return of AT&T and was a party to a tax sharing agreement with AT&T (the "AT&T Tax Sharing Agreement"). Liberty calculated its respective tax liability on a separate return basis. The income tax provision for Liberty was calculated based on the increase or decrease in the tax liability of the AT&T consolidated group resulting from the inclusion of those items in the consolidated tax return of AT&T which were attributable to Liberty.
Under the AT&T Tax Sharing Agreement, Liberty received a cash payment from AT&T in periods when Liberty generated taxable losses and such taxable losses were utilized by AT&T to reduce the consolidated income tax liability. This utilization of taxable losses was accounted for by Liberty as a current federal intercompany income tax benefit. To the extent such losses were not utilized by AT&T, such amounts were available to reduce federal taxable income generated by Liberty in future periods, similar to a net operating loss carryforward, and were accounted for as a deferred federal income tax benefit. During the period from March 10, 1999 to December 31, 2002, Liberty received cash payments from AT&T aggregating $555 million as payment for Liberty's taxable losses that AT&T utilized to reduce its income tax liability. In the event AT&T generates ordinary losses in 2003 or capital losses in 2003 or 2004 and is able to carry back such losses to offset taxable income previously offset by Liberty's losses, Liberty may be required to refund as much as $333 million of these cash payments.
Income tax benefit (expense) consists of:
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LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Income tax benefit (expense) differs from the amounts computed by applying the U.S. federal income tax rate of 35% as a result of the following:
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2003 and 2002 are presented below:
The Company's valuation allowance increased $23 million in 2003, including a $65 million charge to tax expense partially offset by a $42 million reversal of valuation allowance recorded in connection with acquisitions.
At December 31, 2003, Liberty had net operating and capital loss carryforwards for income tax purposes aggregating approximately $2,304 million which, if not utilized to reduce taxable income in future periods, will expire as follows: 2004: $1 million; 2005: $14 million; 2006: $51 million; 2007: $78 million; 2008: $12 million;
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
2009: $64 million; 2010: $5 million; and beyond 2010: $2,079 million. Of the foregoing net operating and capital loss carryforward amount, approximately $1,281 million is subject to certain limitations and may not be currently utilized. The remaining $1,023 million is currently available to be utilized to offset future taxable income of Liberty's consolidated tax group.
AT&T, as the successor to TCI, is the subject of an Internal Revenue Service ("IRS") audit for the 1993-1999 tax years. The IRS notified AT&T and Liberty that it was proposing income adjustments and assessing certain penalties in connection with TCI's 1994 tax return. The IRS, AT&T and Liberty have reached an agreement whereby AT&T will recognize additional income of $94 million with respect to this matter, and no penalties will be assessed. Pursuant to the tax sharing agreement between Liberty and AT&T, Liberty may be obligated to reimburse AT&T for any tax that AT&T is ultimately assessed as a result of this agreement. Liberty is currently unable to estimate any such tax liability and resulting reimbursement, but believes that any such reimbursement will not be material to its financial position.
(11) STOCKHOLDERS' EQUITY
PREFERRED STOCK
Liberty's preferred stock is issuable, from time to time, with such designations, preferences and relative participating, option or other special rights, qualifications, limitations or restrictions thereof, as shall be stated and expressed in a resolution or resolutions providing for the issue of such preferred stock adopted by Liberty's Board of Directors. As of December 31, 2003, no shares of preferred stock were issued.
COMMON STOCK
The Series A common stock has one vote per share, and the Series B common stock has ten votes per share. Each share of the Series B common stock is exchangeable at the option of the holder for one share of Series A common stock.
As of December 31, 2003, there were 56 million shares of Liberty Series A common stock and 28 million shares of Liberty Series B common stock reserved for issuance under exercise privileges of outstanding stock options and warrants.
PURCHASES OF COMMON STOCK
During the years ended December 31, 2003 and 2002, the Company purchased 42.3 million and 25.7 million shares of its common stock for aggregate cash consideration of $437 million and $281 million, respectively. These purchases have been accounted for as retirements of common stock and have been reflected as a reduction of stockholders' equity in the accompanying consolidated balance sheet.
During 2002, Liberty sold put options on 7.0 million shares of its Series A common stock, 4.0 million of which were outstanding at December 31, 2002. Liberty sold another 9.3 million put options in the first quarter of 2003. All of these options expired unexercised prior to December 31, 2003. The Company accounted for these put options pursuant to EITF 00-19, "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock" and recorded a net increase to additional paid-in-capital of $37 million during the year ended December 31, 2003.
(12) TRANSACTIONS WITH OFFICERS AND DIRECTORS
CHAIRMAN'S EMPLOYMENT AGREEMENT
In connection with the AT&T Merger, an employment agreement between the Company's Chairman and TCI was assigned to the Company.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Chairman's employment agreement provides for, among other things, deferral of a portion (not in excess of 40%) of the monthly compensation payable to him for all employment years commencing on or after January 1, 1993. The deferred amounts will be payable in monthly installments over a 20-year period commencing on the termination of the Chairman's employment, together with interest thereon at the rate of 8% per annum compounded annually from the date of deferral to the date of payment. The aggregate liability under this arrangement at December 31, 2003 is $1.6 million, and is included in other liabilities in the accompanying consolidated balance sheet.
The Chairman's employment agreement also provides that in the event of termination of his employment with Liberty, he will be entitled to receive 240 consecutive monthly payments equal to $15,000 increased at the rate of 12% per annum compounded annually from January 1, 1988 to the date payment commences ($82,103 per month as of December 31, 2003). Such payments would commence on the first day of the month succeeding the termination of employment. In the event of the Chairman's death, his beneficiaries would be entitled to receive the foregoing monthly payments. The aggregate liability under this arrangement at December 31, 2003 is $19.7 million, and is included in other liabilities in the accompanying consolidated balance sheet.
The Company's Chairman deferred a portion of his monthly compensation under his previous employment agreement with TCI. The Company assumed the obligation to pay that deferred compensation in connection with the AT&T Merger. The deferred obligation (together with interest at the rate of 13% per annum compounded annually), which aggregated $10.9 million at December 31, 2003 and is included in other liabilities, is payable on a monthly basis, following the occurrence of specified events, under the terms of the previous employment agreement. The rate at which interest accrues on the deferred obligation was established in 1983 pursuant to the previous employment agreement.
OTHER
Effective November 28, 2003, Liberty acquired all the outstanding stock of TP Investment, Inc. ("TPI"), a corporation wholly owned by TP-JCM, LLC, a limited liability company in which the sole member is the Company's Chairman. In exchange for the stock of TPI, TP-JCM received 5,281,739 shares of the Company's Series B common stock, valued in the agreement at $11.50 per share. As prescribed by the Agreement and Plan of Merger pursuant to which the acquisition was effected, that per share value equals 110% of the average of the closing sale prices of the Company's Series A Common Stock for the ten trading days ended November 28, 2003. TPI owns 10,602 shares of Series B Preferred Stock of Liberty TP Management, Inc. ("Liberty TP Management"), a subsidiary of the Company. Those shares of Series B Preferred Stock represent 12% of the voting power of Liberty TP Management. TPI also owns a 5% membership interest (representing a 50% voting interest) in Liberty TP LLC, a limited liability company which owns approximately 20.6% of the common equity and 27.2% of the voting power of Liberty TP Management. As a result of the acquisition, the Company beneficially owns all the equity and voting interests in Liberty TP Management. Liberty TP Management owns our interest in True Position and certain equity interests in Sprint PCS Group, IDT Investments, Inc. and priceline.com.
In connection with the acquisition of TPI, the Company entered into a registration rights agreement. That agreement provides for the registration by the Company under applicable federal and state securities laws, at the holder's request, of the sale of shares of the Company's Series A Common Stock issuable upon conversion of shares of the Series B Common Stock that were issued to TP-JCM.
The shares of Series B Common Stock issued to TP-JCM are subject to the Company's rights to purchase such shares pursuant to a call agreement entered into in February 1998 by the chairman and his spouse. Pursuant to the call agreement, Liberty has the right to acquire all of the Series B Liberty common stock held by the Chairman and his spouse in certain circumstances. The price of acquiring such shares is generally limited to the market price of the Series A Liberty common stock, plus a 10% premium. II-65
LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
During the second quarter of 2001, Liberty purchased 2,245,155 shares of common stock of On Command Corporation ("On Command"), a consolidated subsidiary of Liberty, from the Chairman and Chief Executive Officer of On Command, who at the time was also a director of Liberty, for aggregate cash consideration of $25.2 million. Such purchase price represents a per share price of $11.22. The closing market price for On Command common stock on the day the transaction was signed was $7.77. The Company has included the difference between the aggregate market value of the shares purchased and the cash consideration paid in selling, general and administrative expenses in the accompanying consolidated statement of operations.
In August 2000, On Command sold shares of its Series A Convertible Participating Preferred Stock (the "Preferred Shares") to a former director of Liberty, who was also the Chairman and Chief Executive Officer of On Command, for a $21 million note. The Preferred Shares are convertible into 236,250 shares of Liberty Series A common stock. The note is secured by the Preferred Shares or the proceeds from the sale of such shares and the former director's personal obligations under such loan are limited. The note, which matures on August 1, 2005, may not be prepaid and interest on the note accrues at a rate of 7% per annum. This arrangement has been treated as a fixed plan option for accounting purposes.
(13) STOCK OPTIONS AND STOCK APPRECIATION RIGHTS
LIBERTY
Effective with the Split Off Transaction, Liberty assumed from AT&T the Amended and Restated AT&T Corp. Liberty Media Group 2000 Incentive Plan and renamed it the Liberty Media Corporation 2000 Incentive Plan (the "Liberty Incentive Plan"). Grants by TCI to current and former Liberty employees of options and options with tandem SARs with respect to shares of Liberty Media Group stock prior to 1999 were assumed by Liberty under the Liberty Incentive Plan. Grants of free standing SARs made under the Plan in 2000 and in 2001 prior to the Split Off Transaction were converted into options upon assumption by Liberty.
The Liberty Incentive Plan provides for awards to be made in respect of a maximum of 160 million shares of common stock of Liberty. Awards may be made as grants of stock options, SARs, restricted shares, stock units, cash or any combination of the foregoing.
Effective February 28, 2001 (the "Effective Date"), the Company restructured the options and options with tandem SARs to purchase AT&T common stock and AT&T Liberty Media Group tracking stock (collectively the "Restructured Options") held by certain executive officers of the Company. Pursuant to such restructuring, all Restructured Options became exercisable on the Effective Date, and each executive officer was given the choice to exercise all of his Restructured Options. Each executive officer who opted to exercise his Restructured Options received consideration equal to the excess of the closing price of the subject securities on the Effective Date over the exercise price. The exercising officers received (i) a combination of cash and AT&T Liberty Media Group tracking stock for Restructured Options that were vested prior to the Effective Date and (ii) cash for Restructured Options that were previously unvested. The executive officers used the cash proceeds from the previously unvested options to purchase restricted shares of AT&T Liberty Media Group tracking stock which were converted into shares of Liberty common stock upon completion of the Split Off Transaction. Such restricted shares vested according to a schedule that corresponded to the vesting schedule applicable to the previously unvested options. As of December 31, 2003, all of the restricted shares were vested.
In addition, each executive officer was granted free-standing SARs equal to the total number of Restructured Options exercised. The free-standing SARs were tied to the value of AT&T Liberty Media Group tracking stock and will vest as to 30% in year one and 17.5% in years two through five. The free-standing SARs were granted with an exercise price of $14.70 ($15.35 in the case of Liberty Series B options)
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
and had a fair value of $9.56 on the date of the grant. Upon completion of the Split Off Transaction, the free-standing SARs automatically converted to options to purchase Liberty Series A common stock (and in some cases Liberty Series B common stock). Prior to the Effective Date, the Restructured Options were accounted for using variable plan accounting pursuant to APB Opinion No. 25. Accordingly, the above-described transaction did not have a significant impact on Liberty's results of operations.
In addition to the SARs issued in the aforementioned option restructuring, during 2001 and pursuant to the Liberty Incentive Plan, Liberty awarded 2,104,000 options to purchase Liberty Series A common stock to certain officers and key employees of the Company. Such options have a 10-year term, exercise prices ranging from $12.40 to $16.35, vest as to 25% in each of years 2 through 5 after the date of grant, and had a weighted-average grant date fair value of $9.40.
During the first quarter of 2002, the Company reduced the exercise price of 2.3 million stock options previously granted to three executive officers from a weighted average exercise price of $21.66 to $14.70, which new exercise price exceeded the closing market price of Liberty Series A common stock on the date of repricing. As a result of such repricing, these options are now accounted for as variable plan awards. Options held by Liberty's Chairman, Chief Executive Officer and Chief Operating Officer were not included in the foregoing repricing.
In connection with the Company's Rights Offering, which expired on December 2, 2002, and pursuant to the Liberty Incentive Plan antidilution provisions, the number of shares and the applicable exercise prices of all Liberty options granted pursuant to the Liberty Incentive Plan were adjusted as of October 31, 2002, the record date for the Rights Offering. As a result of the foregoing modifications, all of the Company's outstanding options are now accounted for as variable plan awards.
During the year ended December 31, 2003, Liberty awarded 6,167,000 free standing SARs to its officers and employees. Such SARs have a 10-year term, exercise prices ranging from $11.09 to $14.33, vest as to 20% on each of the first five anniversaries of the respective grant date, and had a weighted average grant date fair value of $5.57 per share.
On December 17, 2002, shareholders of the Company approved the Liberty Media Corporation 2002 Nonemployee Director Incentive Plan (the "NDIP"). Under the NDIP, the Liberty Board of Directors (the "Liberty Board") has the full power and authority to grant eligible nonemployee directors stock options, SARs, stock options with tandem SARs, and restricted stock. Effective September 9, 2003, the Liberty Board granted each nonemployee director of Liberty 11,000 free standing SARs at an exercise price of $11.85. These options expire 10 years from the date of grant, vest on the first anniversary of the grant date and had a grant date fair value of $5.93 per share.
The estimated fair values of the options noted above are based on the Black-Scholes model and are stated in current annualized dollars on a present value basis. The key assumptions used in the model for purposes of these calculations generally include the following: (a) a discount rate equal to the 10-year Treasury rate on the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
date of grant; (b) a 32% volatility factor; (c) the 10-year option term; (d) the closing price of the respective common stock on the date of grant; and (e) an expected dividend rate of zero.
The following table presents the number and weighted average exercise price ("WAEP") of certain options, SARs and options with tandem SARs to purchase Liberty Series A and Series B common stock granted to certain officers, employees and directors of the Company.
The following table provides additional information about the Company's outstanding options to purchase Liberty Series A common stock at December 31, 2003.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
JUNIOR STOCK PLANS
In July 2001, Liberty LWR, Inc. ("LWR"), a wholly-owned subsidiary of Liberty, formed Liberty Livewire Holdings, Inc. ("Livewire Holdings") as a wholly owned subsidiary. LWR then sold to certain officers and a director of Liberty an aggregate 19.872% common stock interest in Livewire Holdings with an aggregate value of $600. Liberty, LWR and these individuals entered into a stockholders agreement pursuant to which the individuals could require Liberty to purchase, after five years, all or part of their common stock interest in Livewire Holdings, in exchange for Liberty common stock, at its then-fair market value. In addition, Liberty had the right to purchase, in exchange for its common stock, their common stock interests in Livewire Holdings for fair market value at any time. Effective May 9, 2003, all of the assets of Livewire Holdings were distributed to LWR as the holder of all of the preferred stock interest in Livewire Holdings, and Livewire Holdings was dissolved.
In September 2000, certain officers of Liberty purchased a 6% common stock interest in a subsidiary for $1.3 million. Such subsidiary owns an indirect interest in an entity that holds certain of Liberty's investments in satellite and technology related assets. Liberty and the officers entered into a shareholders agreement in which the officers could require Liberty to purchase, after five years, all or part of their common stock interest in exchange for Series A Liberty common stock at the then fair market value. The shareholders agreement also provides that upon termination of employment, Liberty will repurchase the officers' interest for the original purchase price plus 6%. In addition, Liberty has the right to purchase, in exchange for Series A Liberty common stock, the common stock interests held by the officers at fair market value at any time. During 2001, two of the officers resigned their positions with the Company, and the Company purchased their respective interests in the subsidiary pursuant to the terms of the agreement. No compensation related to this stock plan was recognized by Liberty in 2003, 2002 or 2001.
In May 2000, Liberty's President and Chief Executive Officer, certain officers of a subsidiary and another individual purchased an aggregate 20% common stock interest in a subsidiary for $800,000. This subsidiary owns a 7% interest in J-COM. Liberty and the individuals entered into a shareholders agreement in which the individuals could require Liberty to purchase, after five years, all or part of their common stock interest in exchange for Series A Liberty common stock at its then fair market value. In addition, Liberty has the right to purchase, in exchange for Series A Liberty common stock, the common stock interests held by the officers at fair market value at any time. Liberty recognized $1 million, less than $1 million, and $4 million of compensation expense related to changes in the market value of its contingent liability to reacquire the common stock interests held by these officers during the years ended December 31, 2003, 2002 and 2001, respectively.
QVC
QVC has a qualified and nonqualified combination stock option/stock appreciation rights plan (collectively, the "Tandem Plan") for employees, officers, directors and other persons designated by the Stock Option Committee of QVC's board of directors. Under the Tandem Plan, the option price is generally equal to the fair market value, as determined by an independent appraisal, of a share of the underlying common stock of QVC at the date of the grant. The fair value of a share of QVC common stock as of the latest valuation date is $2,270. If the eligible participant elects the SAR feature of the Tandem Plan, the participant receives 75% of the excess of the fair market value of a share of QVC common stock over the exercise price of the option to which it is attached at the exercise date. The holders of a majority of the outstanding options have stated an intention not to exercise the SAR feature of the Tandem Plan. Because the exercise of the option component is more likely than the exercise of the SAR feature, compensation expense is measured based on the stock option component. As a result, QVC is applying fixed plan accounting in accordance with APB Opinion No. 25. Under the Tandem Plan, option/SAR terms are ten years from the date of grant, with options/SARs generally becoming exercisable over four years from the date of grant. At December 31, 2003, there were a
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
total of 142,671 options outstanding, 41,632 of which were vested at a weighted average exercise price of $957.44 and 101,039 of which were unvested at a weighted average exercise price of $1,523.21.
In the fourth quarter of 2003, Liberty granted to certain officers and employees of QVC a total of 10,098,978 restricted shares of Liberty Series A common stock. Such shares vest as to 33% on each of January 1, 2005, 2006 and 2007. These shares had a grant date fair value of $10.08 per share.
STARZ ENCORE
Starz Encore has granted Phantom Stock Appreciation Rights ("PSARS") to certain of its officers and employees, including its chief executive officer, under this plan. PSARS granted under the plan generally vest over a five year period. Substantially all of these PSARs are fully vested as of December 31, 2003. Compensation under the PSARS is computed based upon the percentage of PSARS that are vested and a formula derived from the appraised fair value of the net assets of Starz Encore. All amounts earned under the plan are payable in cash, Liberty common stock or a combination thereof. At December 31, 2003 the amount accrued pursuant to this plan was $94 million.
Effective December 27, 2002, the chief executive officer of Starz Encore elected to exercise 54% of his outstanding PSARS. In July 2003, Starz Encore satisfied the amount due the officer with a cash payment of $287 million.
OTHER
Certain of the Company's subsidiaries have stock based compensation plans under which employees and non-employees are granted options or similar stock based awards. Awards made under these plans vest and become exercisable over various terms. The awards and compensation recorded, if any, under these plans is not significant to Liberty.
(14) EMPLOYEE BENEFIT PLANS
Liberty is the sponsor of the Liberty Media 401(k) Savings Plan (the "Liberty 401(k) Plan"), which provides its employees and the employees of certain of its subsidiaries an opportunity for ownership in the Company and creates a retirement fund. The Liberty 401(k) Plan provides for employees to make contributions to a trust for investment in Liberty common stock, as well as several mutual funds. The Company and its subsidiaries make matching contributions to the Liberty 401(k) Plan based on a percentage of the amount contributed by employees. In addition, certain of the Company's subsidiaries have their own employee benefit plans. Employer cash contributions to all plans aggregated $16 million, $10 million and $10 million for the years ended December 31, 2003, 2002 and 2001, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(15) OTHER COMPREHENSIVE EARNINGS (LOSS)
Accumulated other comprehensive earnings (loss) included in Liberty's consolidated balance sheets and consolidated statements of stockholders' equity reflect the aggregate of foreign currency translation adjustments and unrealized holding gains and losses on AFS Securities. The change in the components of accumulated other comprehensive earnings (loss), net of taxes, is summarized as follows:
The components of other comprehensive earnings (loss) are reflected in Liberty's consolidated statements of comprehensive earnings (loss) net of taxes. The following table summarizes the tax effects related to each component of other comprehensive earnings/loss.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(16) TRANSACTIONS WITH AT&T AND OTHER RELATED PARTIES
Subsidiaries of Liberty provide services to various equity affiliates of Liberty, including Discovery Communications. Total revenue recognized by Liberty subsidiaries for such services aggregated $19 million, $6 million and $17 million for the years ended December 31, 2003, 2002 and 2001, respectively.
Certain subsidiaries of Liberty produce and/or distribute programming and other services to cable distribution operators (including AT&T) and others pursuant to long term affiliation agreements. Charges to AT&T were based upon customary rates charged to others. Amounts included in revenue for services provided to AT&T prior to the Split Off Transaction were $210 million for the seven months ended July 31, 2001.
Prior to the Split Off Transaction, AT&T allocated certain corporate general and administrative costs to Liberty pursuant to an intergroup agreement. Management believes such allocation methods were reasonable and materially approximated the amount that Liberty would have incurred on a stand-alone basis. In addition, there were arrangements between subsidiaries of Liberty and AT&T and its other subsidiaries for satellite transponder services, marketing support, programming, and hosting services. These expenses aggregated $20 million during the seven months ended July 31, 2001 (the period immediately prior to the Split Off Transaction) and are included in operating and SG&A expenses in the accompanying consolidated statement of operations.
(17) COMMITMENTS AND CONTINGENCIES
FILM RIGHTS
Starz Encore, a wholly-owned subsidiary of Liberty, provides premium video programming distributed by cable operators, direct-to-home satellite providers and other distributors throughout the United States. Starz Encore has entered into agreements with a number of motion picture producers which obligate Starz Encore to pay fees for the rights to exhibit certain films that are released by these producers. The unpaid balance under agreements for film rights related to films that were available to Starz Encore at December 31, 2003 is reflected as a liability in the accompanying consolidated balance sheet. The balance due as of December 31, 2003 is payable as follows: $177 million in 2004 and $48 million in 2005.
Starz Encore has also contracted to pay fees for the rights to exhibit films that have been released theatrically, but are not available for exhibition by Starz Encore until some future date. These amounts have not been accrued at December 31, 2003. Starz Encore's estimate of amounts payable under these agreements is as follows: $558 million in 2004; $231 million in 2005; $140 million in 2006; $112 million in 2007; $108 million in 2008; and $233 million thereafter.
Starz Encore is also obligated to pay fees for films that are released by certain producers through 2010 when these films meet certain criteria described in the studio output agreements. The actual contractual amount to be paid under these agreements is not known at this time. However, such amounts are expected to be significant. Starz Encore's total film rights expense aggregated $398 million, $358 million and $354 million for the years ended December 31, 2003, 2002 and 2001, respectively.
In addition to the foregoing contractual film obligations, two motion picture studios that have output contracts with Starz Encore through 2006 and 2010, respectively, have the right to extend their contracts for an additional three years. If the first studio elects to extend its contract, Starz Encore has agreed to pay the studio $60 million within five days of the studio's notice to extend. The studio is required to exercise its option by December 31, 2004. If the second studio elects to extend its contract, Starz Encore has agreed to pay the studio a total of $190 million in four annual installments. The studio is required to exercise this option by December 31, 2007. If made, Starz Encore's payments to the studios would be amortized ratably over the term of the respective output agreement extension.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
GUARANTEES
Liberty guarantees Starz Encore's obligations under certain of its studio output agreements. At December 31, 2003, Liberty's guarantee for obligations for films released by such date aggregated $799 million. While the guarantee amount for films not yet released is not determinable, such amount is expected to be significant. As noted above Starz Encore has recognized the liability for a portion of its obligations under the output agreements. As this represents a commitment of Starz Encore, a consolidated subsidiary of Liberty, Liberty has not recorded a separate liability for its guarantee of these obligations.
At December 31, 2003, Liberty has guaranteed Y14.4 billion ($134 million) of the bank debt of J-COM, an equity affiliate that provides broadband services in Japan. Liberty's guarantees expire as the underlying debt matures and is repaid. The debt maturity dates range from 2004 to 2018. In addition, Liberty has agreed to fund up to an additional Y10 billion ($93 million at December 31, 2003) to J-COM in the event J-COM's cash flow (as defined in its bank loan agreement) does not meet certain targets. In the event J-COM meets certain performance criteria, this commitment expires on September 30, 2004.
Liberty has guaranteed various leases, loans, notes payable, letters of credit and other obligations (the "Guaranteed Obligations") of certain other affiliates. At December 31, 2003, the Guaranteed Obligations aggregated approximately $160 million and are not reflected in Liberty's consolidated balance sheet at December 31, 2003. Currently, Liberty is not certain of the likelihood of being required to perform under such guarantees.
In connection with agreements for the sale of certain assets, Liberty typically retains liabilities that relate to events occurring prior to its sale, such as tax, environmental, litigation and employment matters. Liberty generally indemnifies the purchaser in the event that a third party asserts a claim against the purchaser that relates to a liability retained by Liberty. These types of indemnification guarantees typically extend for a number of years. Liberty is unable to estimate the maximum potential liability for these types of indemnification guarantees as the sale agreements typically do not specify a maximum amount and the amounts are dependent upon the outcome of future contingent events, the nature and likelihood of which cannot be determined at this time. Historically, Liberty has not made any significant indemnification payments under such agreements and no amount has been accrued in the accompanying consolidated financial statements with respect to these indemnification guarantees.
OPERATING LEASES
Liberty leases business offices, has entered into pole rental and transponder lease agreements and uses certain equipment under lease arrangements. Rental expense under such arrangements amounted to $74 million, $69 million and $76 million for the years ended December 31, 2003, 2002 and 2001, respectively.
A summary of future minimum lease payments under noncancelable operating leases as of December 31, 2003 follows (amounts in millions):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
It is expected that in the normal course of business, leases that expire generally will be renewed or replaced by leases on other properties; thus, it is anticipated that future minimum lease commitments will not be less than the amount shown for 2003.
LITIGATION
Liberty has contingent liabilities related to legal and tax proceedings and other matters arising in the ordinary course of business. Although it is reasonably possible Liberty may incur losses upon conclusion of such matters, an estimate of any loss or range of loss cannot be made. In the opinion of management, it is expected that amounts, if any, which may be required to satisfy such contingencies will not be material in relation to the accompanying consolidated financial statements.
(18) INFORMATION ABOUT LIBERTY'S OPERATING SEGMENTS
Liberty is a holding company, which through its ownership of interests in subsidiaries and other companies, is primarily engaged in the electronic retailing, media, communications and entertainment industries. Each of these businesses is separately managed. Liberty has organized its businesses into four Groups based upon each businesses' services or products: Interactive Group, International Group, Networks Group and Corporate and Other. Liberty's chief operating decision maker and management team review the combined results of operations of each of these Groups (including consolidated subsidiaries and equity method affiliates), as well as the results of operations of each individual business in each Group.
Liberty identifies its reportable segments as (A) those consolidated subsidiaries that (1) represent 10% or more of its consolidated revenue, earnings before income taxes or total assets or (2) are significant to an evaluation of the performance of a Group; and (B) those equity method affiliates (1) whose share of earnings represent 10% or more of Liberty's pre-tax earnings or (2) are significant to an evaluation of the performance of a Group. The segment presentation for prior periods has been conformed to the current period segment presentation. Liberty evaluates performance and makes decisions about allocating resources to its Groups and operating segments based on financial measures such as revenue, operating cash flow, gross margin, and revenue or sales per customer equivalent. In addition, Liberty reviews non-financial measures such as average prime time rating, prime time audience delivery, subscriber growth and penetration, as appropriate.
Liberty defines operating cash flow as revenue less cost of sales, operating expenses, and selling, general and administrative expenses (excluding stock compensation). Liberty believes this is an important indicator of the operational strength and performance of its businesses, including the ability to service debt and fund capital expenditures. In addition, this measure allows management to view operating results and perform analytical comparisons and benchmarking between businesses and identify strategies to improve performance. This measure of performance excludes depreciation and amortization, stock compensation 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, net income, cash flow provided by operating activities and other measures of financial performance prepared in accordance with GAAP. Liberty generally accounts for intersegment sales and transfers as if the sales or transfers were to third parties, that is, at current prices.
For the year ended December 31, 2003, Liberty has identified the following consolidated subsidiaries and equity method affiliates as its reportable segments:
INTERACTIVE GROUP
- QVC -- consolidated subsidiary that markets and sells a wide variety of consumer products in the US and several foreign countries, primarily by means of televised shopping programs on the QVC networks and via the Internet through its domestic and international websites.
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LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
- Ascent Media Group ("Ascent Media") -- consolidated subsidiary that provides sound, video and ancillary post-production and distribution services to the motion picture and television industries in the United States, Europe and Asia.
INTERNATIONAL GROUP
- UGC -- 52% owned equity method affiliate that provides broadband communications services, including video, voice and data with operations in over 25 countries.
- J-COM -- 45% owned equity method affiliate that provides broadband communications services in Japan.
- Jupiter Programming Co., Ltd. ("JPC") -- 50% owned equity method affiliate that provides cable and satellite television programming in Japan.
NETWORKS GROUP
- Starz Encore -- consolidated subsidiary that provides premium programming distributed by cable operators, direct-to-home satellite providers and other distributors throughout the United States.
- Discovery -- 50% owned equity method affiliate that provides original and purchased cable television programming in the U.S. and over 150 other countries.
- Courtroom Television Network, LLC ("Court TV") -- 50% owned equity method affiliate that operates a basic cable network that provides informative and entertaining programming based on the American legal system.
- Game Show Network, LLC ("GSN") -- 50% owned equity method affiliate that operates a basic cable network dedicated to the world of games, game playing and game shows.
Liberty'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. The accounting policies of the segments that are also consolidated subsidiaries are the same as those described in the summary of significant policies.
The amounts presented below represent 100% of each business' revenue, operating cash flow and operating income. These amounts are combined on an unconsolidated basis and are then adjusted to remove the effects of the equity method investments to arrive at the consolidated balances for each group. This presentation is designed to reflect the manner in which management reviews the operating performance of individual businesses within each group regardless of whether the investment is accounted for as a consolidated subsidiary or an equity investment. It should be noted, however, that this presentation is not in accordance with GAAP since the results of equity method investments are required to be reported on a net basis. Further, we could not, among other things, cause any noncontrolled affiliate to distribute to us our proportionate share of the revenue or operating cash flow of such affiliate.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
PERFORMANCE MEASURES
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
BALANCE SHEET INFORMATION
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LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following table provides a reconciliation of segment operating cash flow to earnings before income taxes:
REVENUE BY GEOGRAPHIC AREA
LONG-LIVED ASSETS BY GEOGRAPHIC AREA
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LIBERTY MEDIA CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(19) QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
(20) SUBSEQUENT EVENT
Liberty's Board of Directors has approved a resolution authorizing the Company to take the necessary actions to effect the spin-off of assets principally comprised of the International Group as a tax free distribution to its shareholders. The completion of this transaction is subject to, among other things, a final determination of the assets to be included in the spin-off, the receipt of a favorable tax opinion and regulatory and other third party approvals. Upon completion of this transaction, the International Group will be a separate publicly traded company. This transaction is expected to be accounted for at historical cost due to the pro rata nature of the distribution.
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PART III.
The following required information is incorporated by reference to our definitive proxy statement for our 2004 Annual Meeting of shareholders presently scheduled to be held in June 2004:
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
We will file our definitive proxy statement for our 2004 Annual Meeting of shareholders with the Securities and Exchange Commission on or before April 29, 2003.
III-1
PART IV.
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a)(1) Financial Statements
Included in Part II of this Report:
(a)(2) Financial Statement Schedules
Included in Part IV of this Report:
(i) All schedules have been omitted because they are not applicable, not material or the required information is set forth in the financial statements or notes thereto.
(ii) Separate financial statements for Telewest Communications plc:
(a)(3) Exhibits
Listed below are the exhibits which are filed as a part of this Report (according to the number assigned to them in Item 601 of Regulation S-K):
IV-1
IV-2
IV-3
(b) Reports on Form 8-K filed during the quarter ended December 31, 2003:
- ---------------
* This report on Form 8-K was "furnished" to the Securities and Exchange Commission, and is not to be deemed (1) "filed" for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to the liabilities of that Section or (2) incorporated by reference into any filing by Liberty under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended.
IV-4
AUDITED CONSOLIDATED FINANCIAL STATEMENTS
AUDITOR'S REPORT to the board of directors and shareholders of Telewest Communications plc
We have audited the accompanying consolidated balance sheets of Telewest Communications plc and subsidiaries (the Group) as of December 31, 2002 and 2001, and the related consolidated statements of operations, shareholders' equity/(deficit) and comprehensive income and cash flows for each of the years in the three-year period ended December 31, 2002. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards in the United Kingdom and the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements on pages IV-6 to IV-47 present fairly, in all material respects, the financial position of Telewest Communications plc and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002 in conformity with generally accepted accounting principles in the United States of America.
The accompanying financial statements have been prepared assuming that the Group will continue as a going concern. As discussed in note 2 to the financial statements, the Group has suffered recurring losses, has a net shareholders deficit and is undergoing financial restructuring and this raises substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
As discussed in note 3 to the consolidated financial statements, the 2002 consolidated financial statements have been restated.
As discussed in note 4 to the consolidated financial statements, the Group adopted SFAS 141, Business Combinations and SFAS 142, Goodwill and Other Intangible Assets, in 2002.
As discussed in note 4 to the consolidated financial statements, the Group changed its method of accounting for derivative instruments and hedging activities in 2001.
KPMG AUDIT PLC Chartered Accountants Registered Auditor London, England
March 26, 2003, except for note 3, which is as of January 16, 2004.
IV-5
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31
All income is derived from continuing operations.
See accompanying notes to the consolidated financial statements. IV-6
CONSOLIDATED BALANCE SHEETS
YEARS ENDED DECEMBER 31
See accompanying notes to the consolidated financial statements. IV-7
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31
See accompanying notes to the consolidated financial statements. IV-8
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY/(DEFICIT) AND COMPREHENSIVE LOSS
There was no other comprehensive income in the year ended December 31, 2000.
See accompanying notes to the consolidated financial statements. IV-9
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
1 ORGANIZATION AND HISTORY
Telewest Communications plc ("the Company") and its subsidiary undertakings (together "the Group") provide cable television, telephony and internet services to business and residential customers in the United Kingdom ("UK"). The Group derives its cable television revenues from installation fees, monthly basic and premium service fees and advertising charges. The Group derives its telephony revenues from connection charges, monthly line rentals, call charges, special residential service charges and interconnection fees payable by other operators. The Group derives its internet revenues from installation fees and monthly subscriptions to its ISP. The cable television, telephony and internet services account in 2002 for approximately 26%, 61% and 5%, respectively, of the Group's revenue.
The Group is also engaged in broadcast media activities, being the supply of entertainment content, interactive and transactional services to the UK pay-TV broadcasting market. The Content Division accounts in 2002 for approximately 8% of the Group's revenue.
2 BASIS OF PREPARATION
The consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America ("US GAAP"). The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The Group's significant estimates and assumptions include capitalisation of labor and overhead costs; impairment of goodwill and long-lived assets (see note 6); and accounting for debt and financial instruments (see note 5). Actual results could differ from those estimates.
The financial statements are prepared on a going concern basis, which the directors believe to be appropriate for the following reasons:
Following the directors' decision on September 30, 2002 not to pay the interest on certain of the Group's bonds and other hedging instruments, the Group is now in default of its bonds and its Senior Secured Facility.
These liabilities are now due for repayment in full and the Group is negotiating with its bondholder creditors and bank facility creditors to effect a reorganization of the Group's debt. This will involve, among other things, the conversion of bond debt to equity and the renegotiation of existing bank facilities. The directors believe the amended facilities will provide the Group with sufficient liquidity to meet the Group's funding needs after completion of the Financial Restructuring. Further details of the planned Financial Restructuring are included in note 23.
In order for the Financial Restructuring to be effective, the Scheme Creditors need to approve the plans by the relevant statutory majority. In addition, the Group's shareholders need to approve the proposed share capital reorganization.
The directors are of the opinion that the status of negotiations of the financial restructuring will lead to a successful outcome and that this is sufficient grounds for issuing the annual financial statements under the assumption of going concern.
The effect on the financial statements as presented, of the going concern basis of preparation being inappropriate, is principally that the book value of tangible fixed assets and investments would be restated from their present value in use to a net realizable value. Whilst the directors believe that the net realizable values would be lower than the current value in use there is insufficient information available for the directors to quantify the difference.
IV-10
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Group faces the following significant risks and uncertainties about:
- its continued ability to raise finance to fund its operations;
- its successful execution of its long term business plan, which in turn will affect the Group's ability to raise further finance under the Senior Secured Facility (see note 16); and
- the need to meet financial and other covenants relating to debt instruments which have already been issued.
The economic environment and currency in which the Group operates is the United Kingdom and hence its reporting currency is Pounds Sterling (L). Certain financial information for the year ended December 31, 2002 has been translated into US Dollars ($), with such US Dollar amounts being unaudited and presented solely for the convenience of the reader, at the rate of $1.6095 = L1.00, the Noon Buying Rate of the Federal Reserve Bank of New York on December 31, 2002. The presentation of the US Dollar amounts should not be construed as a representation that the Pounds Sterling amounts could be so converted into US Dollars at the rate indicated or at any other rate.
3 RESTATEMENT
Subsequent to the issuance of our consolidated financial statements as of and for the year ended December 31, 2002, we have determined the need to adjust the classification of debt previously reflected as non-current in the consolidated balance sheet at December 31, 2002 and write off deferred financing costs as at December 31, 2002 relating to the restated debt. The adjustment of debt reclassifies L1,792 million from non-current "Debt repayable after more than one year" to "Debt repayable within one year". The write off of deferred financing costs decreases other assets and increases interest expense and net loss as at and for the year ended December 31, 2002 by L11 million. There was no impact on the 2001 Consolidated Financial Statements.
These adjustments have been made because the Company recently determined that the effect of non-payment of a hedge contract of L10.5 million in 2002 triggered a default on an additional L1,792 million of bond debt as at December 31, 2002.
We have also determined the need to accrue additional interest of L2 million relating to additional interest for bonds in default as at December 31, 2002. This adjustment increases net loss, interest expense and other liabilities by L2 million as at and for the year ended December 31, 2002.
IV-11
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
4 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company and those of its majority-owned subsidiaries. All significant inter-company accounts and transactions have been eliminated upon consolidation. All acquisitions have been accounted for under the purchase method of accounting. Under this method, the results of subsidiaries and affiliates acquired in the year are included in the consolidated statement of operations from the date of acquisition.
IMPAIRMENT OF LONG LIVED ASSETS AND GOODWILL
The Group applies Statement of Financial Accounting Standard ("SFAS") No. 144, Accounting for the Impairment or disposal of Long-Lived Assets. The Group adopted, from January 1, 2002 SFAS 144 which requires that long-lived assets and certain identifiable intangibles, including goodwill, to be held and used by an entity, be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Indications of impairment are determined by reviewing undiscounted projected future cash flows. If impairment is indicated, the amount of the impairment is the amount by which the carrying value exceeds the fair value of the assets.
BUSINESS COMBINATIONS AND GOODWILL AND OTHER INTANGIBLE ASSETS
In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS 141, Business Combinations and SFAS 142, Goodwill and Other Intangible Assets. SFAS 141 requires all business combinations undertaken after June 30, 2001 to be accounted for using the purchase method. Under SFAS 142, goodwill arising from business combinations and intangible assets with indefinite lives are no longer amortized but are subject to annual review for impairment (or more frequently should indications of impairment arise). Goodwill associated with equity-method investments will also no longer be amortized upon adoption of SFAS 142, but will be subject to impairment testing as part of the investment to which it relates in accordance with Accounting Principles Board Opinion No. ("APB") 18, The Equity Method of Accounting for Investments in Common Stock. Separable intangible assets that do not have indefinite lives will continue to be amortized over their estimated useful lives and will be subject to review for impairment in accordance with SFAS 144 (see below). The amortization provisions of SFAS 142 apply to goodwill and intangible assets acquired after June 30, 2001. For goodwill and intangible assets acquired prior to July 1, 2001, the Group was required to adopt SFAS 142 effective January 1, 2002. As of January 1, 2002 the Group had L2,199 million of unamortized goodwill, L1,892 million of which related to business combinations and L307 million of which related to equity-method investments.
Impairment under SFAS 142 is measured using a two-step approach, initially based on a comparison of the reporting unit's fair value to its carrying value; if the fair value is lower, then the second step compares the implied fair value of the goodwill with its carrying value to determine the amount of the impairment. In connection with SFAS 142's transitional goodwill impairment evaluation, the Statement required the Company to perform an assessment of whether there was an indication that goodwill was impaired as of the date of adoption of January 1, 2002. The Company compared the individual carrying value of its two reporting units, Cable and Content, to their respective fair values. The fair values of the respective reporting units were determined from an analysis of discounted cash flows based on the Company's budgets and long range plan. The discounted cash flow analysis was performed at a reporting unit level. At January 1, 2002 the fair values of
IV-12
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
both reporting units were greater than their respective carrying values and therefore the adoption of SFAS 142 on January 1, 2002, had no impact on the Company's financial position or results of operations.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include highly liquid investments with original maturities of three months or less that are readily convertible into cash.
DERIVATIVES AND HEDGING
At January 1, 2001 the Company adopted SFAS 133 Accounting for Derivative Instruments and Hedging Activities as amended by SFAS 137 and SFAS 138. SFAS 133 established accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and hedging activities. It requires the recognition at fair value of all derivative instruments as assets or liabilities in the Company's balance sheet. The accounting treatment of changes in fair value is dependent upon whether or not a derivative instrument is designated a hedge and if so, the type of hedge and its effectiveness as a hedge.
For derivatives, which are not designated as hedges, changes in fair value are recorded immediately in earnings.
For derivatives designated as cash flow hedges, changes in fair value on the effective portion of the hedging instrument are recorded within other comprehensive income ("OCI") until the hedged transaction occurs and are then recorded within earnings. Changes in the ineffective portion of a hedge are recorded in earnings. For derivatives designated as fair value hedges, changes in fair value are recorded in earnings. The Group has not, however, had any fair value hedges since the adoption of SFAS 133.
The Group discontinues hedge accounting for derivative financial instruments when it is determined that the derivative instrument is no longer effective in offsetting changes in the cash flows of the hedged item; the derivative instrument expires or is sold; the derivative instrument is no longer designated as a hedging instrument, because it is unlikely that a forecasted transaction will occur; a hedged firm commitment no longer meets the definition of a firm commitment; or its management determines that designation of the derivative instrument as a hedging instrument is no longer appropriate. The tests for determining the effectiveness of a cash flow hedge compare on a strict basis the amount and timing of cash flows on the underlying economic exposure with the cash flows of the derivative instrument.
Upon discontinuation of cash flow hedge accounting, the net gain or loss attributable to the hedging instrument, which has been reported in OCI to the date of discontinuation, continues to be reported in OCI until the date the hedged transaction impacts earnings. This occurs unless it is probable that the hedged transaction will not occur by the end of the originally specified time period. If the hedged transaction is not expected to occur, the net gain or loss is reclassified from OCI to earnings upon discontinuation.
Prior to adoption of SFAS 133 the Group had the following accounting policies in respect of financial instruments. Foreign currency forward contracts, options and swaps, which were used to reduce the exchange risk on the principal amounts and early call premiums on certain foreign currency borrowings, were recorded on the balance sheet at their fair value. Gains and losses arising from changes in fair value were recorded concurrently within earnings. Such gains and losses were offset by gains and losses arising from retranslating the principal amounts of the foreign currency borrowings.
The Group also used foreign currency forward contracts and cross currency interest rate swaps to reduce its exposure to adverse changes in exchange rates associated with the interest payments on certain foreign currency borrowings. Such foreign currency forward contracts and cross currency interest rate swaps were accounted for using the accruals method.
The Group also used interest rate swap agreements and an interest rate collar to manage interest rate risk on the Group's borrowings. Net income or expense resulting from the differential between exchanging floating
IV-13
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
and fixed interest payments was recorded within the consolidated statement of operations on an accruals basis from the effective date of the interest rate swap agreements and interest rate collar.
INVESTMENTS
Generally, investments in partnerships, joint ventures and subsidiaries in which the Group's voting interest is 20% to 50%, and others where the Group has significant influence, are accounted for using the equity method. Investments which do not have a readily determinable fair value, in which the Group's voting interest is less than 20%, and in which the Group does not have significant influence, are carried at cost and written down to the extent that there has been an other-than-temporary diminution in value. The Group accounts for certain investments in which the Group's ownership is greater than 50% using the equity method. This method is used for such subsidiaries where the minorities have substantive participating rights such as veto over key operational and financial matters and equal representation on the board of directors.
The Group reviews the carrying values of its investments in affiliates, including any associated goodwill, to ensure that the carrying amount of such investments are stated at no more than their recoverable amounts. The Group assesses the recoverability of its investments by determining whether the carrying value of the investments can be recovered through projected discounted future operating cash flows (excluding interest) of the operations underlying the investments. The assessment of the recoverability of the investments will be impacted if projected future operating cash flows are not achieved. The amount of impairment, if any, is measured based on the projected discounted future operating cash flows using a rate commensurate with the risks associated with the assets.
ADVERTISING COSTS
Advertising costs are expensed as incurred. The amount of advertising costs expensed was L52 million, L48 million, and L38 million for the years ended December 31, 2002, 2001, and 2000, respectively.
PROPERTY AND EQUIPMENT
Property and equipment is stated at cost. Depreciation is provided to write-off the cost, less estimated residual value, of property and equipment by equal installments over their estimated useful economic lives as follows:
The Group accounts for costs, expenses and revenues applicable to the construction and operation of its cable systems in accordance with SFAS 51 Financial Reporting by Cable Television Companies. Initial subscriber installation costs are capitalized and depreciated over the life of the network.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
DEFERRED FINANCING COSTS
Direct costs incurred in raising debt are deferred and recorded on the consolidated balance sheet in other assets. The costs are amortized to the consolidated statement of operations at a constant rate to the carrying value of the debt over the life of the obligation. Deferred financing costs in respect of bond debt in default are written off immediately to the consolidated statement of operations.
MINORITY INTERESTS
Recognition of the minority interests' share of losses of consolidated subsidiaries is limited to the amount of such minority interests' allocable portion of the equity of those consolidated subsidiaries.
FOREIGN CURRENCIES
Transactions in foreign currencies are recorded using the rate of exchange in effect at the date of the transaction. Monetary assets and liabilities denominated in foreign currencies are translated using the rate of exchange prevailing at the balance sheet date and the gains or losses on translation are included in the consolidated statement of operations.
REVENUE RECOGNITION
Revenues are recognized as network communication services are provided. Credit risk is managed by disconnecting services to customers who are delinquent. Connection and activation fees relating to cable television, telephony and internet are recognized in the period of connection to the extent that such fees are less than direct selling costs. Any excess connection and activation fees over direct selling costs incurred are deferred and amortized over the expected customer life.
Occasionally the Group sells capacity on its network to other telecommunications providers. Sales of capacity are accounted for as sales-type leases, operating leases, or service agreements depending on the terms of the transaction. If title is not transferred or if the other requirements of sales-type lease accounting are not met, revenues are recognized rateably over the term of the agreement.
Programming revenues are recognized in accordance with Statement of Position ("SOP") 00-2, Accounting by Producers or Distributors of Films. Revenue on transactional and interactive sales is recognized as and when the services are delivered. Advertising sales revenue is recognized at estimated realizable values when the advertising is aired.
RECOGNITION OF CONTRACT COSTS
Certain of the sales of network capacity referred to above involve the Group constructing new capacity. Where the Group retains some of this new capacity, either for subsequent resale or for use within the business, then an element of the construction costs is retained within inventory or equipment, respectively. The allocation of construction cost between costs expensed to the statement of operations and costs capitalized within inventory or equipment is based upon the ratio of capacity to be sold and to be retained.
PENSION COSTS
The Group operates a defined contribution scheme (the Telewest Communications plc Pension Trust) or contributes to third-party schemes on behalf of employees. The amount included in expenses in 2002, 2001 and 2000 of L11 million, L10 million and L8 million, respectively, represents the contributions payable to the selected schemes in respect of the relevant accounting periods.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
INCOME TAXES
Under the asset and liability method of SFAS 109 Accounting For Income Taxes, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered.
The Group recognises deferred tax assets only where it is more likely than not that the benefit will be realized through future taxable income. Otherwise a valuation allowance is established to provide against deferred tax assets.
SHARE-BASED COMPENSATION
SFAS 123, Accounting for Stock-Based Compensation, encourages, but does not require, companies to record compensation costs for share-based employee compensation plans at fair value. The Group has chosen to continue to account for share-based compensation using the intrinsic value method prescribed in APB 25, Accounting for Stock Issued to Employees and related interpretations. Accordingly, compensation cost for fixed plan share options is measured as the excess, if any, of the quoted market price of the Company's shares at the date of the grant over the amount an employee must pay to acquire the shares. Compensation cost for variable plan share options is measured each period using the intrinsic value method until the variable or performance features of the plan become fixed. Compensation expense is recognized over the applicable vesting period.
Shares purchased by the trustees in connection with the Telewest Restricted Share Scheme and certain LTIP awards, are valued at cost and are reflected as a reduction of shareholders' equity in the consolidated balance sheet. This equity account is reduced when the shares are issued to employees based on the original cost of the shares to the trustees.
EARNINGS PER SHARE
Basic earnings per share has been computed by dividing net loss available to ordinary shareholders by the weighted average number of ordinary shares outstanding during the year. Diluted earnings per share is computed by adjusting the weighted average number of ordinary shares outstanding during the year for all dilutive potential ordinary shares outstanding during the year and adjusting the net loss for any changes in income or loss that would result from the conversion of such potential ordinary shares. There is no difference in net loss and number of shares used for basic and diluted net loss per ordinary share, as potential ordinary share equivalents for employee share options and convertible debt are not included in the computation as their effect would be to decrease the loss per share. The number of potential ordinary shares was 393 million, 393 million and 464 million in 2002, 2001 and 2000, respectively.
INVENTORIES
Inventories of equipment, held for use in the maintenance and expansion of the Group's telecommunications systems, are stated at cost, including appropriate overheads, less provision for deterioration and obsolescence. Network capacity and ducting held for resale are stated at the lower of cost and net realizable value.
NEW ACCOUNTING STANDARDS APPLICABLE TO THE GROUP
SFAS 143 Accounting for Asset Retirement Obligations
In July 2001, the FASB issued SFAS 143, Accounting for Asset Retirement Obligations. SFAS 143, which is effective for fiscal years beginning after June 15, 2002, requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. When the liability is initially IV-16
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
recorded, an entity capitalizes a cost by increasing the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the liability, an entity either settles the obligation for its recorded amount or incurs a gain or loss upon settlement.
Telewest has evaluated its legal retirement obligations in relation to all of its tangible long-lived assets and specifically in relation to the buildings that it occupies and its network assets. Buildings, which are held under operating leases, do not specify a fixed refurbishment payment, but instead specify a standard of physical restoration for which Telewest is responsible. Telewest attempts to maintain properties on an ongoing basis to the standard required by the lease and consequently would not expect to have significant additional relevant obligations in respect of its leased properties. Also Telewest believes that it has no legal or constructive retirement obligations in relation to its network assets, all located in the United Kingdom, as there is no legal requirement for Telewest to retire such assets. The Group does not therefore believe the adoption of SFAS 143 will have a material impact on the financial statements.
SFAS 145 Rescission of FASB Statements 4, 44 and 64, Amendment of FASB 13, and Technical Corrections
In April 2002, the FASB issued SFAS 145, "Rescission of FASB Statements 4, 44 and 64, Amendment of FASB 13, and Technical Corrections". SFAS 145 provides for the rescission of several previously issued accounting standards, new accounting guidance for the accounting for certain lease modifications and various technical corrections that are not substantive in nature to existing pronouncements. The Group has adopted this standard from January 1, 2002 and reclassified L15 million from extraordinary items to expense for the year ended December 31, 2001. No material adjustments have been required in 2002.
SFAS 146 Accounting for Costs Associated with Exit or Disposal Activities
In June 2002, the FASB issued SFAS 146, "Accounting for Costs Associated with Exit or Disposal Activities". SFAS 146 is effective for exit or disposal activities that are initiated after December 31, 2002, and nullifies Emerging Issues Task Force ("EITF") Issue No. 94-3 "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)". SFAS 146 applies to costs associated with an exit activity that do not involve an entity newly acquired in a business combination or with a disposal activity covered by SFAS 144 "Accounting for the Impairment or Disposal of Long-Lived Assets". The Group does not believe the adoption of this statement will have a material impact on its financial position or results of operations.
SFAS 148 Accounting for Stock Based Compensation--Transition and Disclosure
An amendment of SFAS 123 is effective for the Group for the year ended December 31, 2002. SFAS 148 permits two additional transition methods for entities that adopt the fair value based method of accounting for stock-based employee compensation. The Statement also requires new disclosures about the ramp-up effect of stock-based employee compensation on reported results and that those effects be disclosed more prominently by specifying the form, content, and location of those disclosures. The Group has adopted the disclosure provisions of the Statement in these financial statements. The Group has not adopted the fair value based method of accounting for stock-based employee compensation and still accounts for these in accordance with APB Opinion 25, Accounting for Stock Issued to Employees.
Other New Standards
In November 2002, the Emerging Issues Task Force issued its consensus on EITF 00-21, Revenue Arrangements with Multiple Deliverables (EITF 00-21) on an approach to determine whether an entity should divide an arrangement with multiple deliverables into separate units of accounting. According to the EITF, in an arrangement with multiple deliverables, the delivered item(s) should be considered a separate
IV-17
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
unit of accounting if all of the following criteria are met: (1) the delivered item(s) has value to the customer on a standalone basis, (2) there is objective and reliable evidence of the fair value of the undelivered item(s), and (3) if the arrangement includes a general right of return, delivery or performance of the undelivered item(s) is considered probable and substantially in the control of the vendor. If all the conditions above are met and there is objective and reliable evidence of fair value for all units of accounting in an arrangement, the arrangement consideration should be allocated to the separate units of accounting based on their relative fair values. The guidance in this Issue is effective for revenue arrangements entered into in fiscal years beginning after June 15, 2003. The Group believes that the adoption of EITF 00-21 will not have a material impact on the Group's financial statements.
In November 2002, the FASB issued FASB Interpretation 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others ("FIN 45"), which addresses the disclosure to be made by a guarantor in its financial statements about its obligations under guarantees. FIN 45 also requires the recognition of a liability by a guarantor at the inception of certain guarantees. It requires the guarantor to recognize a liability for the non-contingent component of the guarantee, this is the obligation to stand ready to perform in the event that specified triggering events or conditions occur. The initial measurement of this liability is the fair value of the guarantee at inception. The recognition of the liability is required even it is not probable that payments will be required under the guarantee or if the guarantee was issued with a premium payment or as part of a transaction with multiple elements. The Group has adopted the disclosure requirements and will apply the recognition and measurement provisions for all guarantees entered into or modified after December 31, 2002. To date the Company has not entered into or modified guarantees.
In January 2003, the FASB issued FASB Interpretation 46, Consolidation of Variable Interest Entities (FIN 46) which interprets Accounting Research Bulletin (ARB) 51, Consolidated Financial Statements. FIN 46 clarifies the application of ARB 51 with respect to the consolidation of certain entities (variable interest entities--"VIEs") to which the usual condition for consolidation described in ARB 51 does not apply because the controlling financial interest in VIEs may be achieved through arrangements that do not involve voting interests. In addition, FIN 46 requires the primary beneficiary of VIEs and the holder of a significant variable interest in VIEs to disclose certain information relating to their involvement with the VIEs. The provisions of FIN 46 apply immediately to VIEs created after January 31, 2003, and to VIEs in which an enterprise obtains an interest after that date. FIN 46 applies in the first fiscal year beginning after June 15, 2003, to VIEs in which an enterprise holds a variable interest that it acquired before February 1, 2003. To comply with the transitional provisions of FIN 46, Telewest has evaluated its existing structures to determine whether it is reasonably likely that it would be required to consolidate or disclose information about a VIE's nature, purpose, size and activities, together with Telewest's maximum exposure to loss. Telewest is also required to disclose the anticipated impact of adoption of FIN 46 on its financial statements.
Telewest has 50% joint venture interests in two affiliates, UKTV, a joint venture with the BBC, and Front Row Television Limited ("Front Row"), a joint venture with NTL, both of which are accounted for under the equity method, and neither of which are considered VIEs. Management believes that both UKTV and Front Row are businesses as defined by EITF 98-3, Determining Whether a Nonmonetary Transaction Involves Receipt of Productive Assets or of a Business, and FIN 46, Consolidation of Variable Interest Entities (Revised December 2003), and, accordingly, does not consider that either consolidation or additional disclosures are required. Telewest does not otherwise make use of traditional VIE structures in its business and does not currently securitize its receivables or other financial assets. The Group does not therefore believe that the impact of the adoption of FIN 46 will have a material effect on its financial statements.
5 FINANCIAL INSTRUMENTS
The Group holds derivative financial instruments solely to hedge specific risks and does not hold such instruments for trading purposes. The derivatives are held to hedge against the variability in cash flows arising
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
from the effect of fluctuations of GBP:USD exchange rate on the Group's US Dollar-denominated debt and from changes in interest rates on its variable rate bank debt.
The Group maintains risk management control systems to monitor currency exchange and interest rate risk attributable to forecasted debt principal payments and interest rate exposure.
CASH FLOW HEDGES
Hedges of US Dollar Denominated Debt
The Group has issued US Dollar denominated debt instruments with a range of maturities. The Group previously hedged the principal amounts of these instruments up to their first call dates or other such dates where the Group may at its option redeem the instrument before maturity.
The Group has increased its foreign exchange risk since the discontinuation of hedge accounting as described below. The Group continues to monitor this risk until the Financial Restructuring is complete when the US Dollar-denominated debt instruments will be swapped for equity and the foreign exchange risk is minimised.
In the three-month period ended March 31, 2002, the Group determined that it was probable that forecasted future prepayments of principal against outstanding US Dollar-denominated debt would not occur. Accordingly, the cumulative adjustment in OCI of L53 million resulting from marking to market the derivative instruments has been reclassified from OCI to foreign exchange gains in the Statement of Operations. Subsequent adjustments of the carrying value of these instruments to fair value are taken directly to the Statement of Operations as incurred.
In the nine-month period ended September 30, 2002, the Group had the ability to terminate in-the-money derivative contracts that fluctuate in value. Such derivative contracts hedged our exposure to fluctuations in the US Dollar/pound sterling exchange rates on the Group's US Dollar-denominated debt. In March 2002, the Group terminated certain of these derivative contracts with a nominal value of $999 million (L688 million), netting L74 million cash inflow. In May 2002 the Group terminated further derivative contracts with a nominal value of $367 million (L253 million) realizing an additional L30 million cash inflow. In the three-month period ended September 30, 2002, the Group terminated arrangements with a nominal value of $2.3 billion (approximately L1.5 billion). Contracts with a nominal value of $1 billion were settled in cash resulting in an outflow of L28 million. The remaining contracts with a nominal value of $1.3 billion have yet to be settled for a total cost of L33 million of which L19 million was due on October 1, 2002, but the Company deferred such payment and is considering the payment in the context of its Financial Restructuring.
During the 12-month period ended December 31, 2002, the Group recorded a net L48 million transfer from cumulative OCI to the Statement of Operations arising from the dedesignation of derivative contracts as ineffective hedges, as described above. In the 12-month period ended December 31, 2001, the Group recorded a L36 million gain in fair value to cumulative OCI, consisting of a loss of L25 million to short-term derivative liabilities and a L61 million gain to long-term derivative assets.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
HEDGES OF VARIABLE RATE DEBT
As described in note 16 to the consolidated financial statements, the Group has a Senior Secured Facility with a syndicate of banks and a further amount from an Institutional Tranche ("Institutional Tranche"). Drawdowns under the Senior Secured Facility and the Institutional Tranche bear interest at 0.75% to 2.00% above LIBOR and up to 4% above LIBOR respectively, so the Group is exposed to variable cash flows arising from changes in LIBOR. The Group hedges these variable cash flows by the use of interest rate swaps. The interest rate swaps can be summarised as follows:
In June 2002, the Group reviewed the effectiveness as hedges of the derivative instruments hedging our exposure to fluctuations in interest rates on its long-term bank debt. The review concluded that continued designation of these instruments as hedges was no longer appropriate and hedge accounting was discontinued with immediate effect. The dedesignation of these instruments as hedges resulted in a transfer of L7 million from cumulative OCI to interest expense within the Statement of Operations. Any movements in the value of the derivatives after June 2002 are recorded within interest expense.
The Group continues to hedge some of its interest rate risk on its Senior Secured Facility through the use of interest rate swaps. The purpose of the derivative instruments is to provide a measure of stability over the Company's exposure to movements in sterling interest rates on its sterling denominated bank debt.
FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS 107, Disclosures about Fair Value of Financial Instruments requires disclosure of an estimate of the fair values of financial instruments. SFAS 107 defines the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties other than in a forced sale. Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates are subjective in nature and involve uncertainties and matters of significant judgement, and therefore cannot be determined precisely. Changes in assumptions could significantly affect the estimates.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
At December 31, 2002 the Group's significant financial instruments include cash and cash equivalents, trade receivables, interest rate swaps, trade payables and short-term and long-term debt instruments. The following table summarizes the fair value of certain instruments held by and obligations of the Group. The fair value of the other financial instruments held by the Group approximates their recorded carrying amount due to the short maturity of these instruments and these instruments are not presented in the following table:
The estimated fair values of the financial instruments specified above are based on quotations received from independent, third-party financial institutions and represent the net amounts receivable or payable to terminate the position. The estimated fair values of the Debentures and Notes are also based on quotations from independent third-party financial institutions and are based on discounting the future cash flows to net present values using appropriate market interest rates prevailing at the year end.
MARKET RISK AND CONCENTRATIONS OF CREDIT RISK
Market risk is the sensitivity of the value of the financial instruments to changes in related currency and interest rates.
As described above, the Group terminated its portfolio of derivative financial instruments which were used to hedge its exposure to fluctuations in the USD : GBP exchange rate. Consequently the Group is exposed to fluctuations in the value of its US Dollar-denominated debt obligations.
Generally, the Group is not exposed to such market risk arising on its interest rate derivative financial instruments because gains and losses on the underlying assets and liabilities offset gains and losses on the financial instruments.
The Group may be exposed to potential losses due to the credit risk of non-performance by the financial institution counterparties to its portfolio of derivative financial instruments. However such losses are not anticipated as these counterparties are major international financial institutions and the portfolio is spread over a wide range of institutions.
Temporary cash investments also potentially expose the Group to concentrations of credit risk, as defined by SFAS 133. At December 31, 2002 the Group had L160 million on deposit with a major international
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
financial institution. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Group's customer base.
6 IMPAIRMENT OF ASSETS AND GOODWILL
During the year ended December 31, 2002, the Group undertook an impairment review of its network assets, of goodwill arising on recent acquisitions and of its investments in affiliates acquired in recent years. The review covered the Cable and Content Divisions. The principal reasons for the review were: a share price decline indicative of a fall in the values of the underlying assets and a softening of the ad-sales market, declining revenue growth and a lower than expected customer take-up of additional services.
The review found evidence of impairment in the value of goodwill arising on the core Cable and Content business and in the value of the affiliated undertaking UKTV. The carrying amounts of goodwill, fixed assets and the investments in the affiliated undertakings were written down to fair value, resulting in a charge of L1,445 million against goodwill, an impairment of L841 million against fixed assets and a charge of L88 million against the investments in affiliated undertakings. These charges have been included in the statement of operations within impairment of goodwill, impairment of fixed assets and share of net losses of affiliates and impairment, respectively. The estimated fair value of the goodwill and the investment in UKTV was based on projected future cash flows at a post-tax discount rate of 11.5% which the Group believes is commensurate with the risks associated with the assets. The projected future cash flows were determined using the Company's ten-year plan for the business, with a terminal value which takes into account analysts' and other published projections of future trends across pay-TV platforms, including the total television advertising market.
The changes in the carrying amount of goodwill for the years ended December 31, 2002 and 2001 by reportable segment are as follows:
Amortization expense related to goodwill was L183 million (including L27 million related to equity investment goodwill) for the year ended December 31, 2001 (L147 million for the year ended December 31, 2000). The following table reconciles previously reported net income as if the provisions of SFAS 142 were in effect in 2001 and 2000:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
7 BUSINESS COMBINATIONS
On May 30, 2001, the Group acquired 51% of the issued share capital of Rapid Travel Solutions Limited ("Rapid Travel") and was granted a series of call options by, and granted a series of put options to, the vendors in respect of the balance of 49%. Assuming that either party exercises these options, the Group will acquire the remainder of the share capital in tranches ending on November 30, 2003 for total consideration of L4 million. The acquisition has been accounted for using the purchase method of accounting. Goodwill arising on the acquisition was L7 million.
If the Group had acquired Rapid Travel at the beginning of 2000 and 2001, the Group's results would not have been materially different from the actual results as disclosed in these financial statements.
On April 19, 2000 the Company acquired the entire issued share capital of Flextech Plc ("Flextech"), a company engaged in broadcast media activities, for a total consideration of L1,978 million. This comprised 601 million shares of 10p each and acquisition costs of L31 million. The value attributed to the shares issued was 323.85 pence per share, being the average share market price for a five day period around December 17, 2000, the day the terms of the acquisitions were agreed to and announced. The acquisition was accounted for using the purchase method of accounting. The goodwill arising on acquisition of Flextech was L1,382 million. As described in note 16, the Group has undertaken an impairment review of goodwill. As a result of the review, a charge of L429 million has been made.
On November 1, 2000 the Company acquired the entire issued share capital of Eurobell (Holdings) PLC ("Eurobell"), from Deutsche Telekom ("DT") and agreed to pay initial and deferred consideration to DT, (as discussed below), in the form of 5% Accreting Convertible Notes due 2003. The aggregate principal amount of such Notes, following agreement of the deferred consideration is L254 million. The terms of the Accreting Convertible Notes are described in note 16 to these financial statements.
Upon completion of the acquisition, the Company issued a L220 million Accreting Convertible Note to DT in consideration for:
- Eurobell's entire issued share capital, L72 million
- the assignment of an inter-company loan previously owed by Eurobell to DT, L128 million, and
- a cash payment remitted to Eurobell by DT shortly after the acquisition, L20 million.
Subsequently, on January 15, 2001 DT remitted a further cash payment, L30 million, to Eurobell and the Company issued an additional Accreting Convertible Note to DT for L30 million.
In addition under the terms of the acquisition, the Company was obliged to provide deferred consideration, contingent on Eurobell's turnover for the year ended December 31, 2000 exceeding a certain target. As a result, an additional L3.5 million Accreting Convertible Note, dated April 2, 2001 was issued to DT. This deferred consideration was accrued for at December 31, 2000.
Goodwill of L1 million arose on the acquisition.
If the Company had acquired Flextech and Eurobell on January 1, 2000 the Group's net loss of L755 million and loss per share of L0.28 would have been L820 million and L0.28, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
8 SUPPLEMENTAL DISCLOSURES TO CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash paid for interest was L287 million, L335 million and L164 million for the years ended December 31, 2002, 2001 and 2000, respectively.
During 2002 there were no significant non-cash investing activities. The amounts stated for 2001 represent the purchase of Rapid Travel. The amounts stated for 2000 represent the purchase of Flextech and Eurobell. These transactions are described in note 7 to the consolidated financial statements.
In 2002 the Group entered into capital lease obligations with a total capital value of L17 million. The Group entered into no vendor financing arrangements during the year, but had a remaining financed balance of L11 million at December 31, 2002. At December 31, 2002, the Group had accrued a further L57 million of capital expenditure for property and equipment.
9 OTHER RECEIVABLES
Accrued income primarily represents telephone calls made by Cable Division subscribers and Business Services Division customers that have not been billed as at the accounting period end. The period of time over which billings have not been billed varies between two days and four weeks.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
10 INVESTMENTS
The Group has investments in affiliates accounted for under the equity method at December 31, 2002 and 2001 as follows:
During the year Blue Yonder Workwise Limited became a wholly owned subsidiary of the Group. No goodwill arose on the acquisition.
Summarized combined financial information for such affiliates which operate principally in the cable television, broadcasting and interactive media industries is as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
On September 4, 2002 the investment in SMG plc, a listed investment in an associated undertaking, was reclassified as a current asset investment at net realizable value. This resulted in L42 million being written off the carrying value of the investment. The investment in SMG plc was subsequently sold in November 2002 realizing a gain of L1 million.
11 PROPERTY AND EQUIPMENT
Cable and ducting consists principally of civil engineering and fiber optic costs. In addition, cable and ducting includes net book value of pre-construction and franchise costs of L18 million and L14 million as of December 31, 2002 and 2001, respectively. Electronic equipment includes the Group's switching, headend and converter equipment. Other equipment consists principally of motor vehicles, office furniture and fixtures and leasehold improvements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
12 VALUATION AND QUALIFYING ACCOUNTS
13 OTHER ASSETS
The components of other assets, net of amortization and write offs, are as follows:
During the year L11 million of deferred financing costs of debentures were written off in connection with bond debt default.
14 INVENTORY
15 OTHER LIABILITIES
Other liabilities are summarized as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
16 DEBT
Debt is summarized as follows at December 31, 2002 and 2001:
NOTES AND DEBENTURES
The Debentures and Notes are unsecured liabilities of the Group.
The Senior Convertible Notes 2005 are convertible into 114 million ordinary shares of the Group at a conversion price of 288 pence per ordinary share. Conversion is at the holders' option at any time up to the close of business on June 22, 2005. The Senior Convertible Notes 2007 are convertible into 92 million ordinary shares of the Group at a conversion price of 325 pence per ordinary share. Conversion is at the holders' option at any time up to close of business on February 2, 2007. If Notes are called for redemption prior to maturity, each holder has the right to convert Notes into ordinary shares. The Accreting Convertible Notes 2003 are convertible into 162 million ordinary shares of the Group at an initial conversion price of 156.56 pence per ordinary share. Conversion is at maturity at the holder's option, but the Group can elect to settle in cash at any time, in whole but not in part, at 100% of the accreted value provided that for a certain 10 day period prior to redemption, the price per ordinary share has been at least 130% of the average conversion price in effect on each day during the 10 day period.
On January 15, 2001, DT remitted a cash payment of L30 million to its former subsidiary Eurobell, under the terms of the acquisition of Eurobell by the Company on November 1, 2000. In consideration the Company issued additional Accreting Convertible Notes 2003 for the same amount. In addition, under the terms of the acquisition, the Company was obliged to provide deferred consideration, contingent on Eurobell's turnover for
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
the year ended December 31, 2000 exceeding a certain target. As a result additional L3.5 million Accreting Convertible Notes 2003, dated April 2, 2001, were issued to DT.
The unamortized portion of the discounts on issue of the Senior Discount Notes 2009 and Senior Discount Notes 2010 was L73 million and L58 million respectively. The discount on issue is being amortized up to the first call dates of the bonds, such as to produce a constant rate of return on the carrying amount.
The indentures under which the Debentures and Notes were issued contain various covenants, which among other things, restrict the ability of the Group to incur additional indebtedness, pay dividends, create certain liens, enter into certain transactions with shareholders or affiliates, or sell certain assets. As part of its refinancing, the Group elected not to pay: the interest due on October 1, 2002 on its Senior Debentures 2006 and its Senior Discount Debentures 2007; the interest due on November 1, 2002 on its Senior Notes 2008; and the interest due on January 7, 2003 on its Senior Convertible Notes 2005. The non-payment of interest constitutes a default event under the terms of these four bonds. As a consequence of the non-payment of hedge contracts of L10.5 million, all of the remaining bonds were also in default as at December 31, 2002.
SENIOR SECURED FACILITY
On March 16, 2001 the Group entered into a new senior secured credit facility (the "Senior Secured Facility") with a syndicate of banks for L2 billion, of which L1,855 million was drawn down at December 31, 2002. The Group is also able to raise a further L250m from institutional investors (the "Institutional Tranche") of which L145 million was drawn down at December 31, 2002. The first drawdowns under the Senior Secured Facility were used to repay amounts owed under the old senior secured credit facilities.
Borrowings under the Senior Secured Facility are secured on the assets of the Group including the partnership interests and shares of subsidiaries and bear interest at 0.75% to 2.0% over LIBOR (depending on the ratio of borrowings to quarterly, annualized, consolidated net operating cash flow). Borrowings under the Institutional Tranche bear interest at up to 4% above LIBOR.
The Senior Secured Facility contains cross default clauses with other debt instruments. As a result of the Group being in default of its Debentures and Notes, it is in default on the Senior Secured Facility. In addition, on March 14, 2003, Telewest notified its Senior Lenders that, as a result of the exceptional items incurred in 2002 and their impact on Telewest's net operating cash flow, it would breach certain financial covenants under its bank facility in respect of the quarter ended December 31, 2002.
The Group is renegotiating its bank facilities and debt financing arrangements. Further details of the Financial Restructuring are included in note 23.
VENDOR FINANCING
The Group has entered into vendor financing arrangements to fund its purchase of equipment from certain suppliers. Under the terms of these arrangements the Group defers payment for periods up to 36 months. Interest is charged on these arrangements at a rate that is fixed for the life of the arrangements. The balance on these arrangements at December 31, 2002 was L11 million.
SMG LOAN
On July 11, 2001, the Group entered into a contract with Toronto Dominion Bank ("TD"), whereby TD provided a loan to the Group, in return for security over 55% of the Group's shareholding in SMG plc. The loan was fully repaid during the year following the sale of the Group's investment in SMG.
BANK LOANS
Bank loans are property loans secured on certain freehold land and buildings held by the Group. The balance at December 31, 2002 was L7 million.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
MATURITY PROFILE
As a consequence of the defaults referred to above, the Group's long-term debt has been disclosed as repayable within one year. The original Maturity Profile of the Group's long-term debt was as follows:
17 INCOME TAXES
Loss before income taxes is solely attributable to the United Kingdom.
The provisions for income taxes follow:
A reconciliation of income taxes determined using the statutory UK rate of 30% (2001: 30%) to the effective rate of income tax is as follows:
Deferred income tax assets and liabilities at December 31, 2002 and 2001 are summarized as follows:
At December 31, 2002 the Group estimates that it has, subject to Inland Revenue agreement, net operating losses ("NOLs") of L1,647 million available to relieve against future profits. This excludes capital allowances on assets which are available to the Group, but have not been claimed.
A valuation allowance of 100% has been provided due to a history of operating losses and management's belief that the likelihood of realizing the benefit of the deferred tax asset is not more likely than not.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The NOLs have an unlimited carry forward period under UK tax law, but are limited to their use to the type of business which has generated the loss.
18 SHAREHOLDERS' EQUITY
MOVEMENT IN SHARE CAPITAL
On March 31, 2000 the authorized share capital of the Company was increased to L460 million divided into 4,300 million ordinary shares of 10 pence each and 300 million limited voting convertible ordinary shares of 10 pence each.
Between May 5 and July 5, 2000 the Company issued 601 million ordinary shares of 10 pence each in consideration for the entire issued share capital of Flextech. Also in 2000, 4 million ordinary shares of 10 pence each were issued in consideration of L4.6 million on exercise of employee share options.
During 2001 the Company issued 7 million ordinary shares of 10 pence each upon exercise of employee share options. Total consideration received was L6 million. In addition the Company redesignated 20 million ordinary shares of 10 pence each into 20 million limited voting convertible ordinary shares of 10 pence each.
LIMITED VOTING CONVERTIBLE ORDINARY SHARES
The ordinary shares and the limited voting convertible ordinary shares have the same rights, except that the limited voting convertible ordinary shares do not confer the right to vote on resolutions to appoint, reappoint, elect or remove directors of Telewest. No application will be made for the limited voting convertible ordinary shares to be listed or dealt in on any stock exchange. Holders of limited voting convertible ordinary shares are entitled to convert all or some of their limited voting convertible ordinary shares into fully paid ordinary shares, provided that the conversion would not result in a change of control of the Company for the purposes of the indentures governing certain Notes and Debentures. The limited voting convertible ordinary shares are convertible into ordinary shares at the Company's option at any time, subject to certain conditions. The sole holders of the limited voting convertible ordinary shares are Liberty Media and Microsoft.
Members of the Liberty Media Group and/or the Microsoft Group can redesignate all or any of their ordinary shares into limited voting convertible ordinary shares. This is to ensure that, on any future purchase of ordinary shares by members of the Microsoft Group and/or members of the Liberty Media Group, they will, at that time, be able to re-designate such number of their then existing holding of ordinary shares so as to avoid a change of control of the Company for the purposes of the Notes and Debentures.
Future purchases of ordinary shares and/or limited voting convertible ordinary shares by members of the Liberty Media Group and/or the Microsoft Group will, however, be subject to Rule 9 of the UK's City Code on Takeovers and Mergers because both classes of shares are treated as voting shares for that purpose. Under Rule 9, when any person acquires, whether by a series of transactions over a period of time or not, shares which (taken together with shares held or acquired by persons acting in concert with him) carry 30% or more (but less than 50%) of the voting rights of a public company, that person is normally required to make a general offer to shareholders for the entire share capital of the company then in issue. Any person, or group of persons acting in concert, owning shares carrying 50% or more of the voting rights of a public company, subject to their own individual limits, is free to acquire further shares in that public company without giving rise to the requirement to make a general offer for the entire issued share capital of that company.
In May 2001, Liberty Media increased its shareholding in the Company as a result of the purchase of 20 million ordinary shares of 10 pence each. Prior to the increase in shareholding, Liberty Media redesignated 20 million ordinary shares of 10 pence each as limited voting convertible ordinary shares of 10 pence each. As a result Liberty Media and Microsoft's combined shareholdings remained below 50% of the issued ordinary share capital, above which level a change of control for the purposes of the Group's debt securities may occur.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
19 SHARE-BASED COMPENSATION PLANS
At December 31, 2002, the Company operated five types of share-based compensation plans: the Executive Share Option Schemes, the Sharesave Schemes, the Telewest Restricted Share Scheme ("RSS"), the Telewest Long Term Incentive Plan ("LTIP") and an Equity Participation Plan ("EPP").
The Company applies APB 25 and related interpretations in accounting for its share-based compensation plans. Compensation cost is recognized over the estimated service period in respect of performance based share option grants to the extent that the market value of the Company's ordinary shares exceeds the exercise price at the earlier of the vesting date or the Balance Sheet date. Compensation cost is recognized for awards over ordinary shares made under the RSS since the awards have no exercise price. Compensation cost is recognized over the estimated service period in respect of the LTIP to the extent that the market value of the Company's ordinary shares exceeds the exercise price at the earlier of the vesting date or the Balance Sheet date.
Compensation cost recognized for share option grants and awards is as follows:
During the year, no options or awards were granted over any ordinary shares of the Company. If compensation costs for share option grants and awards under the RSS, LTIP, Executive Option Schemes and EPP had been determined based on their fair value at the date of grant for 2001 and 2000 consistent with the method prescribed by SFAS 123, the Group's net loss and basic and diluted loss per share would have been adjusted to the pro forma amounts set out below:
The fair value of each option grant in all plans was estimated as at the date of grant using a Black-Scholes option-pricing model. The model used a weighted-average, risk-free interest rate of 5.5% and 5.8% for grants in 2001 and 2000 respectively, and an expected volatility of 55% and 30%, respectively. The Group does not expect to pay a dividend on its ordinary shares at any time during the expected life of any outstanding option. The Group expects options to be held until maturity.
PERFORMANCE-BASED SHARE OPTION COMPENSATION PLANS
The Group has two performance-based share option plans: the 1995 (No. 1) Executive Share Option Scheme and the 1995 (No. 2) Executive Share Option Scheme. Under both plans, certain officers and employees are granted options to purchase ordinary shares of the Company. The exercise price of each option generally equals the market price of the Company's ordinary shares on the date of grant. The options are exercisable between three and ten years after the date of the grant with exercise conditional on the Company's
IV-32
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
shares out-performing by price the FTSE100 Index over any three-year period preceding exercise. The Company may grant options for up to 295 million ordinary shares.
A summary of the status of the Company's performance-based share option plans as of December 31, 2002, 2001, and 2000 and changes during the years ended on those dates are presented below:
The adjustments during 2000 arose as a result of the transfer in of former Flextech outstanding options.
Share options are forfeited due to employees leaving the Group before their share options become exercisable.
The following table summarizes information about the Company's performance-based share option plans outstanding at December 31, 2002.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
FIXED SHARE OPTION COMPENSATION PLANS
The Company also operates the Sharesave Scheme, a fixed share option compensation scheme. Under this plan, the Company grants options to employees to purchase ordinary shares at up to a 20% discount to market price. These options can be exercised only with funds saved by employees over time in a qualified savings account. The options are exercisable between 37 and 66 months after commencement of the savings contracts.
A summary of the status of the Company's fixed share option plan as of December 31, 2002, 2001, and 2000 and the changes during the years ended on those dates are presented below:
The adjustments during 2000 arose as a result of the transfer in of former Flextech outstanding options.
Share options are forfeited due to employees leaving the Group before their share options become exercisable.
The following table summarizes information about the Company's fixed share options outstanding at December 31, 2002:
TELEWEST RESTRICTED SHARE SCHEME ("RSS")
The Company operates the RSS in conjunction with an employment trust, the Telewest 1994 Employees' Share Ownership Plan Trust (the "Telewest ESOP"), which has been designed to provide incentives to executives of the Company. Under the RSS, executives may be granted awards over ordinary shares of the Company based on a percentage of salary. The awards are made for no monetary consideration. The awards
IV-34
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
generally vest three years after the date of the award and are exercisable for up to seven years after the date when they vest.
The compensation charge related to each award is based on the share price of the ordinary shares on the date the award was made.
A summary of the status of the RSS at December 31, 2002, 2001, and 2000 and changes during the years ended on those dates are presented below:
Share awards are forfeited due to employees leaving the Group before their awards become exercisable.
At December 31, 2002, the 493,034 awards outstanding and the 214,114 awards exercisable have weighted average remaining contractual lives of 7.4 years and 6.3 years respectively.
Deferred compensation cost relating to RSS is L38,000 (2001: L478,000.)
LONG TERM INCENTIVE PLAN ("LTIP")
The LTIP provides for share awards to executive directors and senior executives. Under the LTIP, an executive will be awarded the provisional right to receive, for no payment, a number of Telewest shares with a value equating to a percentage of base salary. The shares will not vest unless certain performance criteria, based on total shareholder return assessed over a three-year period are met. The percentage of salary will be determined by the Remuneration Committee and will be up to 100% of base salary for executive directors.
A summary of the status of the LTIP at December 31, 2002, 2001, and 2000 and changes during the years ended on those dates are presented below:
Share awards are forfeited due to employees leaving the Group before their share options become exercisable or due to performance criteria not being met.
Deferred compensation cost relating to the LTIP is Lnil (2001: L189,000.)
IV-35
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
EQUITY PARTICIPATION PLAN ("EPP")
The Remuneration Committee has provided that, under the EPP, an employee with two years service or at manager level or above, can use up to 100% of the Short Term Incentive Plan ("STIP") bonus payable to the employee to acquire Telewest shares ("bonus shares"). The employee must deposit the bonus shares with the Trustee of the existing Telewest ESOP. In return, the employee is provisionally allocated for no payment a matching number of Telewest shares. Provided the bonus shares are retained for three years and the employee remains employed for three years, the bonus and matching shares would thereafter be released to the employee.
A summary of the status of the Company's EPP at December 31, 2002, 2001, and 2000 and the changes during the years ended on those dates are presented below:
Share awards are forfeited due to employees leaving the Group before their share options become exercisable.
Deferred compensation cost relating to the EPP is L80,000 (2001: L419,000.)
20 ACCUMULATED OTHER COMPREHENSIVE INCOME
The amounts reclassified into earnings are detailed in note 5.
21 COMMITMENTS AND CONTINGENCIES
RESTRICTED CASH
At December 31, 2002, the Group has cash restricted as to use of L12 million which provides security for leasing obligations.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
OTHER COMMITMENTS
The amount of capital expenditure authorized by the Group for which no provision has been made in the consolidated financial statements is as follows:
In addition the Group has contracted to buy L28 million of programming rights for which the license period has not yet started.
CAPITAL AND OPERATING LEASES
The Group leases a number of assets under arrangements accounted for as capital leases, as follows:
Depreciation charged on these assets was L44 million and L45 million for the years ended December 31, 2002 and 2001 respectively.
The Group leases business offices and uses certain equipment under lease arrangements accounted for as operating leases. Minimum rental expense under such arrangements amounted to L21 million, L19 million and L17 million for the years ended December 31, 2002, 2001 and 2000, respectively and is included in depreciation expense detailed in note 11.
Future minimum lease payments under capital and operating leases are summarized as follows as of December 31, 2002:
It is expected that, in the normal course of business, expiring leases will be renewed or replaced.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Group leases capacity on its network to other telecommunications companies. These leases are accounted for as operating leases and revenues received are recognized over the life of the leases as follows:
The assets held under these leases are accounted for as follows:
Depreciation charged on these assets was L2 million and L2 million for the years ended December 31, 2002 and 2001 respectively.
CONTINGENT LIABILITIES
The Group has provided performance bonds in respect of its national licence and to local authorities up to a maximum amount of L6 million (2001: L7 million).
The Group is a party to various other legal proceedings in the ordinary course of business which it does not believe will result, in aggregate, in a material adverse effect on its financial condition or results of operations.
22 RELATED-PARTY TRANSACTIONS
IDENTITY OF RELEVANT RELATED PARTIES
Liberty Media, Inc ("Liberty") and Microsoft are related parties of the Group, in that they control or controlled, directly or indirectly, more than 20% of the voting rights of the Company in 2002, 2001 and 2000.
Flextech up to its acquisition on April 19, 2000 was a related party of the Group as Liberty owned more than 20% of the voting rights of Flextech.
UKTV is a related party of the Group, as the Group owns 50% of the voting rights.
TV Travel Group Limited ("TVT") was a related party of the Group, as the Group owned 37.95% of the voting rights before disposal in 2002.
In 2001 Screenshop Limited ("Screenshop") became a related party when the Group sold its shareholding in Screenshop to Sit-Up Limited in return for a 39.02% shareholding in Sit-Up Limited.
NATURE OF TRANSACTIONS
The Group had a L10 million loan facility with Liberty. Interest charged on this loan was Lnil in 2001 and L1 million in 2000. The balance due to Liberty at December 31, 2000 was L17 million including accrued interest and was repaid in 2001.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Group purchases software and consultancy services from Microsoft, on normal commercial terms. Purchases in the year ended December 31, 2002 amounted to L1 million (2001: L2 million, 2000: L2 million). The balance outstanding in respect of these purchases was Lnil at December 31, 2002, 2001 and 2000.
The Group has billed overheads and costs incurred on their behalf to UKTV, TVT and Screenshop of L11 million, L1 million and L1 million (2001: L8 million, L3 million and L1 million, 2000: L7 million, L10 million and Lnil) respectively. The Group has also made a loan to UKTV. Interest charged on this loan was L12 million (2001: L12 million, 2000: L15 million). Amounts due from UKTV, TVT and Screenshop at December 31, 2002 were L208 million, L1 million and L4 million respectively (2001: L218 million, L28 million and Lnil and 2000: L229 million, L31 million and Lnil respectively).
In the normal course of its business the Group purchases programming from UKTV on normal commercial terms. Purchases in the year ended December 31, 2002 were L13 million (2001: L9 million, 2000: L7 million). The balance due to UKTV at December 31, 2002 was Lnil (2001: L2 million, 2000: Lnil).
23 SUBSEQUENT EVENTS AND FINANCIAL RESTRUCTURING
The Group is renegotiating its bank facilities and debt financing arrangements. Further details of the proposed Financial Restructuring are as follows:
On September 30, 2002, we announced that we had reached a preliminary agreement relating to a financial restructuring (the "Financial Restructuring") with an ad hoc committee of our bondholders ("the Bondholder Committee"). That agreement provides for the cancellation of all outstanding notes and debentures (the "Notes"), representing approximately L3.4 billion of indebtedness, issued by the Company and Telewest Finance (Jersey) Limited and certain other unsecured foreign exchange hedge contracts (the "Hedge Contracts") of the Company in exchange for New Ordinary Shares ("New Shares") representing 97% of the issued share capital of the Company immediately after the Financial Restructuring. The Company's current ordinary shareholders will receive the remaining 3% of the Company's issued ordinary share capital.
We also announced on September 30, 2002 that we were deferring payment of interest under certain of our Notes and the settlement of the Hedge Contracts. Such non-payment continues and has resulted in defaults under the Group's bank facilities and its bonds. Based on one such default, in respect of non-payment of approximately L10.5 million to a Hedge Contract counter-party, that counter-party has filed a petition for the winding-up of the Company with a UK court. The Company intends to deal with this claim as part of the overall restructuring of its unsecured debt obligations and does not believe that the legal action will delay or significantly impede the Financial Restructuring process. The Company will of course continue to meet its obligations to its suppliers and trade creditors and this legal action is expected to have no impact on customer service.
On January 15, 2003, we announced that we had reached a non-binding agreement with respect to the terms of amended and restated credit facilities with both the steering committee of our senior lenders and the Bondholder Committee. In addition, the terms of these facilities have received credit committee approval, subject to documentation and certain other issues, from all of our senior lenders, save for those banks which are also creditors by virtue of the unsecured Hedge Contracts with which we will deal in the overall Financial Restructuring.
The terms of the amended and restated bank facilities are as follows:
- the amended facilities total L2,155 million, comprising term loans of L1,840 million, L190 million of committed overdraft and revolving credit facilities and an uncommitted term facility of L125 million;
- the amended facilities do not amortise; and the majority of the facilities will mature on December 31, 2005 with the balance maturing on June 30, 2006;
- financial covenants will be re-set to reflect the Company's new business plan; and IV-39
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
- the pricing on the facilities will be increased to reflect market sentiment.
These amended facilities will replace the Group's existing bank facilities, (the "Senior Secured Facility") and are, as noted above, conditional on various matters, including the satisfactory finalisation of arrangements for dealing with foreign exchange creditors and the completion of our balance sheet restructuring. These amended credit facilities will provide the Company with substantial liquidity, which is expected to be sufficient to see the Company through to cash flow positive after completion of the Financial Restructuring.
Negotiations are continuing with the Bondholder Committee, the Company's senior lenders and certain other major stakeholders with a view to the timely completion of the Financial Restructuring.
These financial statements have been prepared on a going concern basis and do not include any adjustments that would arise as a result of the going concern basis of preparation being inappropriate. The board of directors have confidence in the successful conclusion of a restructuring of the Company's balance sheet (and any required amendments to the Senior Secured Facility) and, together with and on the basis of cash flow information that they have prepared, the directors consider that the Group will continue to operate as a going concern for a period of at least 12 months from the date of issue of these financial statements. Any restructuring will require the approval of our bankers and various stakeholders. Inherently, there can be no certainty in relation to any of these matters.
24 QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
- ---------------
* In the fourth quarter the Group recorded a goodwill impairment charge of L1,445 million, wrote down the value of its investments in affiliates by L130 million and recorded a fixed asset impairment charge of L841 million.
- ---------------
* In the fourth quarter the Group recorded a goodwill impairment charge of L766 million and wrote down the value of its investments in affiliates by L202 million.
Finance expenses include foreign exchange gains and losses on the retranslation or valuation of US Dollar-denominated financial instruments using period end exchange rates and market valuations.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
25 SEGMENTAL INFORMATION
The Group applies SFAS 131, Disclosures about Segments of an Enterprise and Related Information. SFAS 131 establishes standards for reporting information about operating segments in annual financial statements. It also establishes standards for related disclosures about products and services, and geographic areas. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision-making group, in deciding how to allocate resources and in assessing performance. The Group's chief operating decision-making group is the board of directors. The operating segments are managed separately because each operating segment represents a strategic business unit that offers different products and services in different markets. The Group operates in two main segments: Cable and Content. The Cable segment of our business can be subdivided, for revenue purposes only, between four product ranges: Cable Television, Consumer Telephony, Internet and other, and Business Services. The Internet and other unit comprises internet sales and sales of cable publications. The Content segment provides entertainment content, interactive and transactional services to the UK pay-TV broadcasting market.
The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies. In 2001, the Group changed the structure of its segmental analysis, and certain corresponding information from the previous years has been restated to reflect the change in structure.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following tables present summarized financial information relating to the reportable segments for each of the three years ended December 31, 2002:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
- ---------------
(1) Inter-segmental revenues are revenues from sales in our Content Division which are costs in our Cable Division and are eliminated on consolidation.
(2) In the fourth quarter of 2002, the Group recorded a goodwill impairment charge of L1,445 million and wrote down the value of its investments in affiliates by L130 million. In the fourth quarter of 2001, the Group recorded a goodwill impairment charge of L766 million and wrote down the value of its investments in affiliates by L202 million.
(3) In the fourth quarter of 2002 the Group recorded a fixed asset impairment charge of L841 million.
IV-43
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
LIBERTY MEDIA CORPORATION
By /s/ CHARLES Y. TANABE ------------------------------------ Charles Y. Tanabe Senior Vice President and General Counsel
Dated: March 15, 2004
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
IV-44
EXHIBIT INDEX
Listed below are the exhibits which are filed as a part of this Report (according to the number assigned to them in Item 601 of Regulation S-K):