VARIABLE INTEREST ENTITIES
In the normal course of business, the Company makes investments that support its underlying business strategy and enable it to enter new markets and develop programming. In certain instances, an investment may qualify as a VIE. (See Note 2.) As of December 31, 2013 and 2012, the Company’s VIEs primarily consisted of Hub Television Networks LLC and OWN LLC, which operate pay television networks in the U.S.
The Company accounted for its interests in VIEs using the equity method, as the Company is not the primary beneficiary. The aggregate carrying values of these equity method investments were $789 million and $825 million as of December 31, 2013 and 2012, respectively. The Company recognized its portion of net income and losses generated by VIEs of $10 million in income and $92 million and $33 million in losses for 2013, 2012 and 2011, respectively, in income (loss) from equity investees, net on the consolidated statements of operations.
As of December 31, 2013, the Company’s estimated risk of loss for investment carrying values, unfunded contractual commitments and guarantees made on behalf of VIEs was approximately $833 million. The estimated risk of loss excludes the Company’s non-contractual future funding of OWN and its operating performance guarantee for Hub Television Networks LLC, which are discussed below.
Hub Television Networks LLC
Hub Television Networks LLC operates The Hub Network, which is a pay television network that provides children’s and family entertainment and educational programming. The Company is obligated to provide The Hub Network with funding up to $15 million; the Company has not provided funding as of December 31, 2013. The Company also provides services such as distribution, sales and administrative support for a fee. (See Note 20.)
Based upon the level of equity investment at risk, The Hub Network is a VIE. Discovery and its partner, Hasbro Inc. (“Hasbro”), share equally in voting control and jointly consent to decisions about programming and marketing strategy and thereby direct the activities of The Hub Network that most significantly impact its economic performance. Neither has special governance rights, and both are equally represented on the board of The Hub Network. The partners also share equally in the profits, losses and funding of The Hub Network. The Company has determined that it is not the primary beneficiary of The Hub Network. Accordingly, the Company accounts for its investment in The Hub Network using the equity method.
Through December 31, 2015, the Company has guaranteed the performance of The Hub Network and is required to compensate Hasbro to the extent that distribution metrics decline versus levels historically achieved by the Discovery Kids channel. This guarantee extends on a declining basis through the period of guarantee. Upon inception of The Hub Network on May 22, 2009, the maximum amount potentially due under this guarantee was $300 million. As of December 31, 2013, the maximum amount potentially due under this guarantee was less than $55 million. The maximum exposure to loss is expected to decline to zero during 2014. As The Hub Network’s distribution is obtained under long-term contracts with stable subscriber levels, the Company believes the likelihood is remote that the guaranteed performance levels will not be achieved and, therefore, believes the performance guarantee is unlikely to have an adverse impact on the Company.
The carrying value of the Company’s investment in The Hub Network was $312 million and $322 million as of December 31, 2013 and 2012, respectively. The value of the investment may decline if future results vary negatively from the current long range plan. The Company continues to monitor the valuation of its investment in accordance with GAAP, which requires an impairment charge when there is an other-than-temporary decline in the investment’s value. No impairment was recorded in 2013.
OWN LLC
OWN LLC operates OWN, which is a pay television network and website that provides adult lifestyle content focused on self-discovery, self-improvement and entertainment. Based on the level of equity investment at risk, OWN is a VIE. While the Company and Harpo, Inc. ("Harpo") are partners who share equally in voting control, power is not shared because Harpo holds operational rights related to programming and marketing, as well as selection and retention of key management personnel that significantly impact OWN’s economic performance. Accordingly, the Company has determined that it is not the primary beneficiary of OWN and accounts for its investment in OWN using the equity method.
In connection with the launch of OWN on January 1, 2011, the Company contributed the domestic Discovery Health network to the venture. The contribution did not impact the Company’s ownership interest, voting control or governance rights related to OWN. Subsequent to the contribution, the Company no longer consolidates the domestic Discovery Health network, which was a component of its U.S. Networks segment. However, the Company provides OWN funding, content licenses and services such as distribution, sales and administrative support for a fee. (See Note 20.)
The Company recorded the contribution at fair value, which resulted in a pretax gain of $129 million and tax expense of $27 million. The fair value of the Company’s retained equity interest in OWN was estimated to be $273 million. The gain represents the fair value of the equity investment retained less the carrying values of contributed assets, which included goodwill and other identifiable assets with carrying values of $136 million and $8 million, respectively. The fair value of the contribution of the Discovery Health network to OWN was determined utilizing customary valuation methodologies including discounted cash flow valuation models. The underlying assumptions, such as future cash flows, weighted average costs of capital and long-term growth rates were generally not observable in the marketplace and therefore involved significant judgment.
The Company’s combined advances to and note receivable from OWN, including accrued interest, were $483 million and $482 million as of December 31, 2013 and 2012, respectively. During 2013, the Company received net payments of $34 million from OWN and accrued interest earned on the note receivable of $35 million. During 2012, the Company provided OWN with funding of $136 million and accrued interest on the note receivable of $29 million. The note receivable is secured by the net assets of OWN. While the Company has no further funding commitments, the Company may provide additional funding to OWN, if necessary, and expects to recoup amounts funded. The funding to OWN accrues interest at 7.5% compounded annually. There can be no event of default on the borrowing until 2023. However, borrowings are scheduled for repayment four years after the borrowing date to the extent that OWN has excess cash to repay the borrowings then due. Following such repayment, OWN’s subsequent cash distributions will be shared equally between the Company and Harpo. OWN began repaying amounts owed to the Company during 2013.
In accordance with the venture agreement, losses generated by OWN are generally allocated to both investors based on their proportionate ownership interests. However, the Company has recorded its portion of OWN’s losses based upon accounting policies for equity method investments. Prior to the contribution of the Discovery Health network to OWN at its launch, the Company recognized $104 million or 100% of OWN’s net losses. During the three months ended March 31, 2012, accumulated operating losses at OWN exceeded the equity contributed to OWN, and Discovery resumed recording 100% of OWN’s net losses. The Company will continue to record 100% of OWN's operating losses as long as Discovery provides all funding to OWN and OWN’s accumulated losses continue to exceed the equity contributed. All of OWN's future net income will initially be recorded by the Company until the Company recovers losses absorbed in excess of the Company's equity ownership interest.
The carrying value of the Company’s investment in OWN of $449 million and $469 million as of December 31, 2013 and 2012, respectively, includes a note receivable balance and accumulated investment losses. The early results of OWN’s operations were below its initial business plan, and while recent operating results have improved, there is a possibility that the results of OWN’s future operations will fall below the revised business plan. The Company continues to monitor the financial results of OWN along with other relevant business information to assess the recoverability of the OWN note receivable. No impairment of the investment balance was recorded during 2013.
Harpo has the right to require the Company to purchase all or part of Harpo’s interest in OWN at fair market value up to a maximum put amount every two and a half years commencing January 1, 2016. The maximum put amount ranges from $100 million on the first put exercise date up to $400 million on the fourth put exercise date. The Company has recorded no amounts for the put right.
