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The following is an excerpt from a 10-K SEC Filing, filed by SPICE ENTERTAIMENT COMPANIES INC on 4/15/1998.
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SPICE ENTERTAIMENT COMPANIES INC - 10-K - 19980415 - BUSINESS

Item 1. Business.

INTRODUCTION

Spice Entertainment Companies, Inc. and its subsidiaries (collectively "Spice" or the "Company") is a leading international provider of adult television entertainment. Formed in 1987, our networks and programming are available in over 50 countries and on the Internet.

1997 was an important year for the Company. We refinanced our senior credit facility and completed the disposition of our remaining non-strategic assets, enabling us to focus our energies on our core adult entertainment business. We then successfully launched a new more profitable domestic television network, Spice Hot. On February 3, 1998, the Company entered into a letter agreement to be acquired by Playboy Entertainment, Inc. ("Playboy") for a combination of cash and stock. The proposed transaction is subject to several conditions and is described below in RECENT DEVELOPMENTS.

The Company operates through four operating units: Spice Networks domestic adult pay-per-view networks, Spice International - international adult networks and programming, Spice Direct - direct to the consumer products and services and Spice Productions - adult film production and licensing.

Approximately 50% of our gross revenues for 1997 are derived from our three domestic adult pay-per-view television networks, Spice, the Adam & Eve Channel and Spice Hot ("Spice Networks"). (Pay-per-view television enables a household with an addressable set top decoder or a satellite receiver to purchase a block of programming for a set fee.) Spice Hot, our newest network offers more erotic content. From its launch in October 1997, Spice Hot is now carried by over 25 cable systems and as of April 1, 1998, was available nationwide in over 4.4 million addressable cable and direct broadcast satellite ("DBS") households. Spice and The Adam & Eve Channel feature cable version adult movies and related programming. The Spice Networks are available to over 15 million cable addressable households and over 3.3 million DBS households.

Spice International is responsible for expanding the global distribution of our adult television networks and programming. In Europe, we operate and distribute The Adult Channel, originated from the United Kingdom, and The Home Video Channel. The Adult Channel is distributed in the cable and direct-to-home ("DTH") markets and is currently available in over 40 countries in Europe. We also distribute the Spice and Spice Hot networks throughout Latin America and Spice programming in the Pacific Rim through agreements in Japan.

Spice Direct focuses on products and services marketed directly to consumers. Spice Direct, through agreements with third parties, provides audiotext services promoted on the Spice Networks. Spice Direct is also responsible for the productive utilization of our transponder capacity and provides network playback and programming services to third parties. Spice Direct also operates Cyberspice, our adult Internet website. Spice Productions licenses adult movies from the leading producers of adult movies both in this country and abroad. In order to satisfy the special demands of our television broadcast business, Spice Productions itself now produces approximately two adult movies per month. The Company owns the rights to an extensive library of adult films. We exhibit the films from our library on the Spice Networks and The Adult Channel and license films to third parties.

The following table sets forth the percentage of revenues contributed by each of our operating units during each of the last three fiscal years:

                                                 Years Ended December 31,
                                               --------------------------
                                                 1997      1996      1995
                                               ------    ------    ------
Spice Networks .............................     54.9%     45.3%     43.0%
Spice Direct ...............................     22.5       5.5       6.1
Spice International ........................     18.5      17.6      20.3
                                               ------    ------    ------
Total from Continuing Operations ...........     95.9      68.4      69.4
Discontinued Operations (SEG) ..............     --        19.1      15.2
Suspended/Terminated Operations (CVSP & CPV)      4.1      12.5      15.4
                                               ------    ------    ------
Total Revenue ..............................    100.0%    100.0%    100.0%
                                               ======    ======    ======

The Company was incorporated in 1987 under the laws of the State of Delaware and has its principal executive offices at 536 Broadway, New York, NY 10012.

RECENT DEVELOPMENTS

Proposed Transaction With Playboy. On February 3, 1998, the Company and Playboy executed a letter agreement providing for Playboy's acquisition of all of the outstanding shares of the Company's Common Stock for cash and Playboy stock (the "Proposed Transaction"). The February 3, 1998 agreement provided that for each share of the Company's Common Stock, Company stockholders will receive:

-- $3.60 in cash; and
-- 0.1524 shares of Playboy Class B Stock, subject to a collar designed to provide a minimum value of $2.11 or a maximum value of $2.69 per share of Common Stock.

The February 3, 1998 agreement also provided for tax, working capital and other adjustments to the purchase price.

The terms of the Proposed Transaction were modified by an amendment agreement dated April 15, 1998 which, among other things, eliminated the purchase price adjustments, other than the collar, and modified the consideration to be received by Company stockholders. Under the amended agreement, for each share of the Company's Common Stock, Company stockholders would receive:

-- $3.60 in cash; and
-- 0.1371 shares of Playboy Class B Stock, subject to a collar designed to provide a minimum value of $2.20 or a maximum value of $2.88 per share of Common Stock.

As part of the Proposed Transaction, the Company will transfer to a to-be-named spin-off company (referred to as "Spinco")its digital operations center for video and Internet broadcasts (the "Operations Facility"), its option to acquire the outstanding stock or assets of Emerald Media, Inc. ("EMI"), a leading provider of adult entertainment in the C-band market, and certain rights to a library of adult films. The Company will distribute all of the Spinco capital stock to its stockholders. It is anticipated that the Spinco distribution will occur at the closing of Playboy's acquisition of Spice as part of the merger consideration. Spinco will apply to list its common stock on the Nasdaq SmallCap market. Spinco intends to exercise the EMI Option after the acquisition.

Spinco will retain rights to distribute explicit programming in the U.S., Canada and sovereign islands of the Caribbean in the C-band DTH market. Spinco will also retain EMI's explicit Internet websites and will have C-band DTH broadcast rights to the explicit version of films from the Company's existing library and for use on EMI's websites. Spinco will also have the right to the explicit version of titles licensed by Playboy under any of the Company's existing production agreements on a royalty-free basis. Spinco will provide Playboy with playback services from the Operations Facility for all of Spice's cable network services that Playboy continues to distribute pursuant to a service contract. The service contract will provide for a fair market value service fee and have a two-year term.

The Proposed Transaction is subject to definitive documentation, Company stockholder approval, receipt of a fairness opinion and other customary closing conditions. The waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, has expired and Playboy has completed its due diligence review of the Company.

Playboy and the Company intend to promptly complete preparation of definitive documentation and obtain the approval of the Company's shareholders. Closing of the transaction is expected during the end of the second or beginning of the third calendar quarter. There is no assurance that any definitive agreement regarding the sale of the Company will be reached or that the transaction will be completed.

Refinancing. On January 15, 1997, the Company replaced its credit facility with PNC Bank, N.A. ("PNC") with a new credit facility with Darla, L.L.C. ("Darla"). PNC had provided a credit facility to the Company that had an outstanding principal balance of approximately $14.6 million at December 31, 1996. As part of these arrangements, we had issued PNC a warrant to acquire 100,000 shares of our common stock. Pursuant to a Settlement Agreement dated as of January 15, 1997, by and among PNC and the Company, we paid PNC $9.6 million, issued a $400,000 two-year promissory note and replaced the warrant previously granted to PNC with a new warrant to purchase 597,000 shares of common stock in satisfaction of the PNC credit facility. PNC released its security interest in our assets.

Pursuant to an Amended and Restated Loan and Security Agreement dated as of January 15, 1997, Darla provided the Company with a new credit facility (the "Darla Credit Facility") consisting of a $10.5 million term loan and a revolving credit facility of up to $3.5 million. The term loan proceeds were used to satisfy the $9.6 million cash payment provided for under the agreement with PNC and to pay Darla a loan commitment fee. The Darla Credit Facility matures on July 15, 1999 with quarterly principal amortization totaling $2.5 million due in the last year of the loan. The loan bears interest at 5% over the Citibank prime rate but not less than 13%. The Company has exercised its right to accrue three percentage points of the interest and added it to the principal of the loan. The accrued amount will be forgiven if the Darla Credit Facility is paid in full within two years.

As part of this transaction, we issued 24,250 shares of $100 face value Convertible Preferred Stock Series 1997-A (the "Preferred Stock"). The Preferred Stock has an 8% coupon which we have elected for the first four quarterly periods to pay by issuing additional shares of Preferred Stock. The Preferred Stock is convertible after two years into the Company's common stock at a 10% discount from the then current market price. The Preferred Stock is convertible earlier in other circumstances including when our stock price exceeds $5.00 per share for 30 trading days. As a result of this provision, the Preferred Stock is currently convertible. We agreed to register the shares of common stock underlying the Preferred Stock by entering into a Registration Rights Agreement with Darla.

As part of the Loan Agreement, we entered into various agreements with Darla pledging the stock of all of our domestic operating subsidiaries and The Home Video Channel Limited ("HVC") and granting Darla a security interest in our domestic assets. The Darla loan agreement contains various financial covenants including minimum levels of revenues and adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) for each quarter. We did not meet these covenants for the quarter ended September 30, 1997. On November 14, 1997, Darla and the Company executed an amendment to the Darla loan agreement which revised the revenue and adjusted EBITDA covenants for the balance of the loan's term and waived the financial covenant violations for the quarter ended September 30, 1997.

Emerald Media. In an effort to productively utilize available transponder capacity, we began providing transponder services to Emerald Media, Inc. ("EMI") in the fourth quarter of 1996. EMI is a provider of explicit adult television networks distributed in the domestic C-band DTH market. As part of these arrangements, EMI granted us an option to acquire its business or stock for a formula-determined amount. EMI expanded its operations and now operates several explicit adult television networks in the C-band DTH market. Our agreements with EMI were modified and we currently provide services on three transponders to EMI and handle playback for all of the EMI networks from our Operations Facility. The EMI Option was modified and now has an exercise price of $755,000. The Company will contribute the EMI Option to Spinco as part of the Proposed Transaction.

Operations Facility. In the second quarter of 1995, we entered into agreements with IBM and others to construct the Operations Facility at our New York City headquarters. Approximately $2.1 million of the Operation Facility's cost was to be financed by a capital lease with IBM Credit Corporation ("ICC"). After making an initial $435,000 lease payment, we subsequently renegotiated the lease with IBM and ICC in November 1996. Under the revised agreement, ICC provided an additional $525,000 of financing which we used to purchase video file servers and tape archives from Digital Equipment Corporation ("DEC"). IBM and ICC agreed to reduce the monthly lease payments to $37,000 per month and we agreed to begin making lease payments in February 1997. We are currently using the Operations Facility to playback three of our own networks and the EMI networks. The Company intends to transfer the Operations Facility to Spinco as part of the Proposed Transaction

Sale of Controlling Interest in Danish Satellite Television A/S ("DSTV"). In February 1995, HVC formed DSTV which launched Eurotica, a satellite delivered subscription network based in Denmark that features explicit version adult movies and adult entertainment. Eurotica is marketed to the DTH and cable markets throughout Europe and currently has subscribers in over 25 countries. Eurotica never achieved profitability, in part due to limited distribution and signal piracy.

On July 9, 1997, DSTV entered into a facilities agreement with Rendez-Vous Television International S.A. ("RDT") whereby RDT agreed to pay DSTV an amount equal to the cost of operating Eurotica plus 20% in exchange for the right to market Eurotica in the DTH market on a royalty free-basis. On September 12, 1997, HVC sold 51% of its interest in DSTV to RDT for approximately $45,000. RDT also paid the Company approximately $355,000 for a continued license of DSTV's library of adult films and agreed to license 120 adult films from the Company in the future. We believe that RDT has defaulted on certain of its obligations under these agreements and we are currently evaluating our alternatives with regard to this situation.

Adoption of Anti-Takeover Defenses. During 1997, the Company adopted an array of anti-takeover defenses. These included a Stockholders Rights Plan, amendments to the Company's by-laws and employment agreements with the Company's senior officers.

The purpose of the Stockholders Rights Plan is to give the Company time to analyze a potential hostile take-over and to force a hostile acquirer to negotiate with the Company's Board of Directors. The following summarizes the way the Stockholder Rights Plan achieves these goals: The Stockholder Rights Plan provides for the issuance of rights to each stockholder which are attached to the Common Stock. If a person acquires a specified percentage of the Company's Common Stock or commences a tender offer for the Company which has not been approved by the Board of Directors, the Board of Directors can cause the rights to detach. The detached rights give the Company's stockholders, other than the hostile acquirer, the right to acquire stock at a price that will result in a substantial reduction in the value of the hostile acquirer's Common Stock and make it more expensive to acquire control of the Company. Because the Board of Directors has the right to determine whether the rights should detach, it is likely that a potential acquirer will negotiate with the Board of Directors rather than attempting a hostile takeover of the Company. For more information on the Stockholder Rights Plan, refer to the description contained in the Company's Current Report on Form 8-K filed on June 18, 1997 and the copy of the plan attached to that Form 8-K.

The amendments to the Company's by-laws include provisions that require advance notice to the Company of (i) stockholder nominations to the board of directors and (ii) stockholder proposed amendments to the Company's Certificate of Incorporation and by-laws. The by-laws also require a super-majority vote of directors for certain actions to be taken.

The employment agreements with the senior officers generally provide for severance payments if an officer's employment is terminated within 18 months of a change in control.

Termination of Audiotext Service Provider. Capital Distribution, Inc., d/b/a Cupid Network Television ("Cupid") provided audiotext services (telephone chat lines) promoted on the Spice Network under a Telephone Services Agreement dated October 20, 1995. Cupid paid the Company a fee based on the number of Spice Network subscribers. Cupid subcontracted the operation of the chat lines to Amtec Audiotext Inc. ("Amtec"). Cupid also provided merchandise services under an Amended and Restated Distribution Agreement promoted on Spice and The Adam & Eve Channel.

The Company believed Cupid had breached its agreements with the Company and we attempted to terminate both agreements. Cupid instituted arbitration seeking to prevent the Company from terminating the agreements. The parties agreed to a settlement in a Settlement Agreement dated May 15, 1997 ("Settlement Agreement") that provided for, among other things, the adjournment of the arbitration, termination of the Distribution Agreement and modification of the Telephone Services Agreement.

In the first quarter of 1998, Cupid defaulted in the payment of service fees under the Telephone Services Agreement. The Company and Cupid are negotiating a termination of that agreement. American Telnet replaced Cupid and now provides the audiotext services promoted on the Spice network.

ELIMINATION OF NON-CORE BUSINESSES

Hit Movie Network. During the second quarter of 1997, we withdrew from the hit movie pay-per-view business, a business that did not achieve profitability. As an initial step in limiting our exposure to fund the business' operating losses, we contributed our hit-movie network, the Cable Video Store Network, to a partnership, CVS Partners ("CVSP"). The other CVSP partner, WilTech Cable Television Services, Inc. ("WCTV"), a subsidiary of The Williams Companies, Inc., agreed to fund the partnership. In the first quarter of 1997 and in the face of continuing losses, the CVSP partners elected to shut down the business and terminated satellite delivery of the network on March 31, 1997.

On June 3, 1997, the CVSP partners executed an agreement to dissolve the partnership. Under the terms of the dissolution agreement, WCTV agreed to pay us $580,000, representing past and future transponder services. We agreed to be responsible for winding down the partnership and they contributed an additional $1,030,000 to the partnership which was used to fund the wind-down of the business.

Spector Entertainment Group, Inc. In the fourth quarter of 1996, we determined that Spector Entertainment Group, Inc. ("SEG"), a provider of telecommunications, television production and related services primarily to the pari-mutuel wagering industry, was no longer a strategic fit with our core adult entertainment business. On February 7, 1997, and pursuant to a Settlement Agreement (the "SEG Settlement Agreement") dated January 29, 1997 among the Company, SEG and various Spector family members and affiliates (the "Spector Group"), we conveyed all of our SEG stock to certain members of the Spector Group in exchange for the 700,000 shares of our common stock we had previously issued in the transaction when we acquired SEG.

As part of the SEG Settlement Agreement, we also entered into a Transponder Services Agreement with SEG under which we provided transponder services to SEG for $80,000 a month for two years, subject to SEG's right to terminate upon 90 days prior notice. SEG exercised its termination right and the agreement was terminated on July 15, 1997.

As part of the original acquisition of SEG, we granted certain members of the Spector Group a put to sell all of the stock of another corporation they owned for a formula-determined number of shares of our common stock. As part of the SEG Settlement Agreement, this put was terminated.

Television and Movie Production. The Company, through its wholly-owned subsidiary Cinema Products Video, Inc. ("CPV"), was engaged in the production and distribution of movies, television series and programs and CD-ROMs. After suspending CPV's production activities at the end of 1995, we elected to terminate all of CPV's activities in 1996.

Multimedia Games. We formed a joint venture with TV Games, Inc. ("TVG"), a wholly-owned subsidiary of Multimedia Games, Inc. ("MGAM") to develop and promote high stakes proxy play Class II tribal bingo games. The parties were unable to agree on a business plan or a strategy for going forward with the joint venture. Pursuant to a Purchase Agreement dated June 28, 1996, we exchanged our interest in the joint venture and the 275,000 shares of MGAM stock we had previously acquired for (i) the cancellation of an aggregate of $775,000 of liabilities owed to MGAM and TVG, (ii) a $100,000 promissory note due on July 25, 1996 and (iii) a $400,000 promissory note due in three years. We retained a warrant to acquire 175,000 shares of MGAM stock that we had acquired when the joint ventured was formed.

In the third quarter of 1997, we exercised the warrant and sold the MGAM shares realizing approximately $1.3 million in excess of the warrant exercise price. In the last quarter of 1997, we sold the $400,000 note to a group of investors for $350,000.

SPICE NETWORKS

Introduction. The Spice Networks are among the leading domestic adult pay-per-view networks and for 1997 accounted for over 50% of our revenues. Adult programming is an important source of revenue for cable and DTH operators, typically accounting for between 30% to 50% of the operators' net pay-per-view revenues, surpassing, in many systems, net revenues from hit movies and events. ("Sex Still Sells," Multichannel News, April 7, 1997.) We believe that pay-per-view television distribution of adult programming is the preferred delivery vehicle for adult entertainment primarily for three reasons:

-- the convenience of purchasing pay-per-view programming; the -- ability to make a private purchase; and the ability to make a -- spontaneous entertainment decision.

The Company believes that as the universe of addressable households (those households capable of ordering pay-per-view programming) expands, adult programming will continue to be a mainstay of operators' pay-per-view programming offerings. According to Paul Kagan and other industry analysts, less than 50% of all cable households are currently addressable. The Spice Networks and the other pay-per-view adult television networks are currently available in over 75% of all addressable homes. Industry analysts expect that the universe of addressable households will grow and that adult television programming will be available in an even greater portion of that growing universe.

Television and entertainment industry analysts Veronis, Suhler and Associates project strong gains in addressable households, spending on pay-per-view movies and adult movie service revenue. The Veronis, Suhler 1996 Communications Industry Forecast projects an increase in addressable households from 25.4 million in 1996 to 40.3 million in 2001 and a 14.4% compound annual growth rate in pay-per-view movie spending from 1996 through 2001. Showtime Event Television, in its annual "State of the PPV" report, noted that the pay-per-view business surpassed the $1.2 billion revenue mark in 1997, with adult pay-per-view programming accounting for $253 million.

Pay-per-view television enables a subscriber with an addressable set top decoder or satellite receiver to purchase a block of programming, an individual movie or an event, for a set fee. Pay-per-view programming can be delivered via any number of delivery methods including via cable television, "direct to home" to households with large satellite dishes receiving a C-band low power analog or digital signal (the "C-band DTH market") or with small satellite dishes receiving a Ku-band medium or high power digital signal such as currently offered by DirecTV, Primestar and Echostar (referred to as "DBS services"), wireless cable systems and via new technologies such as cable modem and the Internet. The Spice Networks are currently distributed by all of these delivery methods. The following chart depicts the number of addressable households for each of the Spice Networks since 1989.

The following table is an EDGAR representation of the data points used in the printed graphic presentation:

                                        SPICE NETWORKS GROWTH

               Y/E 1989  Y/E 1990  Y/E 1991  Y/E 1992  Y/E 1993  Y/E 1994  Y/E 1995  Y/E 1996  Y/E 1997
               --------  --------  --------  --------  --------  --------  --------  --------  --------
Spice          0.8       2.3       3.9       4.9       7.4       9.3       12.8      16.3      17.3
AEC                                                              0.4        3.2       3.6       4.4
Spice Hot                                                                                       0.5

Spice Hot. In response to growing Spice customer demand for more erotic product and the greater mainstream acceptance of adult programming, we introduced a new television network, Spice Hot. Spice Hot features hot cable version adult movies, a more erotic version of the cable version featured on Spice and The Adam & Eve Channel.

Our preliminary results indicate that the buy-rates for systems that have replaced Spice with Spice Hot have typically increased between 40% to over 100% over those for Spice. (The buy-rate is the number of purchases per month divided by the number of addressable households.) In addition, Spice Hot commands a higher retail price. Spice Hot is designed to replace Spice in a cable or a DBS system. By replacing Spice with Spice Hot we believe our cable and DBS affiliates can increase their adult pay-per-view revenues without using up valuable channel capacity.

The Paul Kagan Pay TV Newsletter (No. 445, November 30, 1997) reported an increase in revenue per addressable household of 84% and 122% in the two cable systems that recently launched Spice Hot. Buy-rates increased 40% in one system (part-time Spice Hot carriage) and 66% in another (24 hour a day Spice Hot carriage) even with a $2.00 increase in retail prices.

As of April 1, 1998, we have entered into over 25 affiliation agreements for Spice Hot including agreements with a major DBS provider and 6 of the top 15 largest multiple system operators. As of April 1, 1998, Spice Hot was available in over 4.4 million addressable households. Since entering into an affiliation agreement with a major DBS provider and a top ten cable system operator, we have secured additional affiliation agreements with other cable system operators. We believe the acceptance by major cable system and DBS operators and the nationwide availability of Spice Hot from a major DBS operator has and will continue to prompt other cable systems to offer Spice Hot so they can remain on a competitive footing with their programming offerings.

The Spice Hot affiliation agreements have multi-year terms and restrict replacement of Spice Hot with another comparable adult service during their terms. Certain of the Spice Hot affiliation agreement provide Spice with early termination rights if the Proposed Transaction with Playboy is consummated.

Section 505. In part, we launched Spice Hot to make up the revenue that we lost as a result of legislation which effectively restricted the carriage hours of the Spice Networks in many cable systems. Section 505 of the Telecommunications Act of 1996 (the "1996 Act") requires full audio and video scrambling of channels such as the Spice Networks. See GOVERNMENT REGULATION,
Section 505. If a cable system operator cannot comply with the full scrambling requirement, then the channel must be blocked between 6:00 A.M. and 10:00 PM. (The hours between 10:00 P.M. and 6:00 A.M. are referred to as the "safe harbor hours.") Several of our cable affiliates do not comply with the full scrambling requirements and were forced to carry the Spice Networks only during the safe harbor hours. The reduction in carriage hours had and will continue to have a detrimental affect on revenues from affected cable systems.

We developed several means of mitigating the adverse impact of Section
505. These included new feature start times to coincide with the safe harbor hours, alternate audio feeds of music for broadcast in place of the audio track of the Spice Networks during non-safe harbor hours, proposed changes in packaging and retail prices - increasing the retail price and offering a longer block of programming - and aggressive marketing. We found that affected cable systems that adopted one or more of our revenue preserving suggestions had a much lower revenue loss from Section 505 than those systems that did not follow our suggestions. For 1997, we estimate that the aggregate revenue loss attributable to Section 505 was approximately $600,000.

Digital Cable Rollout. Cable operators have begun to introduce digital programming as a means of upgrading their cable systems and to counteract competition from the DBS operators. Spice and the Adam & Eve Channel are currently available on Telecommunications, Inc. ("TCI") All TV digital platform. Digital cable television has many advantages over analog cable television including more channels, better audio and video quality and advanced set-top boxes that are addressable, provide a secure fully scrambled signal and have integrated program guides and advanced ordering technology. (We have found that our buy-rate, on a system by system basis, tends to increase when the more advanced ordering technology is used.)

While there are advantages to digital cable television, we believe the rollout of digital cable will have a mixed impact on our business. In the short term, many TCI systems have recaptured analog channels to make room for the digital tier of programming. In some cases, TCI systems eliminated analog carriage of Spice and/or the Adam & Eve Channel. While Spice and the Adam & Eve Channel are included in the preferred grouping of digital channels that most TCI systems utilize when they rollout digital cable television, we estimate that we lost an aggregate of 600,000 addressable households in the fourth quarter of 1997 and first quarter of this year due to the slow rollout of digital set-top boxes. On the other hand, other multiple system operators have not had to recapture analog channels and the digital rollout has increased our business by adding new Spice and/or Adam & Eve Channel addressable households, all with 24 hour a day carriage.

As digital cable becomes more widely available, industry analysts predict the digital rollout will foster an increase in the number of addressable households and result in better buy-rates for adult television programming because of the use of advanced ordering technology and from the 24 hour a day carriage of adult television networks. The capital costs of the digital rollout are large and the rollout has been slower than originally forecasted. The net effect of all of these factors cannot be accurately predicted at this time.

Programming. Each of the Spice Networks features approximately 60 titles per month, approximately 10 of which are first time exhibitions. Spice and Spice Hot have virtually identical program schedules to facilitate switching between the two networks when the two are exhibited on a shared channel, using the same program guides. Spice and the Adam & Eve Channel have no crossover of programming.

Spice and the Adam & Eve Channel feature "cable version" adult films. Cable version adult films (as contrasted with the explicit or hard core versions) are specially produced and edited to conform to strict, internally developed guidelines which are generally accepted as the standard in the industry. Spice Hot features the "hot cable" version which is more erotic than the cable version.

Competition. The Company competes with all other forms of entertainment including broadcast, premium and other pay-per-view television services. In the adult category, we compete with other outlets for adult entertainment including video stores, adult bookstores, mail order companies and the Internet. We have one principal competitor in our adult pay-per-view television market niche and compete with cable systems who program their own adult movies and from video file server based video delivery systems. Based on our calculation of the number of Spice Networks addressable households and the number of addressable households served by our competition as disclosed in their public filings, we believe that our networks are the most widely distributed domestic adult pay-per-view networks in the cable market.

SPICE INTERNATIONAL

We have been pursuing global distribution of our adult networks and programming since our 1994 acquisition of The Home Video Channel Limited ("HVC"). This past year was one of mixed results. While we have gained a strong foothold in the nascent Latin American market through our agreements with Sky Latin America and others, we have lost market share in the UK DTH market for The Adult Channel primarily as a result of competition. We have restructured the management of the Spice International division and instituted a business plan to address the loss of UK DTH market share.

HVC. HVC owns and operates The Adult Channel, a satellite delivered subscription service that features cable version adult movies and related programming similar to those exhibited on the Spice network. The Adult Channel, which is broadcast four hours a day commencing at midnight, is available to approximately 2 million cable households and approximately 4 million DTH satellite households in the United Kingdom. The Adult Channel is also available to DTH satellite households throughout Continental Europe and currently has subscribers in over 40 countries.

HVC also operates a cable exclusive movie service featuring action and horror movies which began digital satellite delivery in the second quarter of 1996. The Home Video Channel is offered during the evening hours and is programmed during the pre-midnight hours to segue into The Adult Channel. The two services are offered to cable operators as a seamless 8:00 P.M. to 4:00 A.M. programming service at a package price.

In the UK, the Adult Channel has lost DTH subscribers and market share over the last 18 months. Several factors have contributed to this decline, primarily the launch of two competing services in 1995 and increased piracy. In addition The Adult Channel currently uses a transponder that has adversely affected its business in two ways. First, many potential DTH viewers cannot receive The Adult Channel without additional equipment. Second, The Adult Channel follows a foreign language service with limited distribution. This curtails any benefits derived from HVC's practice of broadcasting the first 10 minutes of the Adult Channel unencrypted to secure potential impulse buying and broaden brand awareness. HVC also began directly handling subscriber management services ("SMS") (the function of receiving and processing subscriber orders). There were problems in the transition to HVC of these services which adversely affected revenues and increased costs.

In an effort to address these issues, we restructured HVC's management and instituted certain changes to our business plan for 1998. To remedy the shortcomings with its transponder, HVC secured replacement transponder services from British Sky Broadcasting Limited ("Sky") that will begin in August 1998. The new transponder is both less expensive than The Adult Channel's current transponder and is receivable by potential DTH subscribers without additional equipment. The Adult Channel will follow SCi-Fi and The History Channel, two widely distributed networks. HVC also switched to the Sky encryption technology in October 1997 to curtail signal piracy. We have also increased The Adult Channel's programming budget for 1998 with an added emphasis on European programming. The Company has also increased HVC's advertising budget and reallocated it to the UK DTH market in an effort to regain lost market share.

HVC has expanded its distribution of The Adult Channel throughout the rest of Europe. We have authorized agents throughout Western Europe who distribute DTH subscriptions to The Adult Channel through sales of "smart cards." HVC has entered into an agency agreement with Nuevas Estructuras Televisivas who has secured affiliation agreements for The Adult Channel in over thirty Spanish cable systems. The Adult Channel is now carried on the Canal Digital AS platform which serves subscribers in Scandinavia and we are in the final stages of negotiations to secure carriage on the Canal Plus digital platform serving subscribers in the Benelux countries. HVC is in the final stages of securing a German broadcast license for The Adult Channel. If we are successful in obtaining a German Broadcast license, Deutsche Telekom has expressed interest in distributing The Adult Channel. Deutsche Telekom has more than 16 million cable homes.

HVC has entered into affiliation agreements for The Adult Channel in Eastern Europe, securing carriage in cable systems located in Russia, Lithuania, Estonia and Slovenia. However, one of our more promising programming arrangements was with Metromedia which operated cable systems in Rumania and Russia. Several of the Rumanian cable systems have ceased distribution of The Adult Channel as a result of the devaluation of the Rumanian currency.

DSTV. As described above in "RECENT DEVELOPMENTS," HVC sold a majority of its interest in DSTV to RDT.

Other International Arrangements. The Company entered into a license agreement with Pay Per View Japan Inc. ("PPVJ") to be the exclusive adult pay-per-view program provider to PPVJ's Perfect Choice TV, the first digital television program provider in Japan. We supply PPVJ with Spice-branded programming specially selected and edited for the Japanese market. Perfect Choice was launched on January 15, 1997 and while the initial results were positive, the Company's licensing fees have been dropping. We believe this is because of the availability of multiple channels of Japanese sourced-adult programming and we plan to adjust our programming to fit this market. Perfect Choice has announced its intention to merge with J Sky B, the News Corporation's Japanese affiliate. We are uncertain as to the impact of the proposed merger on our Japanese activity.

Recently, the Company entered into an affiliation agreement with Sky Latin America L.L.C. for carriage of Spice and Spice Hot on its various DTH platforms that serve Latin America. Spice and Spice Hot are currently available in Mexico and Colombia. This arrangement has been expanded to include commercial establishments.

We are also in discussions with cable and DTH operators in the Pacific Rim, Taiwan and China and other areas for carriage of the Company's networks and programming.

SPICE DIRECT

Spice Direct is responsible for the direct marketing of our products and services to consumers including the operation of Cyberspice, our Internet website. Spice Direct also arranges for the productive use of our transponder capacity and network playback services and licenses our programming to third parties.

Audiotext Services. Spice Direct manages the adult-oriented pay-per-call telephone lines (audiotext services) promoted on the Spice Networks. On the Spice Network, these services were provided by Capital Distribution, Inc., d/b/a Cupid Network Television ("Cupid") until its recent replacement by American Telnet, Inc. American Telnet and Allstate Communications Incorporated ("Allstate") provide audiotext services promoted on Spice Hot. PHE, Inc. ("PHE") and VCA Labs, Inc. ("VCA") retained the right, as part of the Company's acquisition of Adam & Eve Communications, Inc., to promote audiotext services on The Adam & Eve Channel.

The audiotext services are promoted on all the Spice Networks with advertisements that we produce or are produced exclusively for us by adult film producers. This enables us to control our networks' on-air look. Under the prior agreement with Cupid, we received a fee based on the number of Spice Network subscribers. Under the agreements with Allstate and American Telnet, we receive a percentage of revenues from the audiotext services. PHE and VCA are contractually obligated to pay us a sliding percentage of their revenues from the audiotext services promoted on the Adam & Eve Channel.

The operators of the audiotext services are responsible for the administration of the telephone lines and are contractually required to comply with all applicable rules and regulations. The telephone lines feature computerized audio programs and live operators on both 800 and 900 telephone lines. The audiotext service providers employ the operators and administrators of the telephone lines promoted on our networks. As described above in RECENT DEVELOPMENTS, Cupid provided the audiotext services promoted on the Spice Network until March 20, 1998. Cupid defaulted in the payment of service fees under the Telephone Services Agreement and the Company and Cupid have agreed to a negotiated termination of that agreement. American Telnet now provides the audiotext services promoted on the Spice network.

Merchandising. In between feature movies on Spice and the Adam & Eve Channel, we previously exhibited home shopping segments that offered adult-themed products in provocatively staged segments. We believed that we could make more productive use of the interstitial time and as part of the Settlement Agreement with Cupid the Company and Cupid agreed to terminate the home shopping segments in the third quarter of this year.

Cyberspice. In 1994, we began Cyberspice as an on-line bulletin board service which utilized our adult programming and cross-promoted the Spice Networks. Cyberspice was converted to a website on the Internet in the second quarter of 1995. E.O.L. Communications Corp. ("EOL") was responsible for maintaining and operating the Internet server where Cyberspice resides (a set of functions referred to as "hosting") until May 31, 1997. EOL included Cyberspice in a bouquet of EOL operated adult pay sites. Under the arrangement with EOL, we received a portion of all revenues generated by customers of EOL's pay sites who accessed those sites through Cyberspice.

In June 1997, we transferred hosting of Cyberspice to Media on Demand, Inc., ("MOD"). Under our agreement with MOD, we share revenues generated by Cyberspice from pay services including audiotext services and merchandise sales. In addition, MOD encodes Spice Hot and transmits a simultaneous webcast of Spice Hot (a broadcast of Spice Hot which can be viewed by a subscriber from the Internet) which is offered on a pay-per-view or monthly subscription basis. We are also developing with MOD a database accessible library of video clips from our adult film library. Cyberspice subscribers will be able to select video clips meeting user-designed criteria for download on a pay basis. Under a revenue sharing arrangement with Babenet, an affiliate of VCA, Cyberspice subscribers can access Babenet's live nude chat services. See "GOVERNMENT REGULATION, On-Line Services."

Transponder and Playback Services. We began to digitally compress our Spice Networks on September 1, 1996 which made three transponders available for productive utilization. We designed the Operations Facility with the ability to increase the number of networks for which we can provide playback services with nominal incremental capital cost.

Pursuant to agreements dated as of August 30, 1996, the Company began providing transponder services to EMI, which at that time owned and operated a single explicit television network distributed in the C-band DTH market. EMI acquired two additional networks in February 1997 and launched two more in the third quarter of 1997 and the first quarter of 1998. The Company has provided transponder services for three of EMI's networks since February 1997 and provides digital compressed transponder services for another television network. We also provide playback services for the EMI networks.

As described above in RECENT DEVELOPMENTS, we intend to contribute the Operations Facility and the EMI Option to Spinco as part of the Proposed Transaction with Playboy. If the Proposed Transaction, including the spin-off, is consummated, it is anticipated that Spinco will exercise the EMI Option and operate the EMI networks and the Operations Facility.

SPICE PRODUCTIONS

Spice Productions is responsible for licensing and producing adult movies for use on our networks and for other program licensing arrangements. With a full-time staff of five, Spice Productions screens adult movies to select the ones that meet our strict criteria for exhibition on our networks. We have an extensive library of adult movies with worldwide rights in perpetuity in over 450 titles and more limited rights in over 250 titles for a more limited period of time.

We license rights to adult films under two general categories of license agreements: agreements where we acquire most of the rights to the adult movie (referred to as "production agreements") and agreements where we acquire more limited rights (referred to as "license agreements").

Production Agreements. Under our production agreements, we generally acquire worldwide television rights (pay-per-view, subscription, premium and broadcast television rights) in perpetuity for delivery using all known and to be developed methods of delivery including via the Internet, for both the cable and explicit version of each movie. We also have the right to edit the movies and create the hot cable version featured on Spice Hot.

We have a long-term production agreement with VCA and more limited production agreements with, among others, All-Channel Films, Elegant Angel Video, Eyeland Pictures, Fred H. Schulte, Golden Orchid Productions, Lone Wolf Productions, Parco L.L.C., Sin City Entertainment, Primal Productions, Ultra Image Productions, Wellwood Entertainment, Inc. and Wicked Pictures. VCA supplies approximately one-fourth of the adult films which we license under production agreements. The Company believes that the VCA Production Agreement was automatically renewed for an additional five-year term commencing April 10, 1998. VCA has disputed the automatic renewal of the agreement but continues to supply movies under the Production Agreement. We are currently in discussion with VCA to modify the terms of the Production Agreement for the renewal term.

We have also entered into production agreements with foreign producers as part of the Company's strategy to globalize our programming and to meet local content requirements.

License Agreements. Under the terms of our license agreements, the Company will typically license the cable and explicit versions for adult films in the United States and/or Europe for between one to three years. The license agreements permit unlimited exhibitions in return for a flat license fee. Most of the movies exhibited on the Adam & Eve Channel are licensed under these arrangements. We license adult movies from the adult film producers mentioned above and others.

In-House Productions. Most adult films are produced for sale in the home video market which has a different target audience than our networks. To more directly meet the special demands of our broadcast-based television network business, we started to produce our own adult movies in 1997. Spice Production currently makes, on average, two adult movies per month. We hire adult film producers and stars to make these productions. To date we have completed 13 movies with approximately 18 more scheduled for the balance of the year. We are currently exploring the license of home video rights to our movies for distribution by third parties.

NETWORK DELIVERY

Satellite Transmission. The Company delivers its video programming to cable systems and DTH customers via digitally compressed satellite transmission. We believe that this is the most efficient delivery method currently available for distribution of the Spice Networks. Satellite delivery of video programming is accomplished as follows: The video programming (movies and interstitial programming) is played back at a facility such as our Operations Facility. The program signal is then encrypted so that the signal is unintelligible unless it is passed through the proper decoding devices. The signal may be transmitted (uplinked) to the satellite as an analog signal or digitally compressed and combined with other signals. (By digitally compressing several channels, we can spread the cost of a transponder over several networks.) The signal is transmitted from an earth station to a designated transponder on a communications satellite.

The transponder receives the analog or digitally compressed program signal uplinked by the earth station, amplifies the signal and broadcasts (downlinks) it to satellite dishes located within the satellite's area of signal coverage. The signal coverage of the domestic satellite utilized by the Company is the Continental United States, portions of Mexico, the Caribbean, and Canada. The signal coverage of the satellite utilized by the Adult Channel is Continental Europe and portions of North Africa. Each transponder can retransmit four or more complete digitally compressed color television signals or one analog color television signal.

For cable systems, the encrypted digitally compressed signal received by the cable system's satellite dish is then decoded and decompressed using, for the Company's domestic television networks, General Instrument Digicipher II decoders. The cable system then rescrambles the signal using scrambling technology compatible with the addressable set top boxes deployed in its system and then distributes the signal throughout its cable system. For DTH subscribers, their set top box contains the descrambling equipment.

To offer pay-per-view services, the set top boxes must have an electronic "address" and the cable system or satellite service provider must be able to remotely control each customer's set top box and cause it to descramble the television signal for a specified period of time after the customer has made a purchase of a premium service or a pay-per-view event. The ability to control the scrambling and descrambling of a signal from a cable system's facilities - known as addressability - is essential for the marketing and delivery of pay-per-view programming services.

In Europe, DTH subscribers purchase "smart cards" from distributors, including appliance and electronics stores. These smartcards are programmed to permit reception of a premium programming service. The smart cards are then inserted into the satellite receiver or set top box which descrambles the signal for a specified period of time.

Service Providers. We utilize transponder services for our domestic networks pursuant to a February 7, 1995 Agreement ("Transponder Agreement") with AT&T Corp. The Transponder Agreement initially provided for services on five transponders on AT&T's T4 Satellite. This was reduced to four transponders when AT&T preempted one of our transponders. At our request, the Transponder Agreement `s term was also shortened from the end of the satellite's useful life (estimated to be 12 years) to October 31, 2004 pursuant to a letter agreement dated March 31, 1997 between the Company and Loral Skynet (which acquired AT&T's satellite business). In exchange, we granted Loral a right to preempt one of our transponders after September 1, 1997. To date, Loral has not exercised its preemption right. See "MANAGEMENT DISCUSSION AND ANALYSIS."

HVC obtained part-time transponder services for The Adult Channel from Societe Europeenne des Satellites S.A. ("SES"), the owner of the Astra 1C satellite, through January 31, 1997. This arrangement was replaced with an agreement effective February 1, 1997 with Filmnet AB for part-time transponder services on Astra 1A. The agreement with Filmnet AB was replaced with an agreement with Asia TV Limited for part-time transponder services on Astra 1D through November 30, 1998.

HVC has secured part-time transponder services on Astra 1B from Sky pursuant to an agreement that will commence on August 1, 1998 and continue through December 31, 2002. The Company is attempting to release its Astra 1D transponder capacity back to Asia TV Limited after a one month period of dual illumination during August 1998. Commencing in June 1, 1996, The Home Video Channel began digital satellite distribution to cable systems on the Intelsat satellite pursuant to a five-year agreement with British Telecommunications plc dated April 24, 1996.

The Operations Facility, which became operational in February 1997, currently handles playback for three of the Company's networks and the EMI networks utilizing video file servers. This application of new technology loads and stores digitized programming in the memory of the video file servers. Under automated software control, the programming is then "streamed" from the video file servers and transmitted, over fiber optic cable, to the uplink facility. By employing this technology, the Company has been able to add additional networks quickly and efficiently.

The Company contracted with Atlantic Satellite Communications, Inc. ("Atlantic") for fiber connectivity from the Operations Facility to Atlantic's uplink facility and for uplink services pursuant to a three-year agreement dated as of February 24, 1997.

As discussed above, our domestic network signals are encrypted and digitally compressed using Digicipher encoders (manufactured by General Instruments) which is currently the industry standard scrambling technology. The Company leased a General Instruments Digicipher encoder and 1,210 decoders from Vendor Capital Group. The decoders were then provided to Spice Networks affiliates.

HVC provides playback services for The Adult Channel. British Telecommunications currently handles uplink services for The Adult Channel until Sky takes over in August 1998. HVC previously used the News Datacom Videocrypt encryption technology and its own proprietary smart card. HVC now uses a more advanced secure generation of this encryption technology and uses the Sky smart card. Over 90% of UK DTH subscribers use the Sky card. Satellite Encryption Services Ltd., a Sky affiliate, is responsible for authorizing and deauthorizing Sky cards on HVC's behalf. TV Direct Limited used to handle subscriber management services (order processing) for HVC until HVC began handling this function itself.

PRINCIPAL CUSTOMERS

For 1997, our principal customers were EMI which accounted for approximately 14% of consolidated revenues and TCI, DirecTV and Time Warner, Spice Networks customers, each of which accounted for approximately 9% of consolidated revenues. TCI and Time Warner accounted for 18% and 9%, respectively, of our consolidated revenues for 1996 and 11% and 7%, respectively, of our consolidated revenues for 1995.

GOVERNMENTAL REGULATIONS

Congress enacted the 1996 Act, a comprehensive overhaul of the Federal Communications Act of 1934. The 1996 Act contains several provisions which may impact the Company. (All Section references which follow refer to the Act.)

Section 505. Section 505 requires full audio and video scrambling of channels which are primarily dedicated to sexually explicit programming. If a multi-channel video programming distributor (which includes a cable system operator) cannot comply with the full scrambling requirement, then the channel must be blocked between 6:00 AM and 10:00 PM. (referred to as "time channeling"). The Spice Networks feature "sexually explicit" programming within the contemplation of Section 505. While the Company fully scrambles its signal, several of the Company's cable affiliates lack the technical capability to fully scramble the audio and, to a lesser extent, the video portion of the signal.

The Company filed an action in Delaware District Court challenging the constitutionality of Section 505. After initially granting the Company's application for a temporary restraining order enjoining enforcement of Section 505, the District Court denied the Company's application for a preliminary injunction. On March 24, 1997, the Supreme Court affirmed the District Court's decision and Section 505 took effect on or about May 1, 1997.

When Section 505 took effect, the Company's revenues were adversely affected with several cable systems moving to time channeling. The Company developed several means of mitigating the adverse impact of Section 505. These included new feature start times to coincide with the safe harbor hours, alternate audio feeds of music for broadcast in place of the audio track of the Spice Networks during non-safe harbor hours, proposed changes in packaging and retail prices - increasing the retail price and offering a longer block of programming - and aggressive marketing.

While we continue to believe that Section 505 is unconstitutional because there are other less restrictive means of blocking access by minors and others to unwanted partially scrambled television programming (both ours and other types of programming that some may find offensive), we believe we can successfully operate our business within the legal framework established by
Section 505.

Closed Captioning. Section 713 of the 1996 Act also directed the Federal Communications Commission ("FCC") to adopt rules requiring that video programming be accessible via closed captioning unless exempted. The FCC issued a Report and Order on August 22, 1997 which provided rules on closed captioning. Under the rules, responsibility for closed captioning falls on the video programming distributors (broadcasters, cable and DBS operators) unless they do not have editorial control over the programming. In that case, responsibility falls on the programmer. The rules also provide transitional rules for phased-in implementation of closed captioning which require that 95% of new programming - programming created after the January 1, 1998 effective date of the rules must be closed captioned after a staged 8 or 10 year transition period. The rules require that 75% of library programming - programming published or completed prior to the January 1, 1998 effective date - must be closed captioned after a 10-year transition period.

The rules contain exemptions from the closed captioning requirement based on economic burden. These include exemptions for new networks, late night programming, local origination and public education programming, interstitial programming, advertising and a revenue-based exemption. An exemption may also be granted upon a showing of "undue burden." The FCC plans to establish a petitioning process for exemptions based on undue burden. Applications for exemptions for undue burden may be based on:

1. the nature and cost of the closed captioning;
2. the impact on the program provider;
3. the financial resources of the program provider; or
4. the type of operations of the program provider.

We are currently evaluating the impact of the closed captioning rules on our business and whether to file an exemption application claiming undue burden. If the Spice Networks are required to include closed captioning, the Company will be adversely affected as a result of the additional costs incurred to comply with the rules. It is not possible, at this time to quantify the cost of closed captioning the movies exhibited on the Spice Networks. Moreover, if we elect to file an exemption application, it is uncertain whether such an application would be granted.

On-Line Services. The 1996 Act also contained provisions aimed at curbing indecent material on the Internet. The Supreme Court declared this provision unconstitutional. The Company plans to carefully monitor future developments in laws regulating adult content on the Internet, and will adjust its practices and procedure accordingly. While the provision of the 1996 Act regulating the Internet is not in effect, the Company has conformed its practices with a safe harbor provision contained in the 1996 Act. Under this provision, content providers will have no liability if certain adult material is made available only to persons with a credit card, which the Act presumes can be obtained only by person over 18 years of age. The webcast of Spice Hot and other more explicit material and services on Cyberspice are available only to persons who both certify that they are over the age of 18 and who have a credit card.

Other Provisions of the 1996 Act. The 1996 Act will also affect our businesses in other ways. The principal purpose of the 1996 Act was to promote deployment of advanced telecommunications and information technologies in the marketplace by deregulating pricing in the cable television industry and increasing competition in the telecommunications industry by permitting the entry of the cable and telephone companies into each other's markets. The effect of increased competition on the Company's networks is unclear at this point in time.

CURRENCY RATES AND REGULATIONS

Our foreign operations are subject to the risk of fluctuation in currency exchange rates and to exchange controls. The Company cannot predict the extent to which such controls and fluctuations in currency rates may affect its operations in the future or its ability to remit dollars abroad. See Note 3 to the Consolidated Financial Statements "Summary of Significant Accounting Policies - Foreign Currency Translation."

EMPLOYEES

At March 31, 1997, the Company had a total of 104 employees.

Item 2.  Properties.

We lease the following locations:

Headquarters:

         536 Broadway
         New York, NY  10012                             24,750 square feet(1)

Other Offices:

         2716 Ocean Park Blvd., Suite 1007
         Santa Monica, CA  90405                          2,625 square feet

         1755 Park Street, Suite 200
         Naperville, IL  60563                              330 square feet(2)

         1300 West Belmont Avenue, Suite 201
         Chicago, IL  60657                                 150 square feet(2)

         120 International Parkway
         Heathrow, FL  60563                                330 square feet(2)

         Home Video Channel Limited
         Aquis House, Station Rd.
         Hayes, Middlesex UB3 4DX
         United Kingdom                                   5,020 square feet

We believe our leased locations are suitable and adequate for the conduct of our business.


1) We also use a portion of the roof at the headquarters for equipment relating to the Operations Facility.

2) We lease offices in professional suites. In addition to the square footage indicated, we have use of common areas in the professional suites.

BROKERAGE PARTNERS