UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington, D.C. 20549




Form
10-Q


(Mark
One)




x
            QUARTERLY
      REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934


For
the quarterly period ended March 31, 2009





OR




o
            TRANSITION
      REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934


For
the transition period from __________ to __________





Commission file number
000-25659




KIT DIGITAL,
INC.


(Exact
Name of Registrant as Specified in Its Charter)




Delaware
                  11-3447894(State
      or Other Jurisdiction of
                  (I.R.S.
      EmployerIncorporation
      or Organization)
                  Identification
      No.)168 Fifth Avenue, Suite 301, New York, New
      York
                  10010(Address
      of Principal Executive Offices)
                  (Zip
      Code)





(646)
502-7484


(Registrant’s
Telephone Number, Including Area Code)




Check
whether the issuer (1) filed all reports required to be filed by Section 13 or
15(d) of the Exchange Act during the past 12 months (or for such shorter period
that the registrant was required to file such reports), and (2) has been subject
to such filing requirements for the past 90 days. Yes x   No o





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such
files).    Yes  o   No o(not
required)




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
definition of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check
one):




Large
Accelerated Filer o                                                                       
Accelerated Filer  o




Non-accelerated
Filer o                                                                           Smaller
Reporting Company  x





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).


Yes o   No x





As of May
15, 2009, there were 4,805,489 shares of the registrant’s common stock
outstanding.










KIT
digital, Inc.




TABLE OF CONTENTS





PagePART
      I - FINANCIAL INFORMATIONItem
      1.
                  Financial
      StatementsConsolidated
      Balance Sheets - As of March 31, 2009 (unaudited) and December 31,
      2008
                  2Consolidated
      Statements of Operations and Comprehensive Income (Loss) - For the three
      months ended March 31, 2009 and 2008 (unaudited)
                  3Consolidated
      Statements of Cash Flows - For the three months ended March 31, 2009 and
      2008 (unaudited)
                  4Notes
      to Consolidated Financial Statements (unaudited)
                  6Item
      2.
                  Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
                  17Item
      3.
                  Quantitative
      and Qualitative Disclosures About Market Risk
                  22Item
      4T.
                  Controls
      and Procedures
                  23PART
      II - OTHER INFORMATIONItem
      1.
                  Legal
      Proceedings
                  24Item
      1A.
                  Risk
      Factors
                  24Item
      2.
                  Unregistered
      Sales of Equity Securities and Use of Proceeds
                  24Item
      3.
                  Defaults
      Upon Senior Securities
                  24Item
      4.
                  Submission
      of Matters to a Vote of Security Holders
                  24Item
      5.
                  Other
      Information
                  24Item
      6.
                  Exhibits
                  24SIGNATURES
                  25









PART
I - FINANCIAL INFORMATION




Item
1.  Financial
Statements




KIT
DIGITAL, INC. AND SUBSIDIARIES


CONSOLIDATED
BALANCE SHEETS


(Amounts
in Thousands, Except Share Data)


March
      31, 2009
                                            
                                            
                                            December
      31, 2008 (A)(Unaudited)Assets:Current
      assets:Cash
      and cash equivalents
                                            
                                            $
                                            2,525
                                            
                                            
                                            $
                                            5,878Investments
                                            
                                            
                                            200
                                            
                                            
                                            
                                            -Accounts
      receivable, net
                                            
                                            
                                            9,073
                                            
                                            
                                            
                                            8,331Inventory,
      net
                                            
                                            
                                            1,088
                                            
                                            
                                            
                                            2,130Other
      current assets
                                            
                                            
                                            2,943
                                            
                                            
                                            
                                            1,539Total
      current assets
                                            
                                            
                                            15,829
                                            
                                            
                                            
                                            17,878Property
      and equipment, net
                                            
                                            
                                            4,128
                                            
                                            
                                            
                                            2,928Deferred
      tax assets
                                            
                                            
                                            64
                                            
                                            
                                            
                                            64Software,
      net
                                            
                                            
                                            2,087
                                            
                                            
                                            
                                            2,265Customer
      list, net
                                            
                                            
                                            2,765
                                            
                                            
                                            
                                            2,988Domain
      names, net
                                            
                                            
                                            16
                                            
                                            
                                            
                                            19Goodwill
                                            
                                            
                                            16,150
                                            
                                            
                                            
                                            15,167Total
      assets
                                            
                                            $
                                            41,039
                                            
                                            
                                            $
                                            41,309Liabilities
      and Stockholders' Equity:Current
      liabilities:Bank
      overdraft
                                            
                                            $
                                            1,454
                                            
                                            
                                            $
                                            1,456Capital
      lease and other obligations
                                            
                                            
                                            356
                                            
                                            
                                            
                                            395Secured
      notes payable
                                            
                                            
                                            934
                                            
                                            
                                            
                                            966Senior
      secured notes payable, net of debt discount of $412 and
    $550
                                            
                                            
                                            1,088
                                            
                                            
                                            
                                            950Accounts
      payable
                                            
                                            
                                            6,649
                                            
                                            
                                            
                                            5,775Accrued
      expenses
                                            
                                            
                                            3,447
                                            
                                            
                                            
                                            2,240Income
      tax payable
                                            
                                            
                                            152
                                            
                                            
                                            
                                            160Acquisition
      liability – Kamera
                                            
                                            
                                            1,500
                                            
                                            
                                            
                                            3,000Acquisition
      liability – Visual
                                            
                                            
                                            1,075
                                            
                                            
                                            
                                            2,218Derivative
      liability
                                            
                                            
                                            3,720
                                            
                                            
                                            
                                            -Other
      current liabilities
                                            
                                            
                                            2,233
                                            
                                            
                                            
                                            3,818Total
      current liabilities
                                            
                                            
                                            22,608
                                            
                                            
                                            
                                            20,978Capital
      lease and other obligations, net of current
                                            
                                            
                                            862
                                            
                                            
                                            
                                            949Secured
      notes payable, net of current
                                            
                                            
                                            202
                                            
                                            
                                            
                                            236Acquisition
      liability - Visual, net of current
                                            
                                            
                                            538
                                            
                                            
                                            
                                            1,075Total
      liabilities
                                            
                                            
                                            24,210
                                            
                                            
                                            
                                            23,238Equity:Stockholders’
      equity:Common
      stock, $0.0001 par value: authorized 30,000,000 shares; issued and
      outstanding 4,745,756 and 4,183,280, respectively
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -Additional
      paid-in capital
                                            
                                            
                                            105,118
                                            
                                            
                                            
                                            101,057Accumulated
      deficit
                                            
                                            
                                            (84,281
                                            )
                                            
                                            
                                            (82,499
                                            )Accumulated
      other comprehensive loss
                                            
                                            
                                            (288
                                            )
                                            
                                            
                                            (250
                                            )Total
      stockholders' equity
                                            
                                            
                                            20,549
                                            
                                            
                                            
                                            18,308Non-controlling
      interest
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (237
                                            )Total
      equity
                                            
                                            
                                            20,549
                                            
                                            
                                            
                                            18,308Total
      liabilities and equity
                                            
                                            $
                                            41,039
                                            
                                            
                                            $
                                            41,309





(A) -
Reference is made to the Company’s Annual Report on Form 10-K for the year ended
December 31, 2008, filed with the U.S. Securities and Exchange Commission on
April 15, 2009.




The
Accompanying Notes are an Integral Part of these Consolidated Financial
Statements.





2





KIT
DIGITAL, INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)


(Amounts
in Thousands, Except Share and Per Share Data)


(Unaudited)


Three
      months endedMarch 31,2009
                                                    
                                                    
                                                    2008Revenue
                                                    
                                                    $
                                                    9,624
                                                    
                                                    
                                                    $
                                                    3,502Variable
      and direct third party costs:Cost
      of goods and services
                                                    
                                                    
                                                    3,478
                                                    
                                                    
                                                    
                                                    -Hosting,
      delivery and reporting
                                                    
                                                    
                                                    282
                                                    
                                                    
                                                    
                                                    515Content
      costs
                                                    
                                                    
                                                    461
                                                    
                                                    
                                                    
                                                    184Direct
      third party creative production costs
                                                    
                                                    
                                                    805
                                                    
                                                    
                                                    
                                                    753Total
      variable and direct third party costs
                                                    
                                                    
                                                    5,026
                                                    
                                                    
                                                    
                                                    1,452Gross
      profit
                                                    
                                                    
                                                    4,598
                                                    
                                                    
                                                    
                                                    2,050General
      and administrative expenses:Compensation,
      travel and associated costs (including non-cash stock-based compensation
      of $280 and $4,001, respectively)
                                                    
                                                    
                                                    3,693
                                                    
                                                    
                                                    
                                                    8,324Legal,
      accounting, audit and other professional service fees
                                                    
                                                    
                                                    270
                                                    
                                                    
                                                    
                                                    345Office,
      marketing and other corporate costs
                                                    
                                                    
                                                    717
                                                    
                                                    
                                                    
                                                    838Merger
      and acquisition and investor relations expenses
                                                    
                                                    
                                                    378
                                                    
                                                    
                                                    
                                                    -Depreciation
      and amortization
                                                    
                                                    
                                                    683
                                                    
                                                    
                                                    
                                                    245Restructuring
      charges
                                                    
                                                    
                                                    119
                                                    
                                                    
                                                    
                                                    2,745Other
      non-recurring charges
                                                    
                                                    
                                                    244
                                                    
                                                    
                                                    
                                                    135Impairment
      of property and equipment
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    229Total
      general and administrative expenses
                                                    
                                                    
                                                    6,104
                                                    
                                                    
                                                    
                                                    12,861Income
      (Loss) from operations
                                                    
                                                    
                                                    (1,506
                                                    )
                                                    
                                                    
                                                    (10,811
                                                    )Interest
      income
                                                    
                                                    
                                                    1
                                                    
                                                    
                                                    
                                                    61Interest
      expense
                                                    
                                                    
                                                    (139
                                                    )
                                                    
                                                    
                                                    (14
                                                    )Amortization
      of deferred financing costs and debt discount
                                                    
                                                    
                                                    (164
                                                    )
                                                    
                                                    
                                                    -Derivative
      income
                                                    
                                                    
                                                    1,950
                                                    
                                                    
                                                    
                                                    -Other
      income
                                                    
                                                    
                                                    29
                                                    
                                                    
                                                    
                                                    22Net
      income (loss) before income taxes
                                                    
                                                    
                                                    171
                                                    
                                                    
                                                    
                                                    (10,742
                                                    )Income
      tax expense
                                                    
                                                    
                                                    (3
                                                    )
                                                    
                                                    
                                                    (1
                                                    )Net
      income (loss)
                                                    
                                                    
                                                    168
                                                    
                                                    
                                                    
                                                    (10,743
                                                    )Plus:
      Net loss attributable to the non-controlling interest
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    96Net
      income (loss) available to common shareholders
                                                    
                                                    $
                                                    168
                                                    
                                                    
                                                    $
                                                    (10,647
                                                    )Basic
      net income (loss) per common share
                                                    
                                                    $
                                                    0.04
                                                    
                                                    
                                                    $
                                                    (9.57
                                                    )Diluted net
      income (loss) per common share
                                                    
                                                    $
                                                    0.02
                                                    
                                                    
                                                    $
                                                    (9.57
                                                    )Basic
      weighted average common shares outstanding
                                                    
                                                    
                                                    4,289,630
                                                    
                                                    
                                                    
                                                    1,112,459Diluted weighted
      average common shares outstanding
                                                    
                                                    
                                                    7,900,591
                                                    
                                                    
                                                    
                                                    1,112,459Comprehensive
      income (loss):Net
      loss
                                                    
                                                    $
                                                    168
                                                    
                                                    
                                                    $
                                                    (10,647
                                                    )Foreign
      currency translation gain (loss)
                                                    
                                                    
                                                    (37
                                                    )
                                                    
                                                    
                                                    64Comprehensive
      income (loss)
                                                    
                                                    $
                                                    131
                                                    
                                                    
                                                    $
                                                    (10,583
                                                    )





The
Accompanying Notes are an Integral Part of these Consolidated Financial
Statements.





3





KIT
DIGITAL, INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(Amounts
in Thousands)


(Unaudited)




Three
      months endedMarch 31,2009
                                  
                                  
                                  2008Operating
      Activities:Net
      income (loss)
                                  
                                  $
                                  168
                                  
                                  
                                  $
                                  (10,647
                                  )Adjustments
      to reconcile net loss to net cash used by operating
      activities:Provision
      for doubtful accounts
                                  
                                  
                                  57
                                  
                                  
                                  
                                  94Depreciation
                                  
                                  
                                  279
                                  
                                  
                                  
                                  108Amortization
      of intangible assets
                                  
                                  
                                  404
                                  
                                  
                                  
                                  137Amortization
      of deferred financing costs
                                  
                                  
                                  26
                                  
                                  
                                  
                                  -Amortization
      of debt discount
                                  
                                  
                                  138
                                  
                                  
                                  
                                  -Derivative
      income
                                  
                                  
                                  (1,950
                                  )
                                  
                                  
                                  -Loss
      on impairment of property and equipment
                                  
                                  
                                  -
                                  
                                  
                                  
                                  229Loss
      on impairment of goodwill
                                  
                                  
                                  -
                                  
                                  
                                  
                                  1,038Non-cash
      stock based compensation
                                  
                                  
                                  407
                                  
                                  
                                  
                                  4,001Non-controlling
      interest
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (96
                                  )Changes
      in assets and liabilities:Accounts
      receivable
                                  
                                  
                                  (799
                                  )
                                  
                                  
                                  (774
                                  )Inventories
                                  
                                  
                                  1,042Other
      assets
                                  
                                  
                                  (1,430
                                  )
                                  
                                  
                                  55Accounts
      payable
                                  
                                  
                                  874
                                  
                                  
                                  
                                  (534
                                  )Accrued
      expenses
                                  
                                  
                                  1,207
                                  
                                  
                                  
                                  1,464Income
      tax payable
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (12
                                  )Other
      liabilities
                                  
                                  
                                  (1,585
                                  )
                                  
                                  
                                  119Total
      adjustments
                                  
                                  
                                  (1,330
                                  )
                                  
                                  
                                  5,829Net
      cash used by operating activities - forward
                                  
                                  
                                  (1,162
                                  )
                                  
                                  
                                  (4,818
                                  )Investing
      Activities:Release
      of restricted cash
                                  
                                  
                                  -
                                  
                                  
                                  
                                  100Cash
      paid into investments
                                  
                                  
                                  (200
                                  )
                                  
                                  
                                  -Cash
      paid in acquisition of Visual
                                  
                                  
                                  (180
                                  )
                                  
                                  
                                  -Proceeds
      from sale of equipment
                                  
                                  
                                  -
                                  
                                  
                                  
                                  33Purchase
      of equipment
                                  
                                  
                                  (1,512
                                  )
                                  
                                  
                                  (26
                                  )Net
      cash (used) provided by investing activities - forward
                                  
                                  $
                                  (1,892
                                  )
                                  
                                  $
                                  107




4




KIT
DIGITAL, INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF CASH FLOWS (continued)


(Amounts
in Thousands)


(Unaudited)




Three
      months endedMarch 31,2009
                                            
                                            
                                            2008Net
      cash used by operating activities - forwarded
                                            
                                            $
                                            (1,162
                                            )
                                            
                                            $
                                            (4,818
                                            )Net
      cash (used) provided by investing activities - forward
                                            
                                            
                                            (1,892
                                            )
                                            
                                            
                                            107Financing
      Activities:Proceeds
      from exercise of stock options
                                            
                                            
                                            25
                                            
                                            
                                            
                                            -Bank
      overdraft
                                            
                                            
                                            (2
                                            )
                                            
                                            
                                            89Payment
      of Secured notes
                                            
                                            
                                            (67
                                            )Payment
      on capital leases
                                            
                                            
                                            (126
                                            )
                                            
                                            
                                            (28
                                            )Net
      cash (used) provided by financing activities
                                            
                                            
                                            (170
                                            )
                                            
                                            
                                            61Effect
      of exchange rate changes on cash
                                            
                                            
                                            (129
                                            )
                                            
                                            
                                            41Net
      decrease in cash and cash equivalents
                                            
                                            
                                            (3,353
                                            )
                                            
                                            
                                            (4,609
                                            )Cash
      and cash equivalents - beginning of period
                                            
                                            
                                            5,878
                                            
                                            
                                            
                                            10,189Cash
      and cash equivalents - end of period
                                            
                                            $
                                            2,525
                                            
                                            
                                            $
                                            5,580Supplemental
      disclosures of cash flow information:Cash
      paid during the period for:Income
      taxes
                                            
                                            $
                                            -
                                            
                                            
                                            $
                                            -Interest
                                            
                                            $
                                            139
                                            
                                            
                                            $
                                            13





The
Accompanying Notes are an Integral Part of these Consolidated Financial
Statements.





5





KIT
DIGITAL, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Amounts
in Thousands, Except Share and Per Share Data)


(Unaudited)




(1)
Basis of Presentation




KIT
digital, Inc. ("we," "us," "our," the "Company" or "KIT digital"), through our
operating subsidiaries, provides enterprise clients an end-to-end technology
platform for managing Internet Protocol (“IP”)-based video assets across the
browser, mobile device and IPTV set-top box-enabled television set.. We offer
creative interface design, branding, strategic planning and technical
integration services to complement our “VX”-branded software platform. Our
business is divided into two segments: Digital Media Solutions and Professional
Services (formerly “Agency Services”). Digital Media Solutions includes the
delivery of IP video software solutions, including software-as-a-service
(“SaaS”) fees, enterprise license fees, software usage fees, set-up/support
services, storage, hardware components, content delivery, content syndication,
and advertising-based monetization. Professional Services include technical
integration services, interface design, branding, strategic planning, creative
production, online marketing, media planning and analytics.





On March
6, 2009, we filed a certificate of amendment of our certificate of incorporation
to (i) effect a 1-for-35 reverse stock split of our common stock; (ii) decrease
the total number of shares of common stock authorized to be issued from
500,000,000 shares to 30,000,000 shares; and (iii) eliminate the authorization
of a class of preferred stock.  The changes made by the certificate of
amendment were effective on March 9, 2009, and per share amounts in the
accompanying financial statements have been adjusted for the reverse stock
split.  As a result of the reverse stock split, we had 4,805,489
outstanding shares of common stock as of May 15, 2009.  Effective
March 9, 2009, our ticker symbol on the OTC Bulletin Board was changed to “KDGL”
from “KITD.”





The
accompanying unaudited consolidated financial statements of KIT digital, Inc.
and subsidiaries have been prepared in accordance with generally accepted
accounting principles for interim financial information and the instructions to
Form 10-Q and Article 8 of Regulation S-X. Accordingly, they do not include all
information and footnotes required by general accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) considered necessary in order to make the interim
financial statements not misleading have been included. The consolidated results
of operations for the three months ended March 31, 2009 are not necessarily
indicative of the results that may be expected for the year ending December 31,
2009. These interim consolidated financial statements should be read in
conjunction with the consolidated financial statements and footnotes thereto of
the Company and management’s discussion and analysis of financial condition and
results of operations included in the our annual report on Form 10-K for the
year ended December 31, 2008.





(2)
Summary of Significant Accounting Policies





Principles of
Consolidation - Our consolidated financial statements include the
accounts of KIT digital, Inc., and all its wholly-owned subsidiaries. Included
in the consolidation with wholly-owned subsidiary Kamera Content AB (“Kamera”)
are Kamera’s 95%-owned subsidiary Kamera (S) PTE Ltd and its 55%-owned
subsidiary Swegypt Company for Telecommunications (S.A.E).





Management
Estimates - The preparation of financial statements in conformity with
U.S. generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities, disclosure of contingent assets and liabilities at the date of the
financial statements, and the reported amounts of revenues and expenses during
the reporting period. Certain amounts included in the financial statements are
estimated based on currently available information and management's judgment as
to the outcome of future conditions and circumstances. Changes in the status of
certain facts or circumstances could result in material changes to the estimates
used in the preparation of financial statements and actual results could differ
from the estimates and assumptions.




6




KIT
DIGITAL, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Amounts
in Thousands, Except Share and Per Share Data)


(Unaudited)




Foreign Currency
Translation - Assets and liabilities of KIT digital’s foreign
subsidiaries are translated at current exchange rates and related revenues and
expenses are translated at average exchange rates in effect during the periods.
Resulting translation adjustments are recorded as a component of accumulated
other comprehensive income (loss) in stockholders' equity.





Fair Value of
Financial Instruments - On the first day of fiscal 2008, we adopted
Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value
Measurements.” SFAS 157 defines fair value, establishes a framework for
measuring fair value in GAAP and expands disclosure about fair value
measurements. SFAS 157 defines fair value as the amount that would be received
upon sale of an asset or paid to transfer a liability in the principal or most
advantageous market for the asset or liability in an orderly transaction between
market participants on the measurement date. SFAS 157 also establishes a fair
value hierarchy which prioritizes the types of inputs to valuation techniques
that companies may use to measure fair value. The fair value hierarchy gives the
highest priority to quoted prices in active markets for identical assets or
liabilities (Level 1). The next highest priority is given to inputs other than
quoted prices included in Level 1 that are observable for the asset or
liability, either directly or indirectly (Level 2). The lowest priority is given
to unobservable inputs in which there is little or no market data available and
which require the reporting entity to develop its own assumptions (Level 3). No
Level 2 or Level 3 inputs were used to record assets or liabilities at fair
value.






Fair
      Value Measurements at Reporting Date UsingQuoted
      Prices inActive
      Markets for
                                      
                                      Significant
      Other
                                      
                                      Significant
      OtherIdentical
      Assets
                                      
                                      Observable
      Inputs
                                      
                                      Unobservable
      InputsDescription
                                      
                                      March
      31, 2009
                                      
                                      (Level
      1)
                                      
                                      (Level
      2)
                                      
                                      (Level
      2)Investments
                                      
                                      $
                                      200
                                      
                                      $
                                      200
                                      
                                      -
                                      
                                      -


Risk
Concentrations - Financial instruments which potentially subject us to
concentrations of credit risk consist principally of cash and cash equivalents
and trade accounts receivable. From time to time, we obtain collateral for our
cash and cash equivalent accounts where we deem prudent and is feasible. We
believe no significant concentration of credit risk exists with respect to these
investments. The amount of cash beyond insured amounts as of March 31, 2009 was
$2,506.




Concentrations
of credit risk with respect to trade accounts receivable are limited due to the
nature of our customers who are dispersed across many industries and geographic
regions. The allowance for doubtful accounts as of March 31, 2009 was $514. As
of March 31, 2008, no customers made up more than 10% of our trade accounts
receivable. As of March 31, 2009, two customers accounted for approximately
29.1% of our trade accounts receivable. We routinely assess the financial
strength of customers and, based upon factors concerning credit risk, we
establish an allowance for doubtful accounts. Management believes that accounts
receivable credit risk exposure beyond such allowance is limited, and client
payments have been made subsequent to March 31, 2009 which have had the effect
of lowering the concentration of trade accounts receivable.





Impairment of
Long-Lived Assets - We review our long-lived assets and identifiable
intangibles for impairment at least annually and whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. When such factors and circumstances exist, we compare the projected
undiscounted future cash flows associated with the future use and disposal of
the related asset or group of assets to their respective carrying amounts.
Impairment, if any, is measured as the excess of the carrying amount over the
fair value based on market value (when available) or discounted expected cash
flows of those assets, and is recorded in the period in which the determination
is made.





Cash and Cash
Equivalents - We consider all highly liquid investments with original
maturities of ninety days or less when purchased to be cash and cash
equivalents. As of March 31, 2009, we had $2,001 of cash equivalents in an
account that pays interest at LIBOR, plus 150 basis points. This account is
guaranteed and backed by liquid collateral instruments, and can be redeemed with
14 days written notice.




7




KIT
DIGITAL, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Amounts
in Thousands, Except Share and Per Share Data)


(Unaudited)




Investments
– Investments include an investment in a limited partnership fund which
invests, on a hedged basis, primarily in the U.S. equity markets. This
investment was made in March 2008 and is recorded at a fair value of
$200.





Property and
Equipment - Property and equipment are stated at cost less accumulated
depreciation. Depreciation is provided for using the straight-line and declining
balance methods of accounting over the estimated useful lives of the assets
which range from one year to twenty years.





Routine
maintenance and repair costs are charged to expense as incurred and renewals and
improvements that extend the useful life of the assets are capitalized. Upon
sale or retirement, the cost and related accumulated depreciation are eliminated
from the respective accounts and any resulting gain or loss is reported in the
statement of operations.





Income Taxes
- Pursuant to SFAS No. 109, "Accounting for Income Taxes," income tax
expense (or benefit) for the year is the sum of deferred tax expense (or
benefit) and income taxes currently payable (or refundable). Deferred tax
expense (or benefit) is the change during the year in a company's deferred tax
liabilities and assets. Deferred tax liabilities and assets are determined based
on differences between financial reporting and tax bases of assets and
liabilities, and are measured using the enacted tax rates and laws that will be
in effect when the differences are expected to reverse.





Intangible Assets
- Amortizable intangible assets of the Company are recorded at cost less
accumulated amortization. Amortization is computed using the straight-line
method over the estimated useful lives of the assets, with periods of up to five
years. Goodwill is reviewed for impairment at least annually and all other
intangible assets are reviewed for impairment if events or circumstances
indicate that carrying amounts may not be recoverable (See Note 6).





Inventory- Inventories are valued at the lower of cost (first-in, first-out
method) or market and are comprised of finished goods. On a quarterly basis, we
review inventory quantities on hand and analyze the provision for excess and
obsolete inventory based primarily on product age in inventory and our estimated
sales forecast, which is based on sales history and anticipated future demand.
Our estimates of future product demand may not be accurate and we may understate
or overstate the provision required for excess and obsolete inventory.
Accordingly, any significant unanticipated changes in demand could have a
significant impact on the value of our inventory and results of
operations.  As of March 31, 2009 and December 31, 2008, our reserves
for excess and obsolete inventory were $120 and $157, respectively.




Derivative
Financial Instruments - Upon the adoption of EITF 07-05 “Determining
Whether an Instrument (or Embedded Feature) Is Indexed to an Entity's Own Stock”
on January 1, 2009, certain of our financial instruments with “down-round”
protection features are no longer considered indexed to our Company’s stock for
purposes of determining whether they meet the first part of the scope exception
in paragraph 11(a) of Statement 133. As such, these instruments no longer meet
the conditions to obtain equity classification and are required to be carried as
derivative liabilities, at fair value with changes in fair value reflected in
our income (loss).  The fair value of the investor warrants issued in
the May 2008 private placement was $5,670 and $3,720 on January 1, 2009 and
March 31, 2009, respectively.




8




KIT
DIGITAL, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Amounts
in Thousands, Except Share and Per Share Data)


(Unaudited)




Research and
Development - Costs incurred in research and development are expensed as
incurred. Software development costs are required to be capitalized when a
product’s technological feasibility has been established through the date the
product is available for general release to customers. We doe not capitalize any
software development costs, as technological feasibility is generally not
established until a working model is completed, at which time substantially all
development is complete.





Revenue
Recognition - We recognize revenue in accordance with the following
authoritative literature: AICPA Statement of Position ("SOP") No. 97-2,
"Software Revenue Recognition" and Securities and Exchange Commission ("SEC")
Staff Accounting Bulletin ("SAB") No. 104, "Revenue Recognition in Financial
Statements", which requires that four basic criteria be met before revenue can
be recognized: (i) persuasive evidence that an arrangement exists; (ii) the
price is fixed or determinable; (iii) collectability is reasonably assured; and
(iv) product delivery has occurred or services have been rendered. We recognize
revenue, net of sales taxes assessed by any governmental
authority.  Revenues are derived principally from the delivery of
digital media solutions and professional services. Our revenues include fees
charged for software-as-a-service (“SaaS”), enterprise licenses, software usage,
storage, software set-up/support services, hardware components, content
delivery, content syndication fees, advertising-based monetization and
professional services.  Revenue is recognized when the product and/or
service has been provided to the customer. We may enter into agreements whereby
we guarantee a minimum service level, or a minimum number of impressions,
click-throughs or other criteria on our software platform’s points of
distribution for a specified period. To the extent these guarantees are not met,
we may defer recognition of the corresponding revenue until guaranteed delivery
levels are achieved.





Stock-Based
Compensation - On January 1, 2006, the Company adopted SFAS No. 123R,
“Share-Based Payment.” Among other items, SFAS 123R requires companies to record
compensation expense for share-based awards issued to employees and directors in
exchange for services provided. The amount of the compensation expense is based
on the estimated fair value of the awards on their grant dates and is recognized
over the required service periods. Our share-based awards include stock options,
warrants and restricted stock awards.





We
adopted SFAS 123R using the modified prospective transition method, which
requires the application of the accounting standard to all share-based awards
issued on or after January 1, 2006 and any outstanding share-based awards that
were issued but not vested as of January 1, 2006. For the three months ended
March 31, 2009 and 2008, we recognized $280 and $4,001, respectively, of
stock-based compensation expense in the consolidated statements of
operations.





The
estimated fair value underlying our calculation of compensation expense for
stock options is based on the Black-Scholes-Merton pricing model. SFAS 123R
requires forfeitures of share-based awards to be estimated at the time of grant
and revised, if necessary, in subsequent periods if estimates change based on
the actual amount of forfeitures experienced.





On March
17, 2008, the Board of Directors adopted an incentive compensation plan (the
“2008 Incentive Stock Plan”). The 2008 Incentive Stock Plan currently has
reserved 857,143 shares of common stock for issuance. Under the 2008 Incentive
Stock Plan, options may be granted which are intended to qualify as Incentive
Stock Options under Section 422 of the Internal Revenue Code of 1986 or which
are not intended to qualify as Incentive Stock Options thereunder. In addition,
direct grants of stock or restricted stock may be awarded.





Under the
2004 Stock Option Plan, we did not grant options to purchase shares of our
common stock during the three months ended March 31, 2009. During the three
months ended March 31, 2009, a total of 4,583 stock options vested, no stock
options were cancelled or expired, no stock options were forfeited, and 40,694
stock options were unvested as of March 31, 2009. A total of 81,429 stock
options were outstanding under this plan on March 31, 2009.





Under the
2008 Incentive Stock Plan, we granted options with exercise prices of $7.00 to
purchase 93,374 shares of its common stock during the three months ended March
31, 2009. During the three months ended March 31, 2009, a total of 79,211 stock
options vested, 8,820 stock options were exercised, and 22,750 stock options
were cancelled, expired or forfeited with 321,298 stock options unvested as of
March 31, 2009. A total of 481,988 stock options were outstanding under this
plan on March 31, 2009.




9




KIT
DIGITAL, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Amounts
in Thousands, Except Share and Per Share Data)


(Unaudited)




Also
included in non-cash compensation are warrants to purchase 34,286 shares of
common stock with an exercise price of $4.655 issued to Robin Smyth, our former
Chief Financial Officer on March 30, 2008, that vest over 36 months from the
issue date. During the year ended March 31, 2009, a total of 2,858 warrants
vested with 22,857 warrants unvested as of March 31, 2009.





Net Income (Loss)
Per Share - We compute net income (loss) per common share under
the provisions of SFAS No. 128, "Earnings per Share," which establishes
standards for computing and presenting earnings per share. SFAS No. 128 requires
us to report both basic net (loss) income per share, which is based on the
weighted average number of common shares outstanding during the period, and
diluted net (loss) income per share, which is based on the weighted average
number of common shares outstanding plus all potentially dilutive common shares
outstanding. All equivalent shares underlying options and warrants were excluded
from the calculation of diluted loss per share because we had net losses for all
periods presented and therefore equivalent shares would have an anti-dilutive
effect.





Reclassification
- Certain prior period amounts have been reclassified to conform to the
current presentation.





Recent Accounting
Pronouncements –   In December 2007, the Financial Accounting
Standards Board (“FASB”) issued SFAS No. 141 (revised 2007), “Business
Combinations,” and SFAS No. 160, “Accounting and Reporting of
Non-controlling Interest in Consolidated Financial Statements, an amendment of
ARB 51,” which will change the accounting for and reporting of business
combination transactions and non-controlling interests in consolidated financial
statements. The provisions of SFAS 141R and SFAS 160 were effective
for the us on January 1, 2009. SFAS 141R had no impact on previously
recorded acquisitions. SFAS 160 requires changes in classification and
presentation of minority interests in the consolidated balance sheets,
statements of operations and stockholders’ equity. We implemented these changes,
which led to changes in the presentation of prior period results.





In April
2009, the FASB issued FSP No. FAS 107-1 and APB 28-1, Interim Disclosures about
Fair Value of Financial Instruments. This FSP amends FASB Statement No. 107,
Disclosures about Fair Value of Financial Instruments, to require disclosures
about fair value of financial instruments for interim reporting periods of
publicly traded companies as well as in annual financial statements. This FSP
also amends APB Opinion No. 28, Interim Financial Reporting, to require those
disclosures in summarized financial information at interim reporting periods.
This FSP shall be effective for interim reporting periods ending after June 15,
2009. We are currently evaluating the impact that this standard may have on our
financial statements.





In April
2009, the FASB issued FSP No. FAS 115-2 and FAS 124-2, Recognition and
Presentation of Other-Than-Temporary Impairments. This FSP amends the
other-than-temporary impairment guidance in U.S. GAAP for debt securities to
make the guidance more operational and to improve the presentation and
disclosure of other-than-temporary impairments on debt and equity securities in
the financial statements. The FSP does not amend existing recognition and
measurement guidance related to other-than-temporary impairments of equity
securities. The FSP shall be effective for interim and annual reporting periods
ending after June 15, 2009. We are currently evaluating the impact that this
standard may have on our financial statements.





In April
2009, the SEC released Staff Accounting Bulletin No. 111 (“SAB 111”), which
amends SAB Topic 5-M. SAB 111 notes that FSP No. 115-2 and FAS 124-2 were scoped
to debt securities only, and the FSP referred readers to SEC SAB Topic 5-M for
factors to consider with respect to other-than-temporary impairments for equity
securities. With the amendments in SAB 111, debt securities are excluded from
the scope of Topic 5-M, but the SEC staff’s views on equity securities are still
included within the topic. We are currently evaluating the impact that this
standard may have on our financial statements.




10




KIT
DIGITAL, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Amounts
in Thousands, Except Share and Per Share Data)


(Unaudited)




In April
2009, the FASB issued FSP No. FAS 141(R)-1, Accounting for Assets Acquired and
Liabilities Assumed in a Business Combination That Arise from Contingencies, to
address some of the application issues under SFAS 141(R). The FSP deals with the
initial recognition and measurement of an asset acquired or a liability assumed
in a business combination that arises from a contingency provided the asset or
liability’s fair value on the date of acquisition can be determined. When the
fair value can’t be determined, the FSP requires using the guidance under SFAS
No. 5, Accounting for Contingencies, and FASB Interpretation (FIN) No. 14,
Reasonable Estimation of the Amount of a Loss. This FSP was effective for assets
or liabilities arising from contingencies in business combinations for which the
acquisition date is on or after January 1, 2009. SFAS 141(R) may have a material
impact on our consolidated financial statements if or when it enters into
another business transaction.





(3)
Going Concern





The
accompanying consolidated financial statements have been prepared assuming that
we will continue as a going concern, which contemplates the realization of
assets and the satisfaction of liabilities in the normal course of business.
Since its inception, we have incurred losses, have an accumulated deficit, and
have experienced negative cash flows. Our cash flows have improved sequentially
over the last five operating quarters, and management expects cash flows from
operating activities to continue to improve, primarily as a result of the
ongoing increase in revenue and maintenance of reduced costs on a relative
basis. Furthermore, in the event the Company has required working capital in the
past, we have historically received advances from KIT Media, Ltd. (“KIT Media”),
an entity controlled by our chairman and chief executive officer Kaleil Isaza
Tuzman, at pricing in line with prevailing market availability. However, there
can be no assurance thereof, and this raises doubt about our ability to continue
as a going concern. The accompanying consolidated financial statements do not
include any adjustments that might be necessary should we are unable to continue
as a going concern.




(4)
Acquisitions





On March
6, 2009, we acquired the remaining 49% outstanding share capital that we did not
previously own in subsidiary Reality Group Pty. Ltd., in consideration of
issuing the sellers 90,073 shares of our common stock for a total purchase price
of $631.  Reality Group’s activities are part of the Professional
Services segment of our business.





(5)
Acquisition Liabilities





On March
9, 2009, we issued 300,539 shares of our common stock in satisfaction of a
$1,500 acquisition liability incurred in connection with the acquisition of
Kamera Content AB in 2008. This reduced the remaining total liability included
in the Balance Sheet in “Acquisition liability - Kamera” to $1,500 as of March
31, 2009.





On March
31, 2009, we issued 163,044 shares of our common stock to the former
shareholders of Visual Connection a.s., pursuant to the Visual Share Purchase
Agreement dated October 5, 2008, in satisfaction of a $1,500 acquisition
liablility. This reduced the liability included in the Balance Sheet in
“Acquisition liability – Visual” to $1,075 and “Acquisition liability – Visual,
net of current” to $538 as of March 31, 2009.





11





KIT
DIGITAL, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Amounts
in Thousands, Except Share and Per Share Data)


(Unaudited)




(6)
Derivative Liabilities





In June
2008, the Emerging Issues Task Force issued EITF Consensus No. 07-05
“Determining Whether an Instrument (or Embedded Feature) Is Indexed to an
Entity's Own Stock”.  Under EITF 07-05, instruments which contain full
ratchet anti-dilution provisions will no longer be considered indexed to a
company’s own stock for purposes of determining whether it meets the first part
of the scope exception in paragraph 11(a) of Statement 133.  The
adoption of this EITF required us to (1) evaluate our instrument’s contingent
exercise provisions and (2) evaluate the instrument’s settlement provisions.
Based upon applying this approach to instruments within the scope of the
consensus, we have determined that certain of our warrants which were classified
in stockholders’ equity on December 31, 2008, no longer meet the definition of
Indexed to a Company’s Own Stock provided in the Consensus. Accordingly,
effective on January 1, 2009, we were required to reclassify those Warrants, at
their fair value to liabilities.  SFAS No. 133, “Accounting for
Derivative Instruments and Hedging Activities” (“FAS 133”) requires that the
fair value of these liabilities be re-measured at the end of every reporting
period with the change in value reported in the statement of
operations.  The difference between the amount at which the warrants
were originally recorded in the financials and the fair value of the instruments
on January 1, 2009 was considered a cumulative effect of a change in the
accounting principle, and required an adjustment to the opening balance of
retained earnings in the amount of $14,580.  The common shares indexed
to the derivative financial instruments recorded as liabilities at January 1,
2009 and March 31, 2009 were 2,143.





We
estimate fair values of derivative financial instruments using various
techniques (and combinations thereof) that are considered to be consistent with
the objective measuring fair values. In selecting the appropriate technique, we
consider, among other factors, the nature of the instrument, the market risks
that it embodies and the expected means of settlement. For less complex
derivative instruments, such as free-standing warrants, we generally use the
Black-Scholes-Merton (“BSM”) option valuation technique, adjusted for the effect
of dilution, because it embodies all of the requisite assumptions (including
trading volatility, estimated terms, dilution and risk free rates) necessary to
fair value these instruments. Estimating fair values of derivative financial
instruments requires the development of significant and subjective estimates
that may, and are likely to, change over the duration of the instrument with
related changes in internal and external market factors. In addition,
option-based techniques (such as BSM) are highly volatile and sensitive to small
changes in trading volatility and the trading market price of our common stock,
and BSM does not effectively capture the cash-exercise nature of our warrants
(and lack of liquidity in the underlying instrument). Since derivative financial
instruments are initially and subsequently carried at fair values, our income
(loss) will reflect the variability of the BSM method, the volatility in these
estimates, and any changes made in the assumptions upon which these estimates
are predicated.




The
following tables summarize the components of derivative liabilities as of March
31, 2009 and the re-measurement date, January 1, 2009:




12




KIT
DIGITAL, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Amounts
in Thousands, Except Share and Per Share Data)


(Unaudited)




March
      31, 2009
                  
                  
                  Re-measurement
      date
                    January
      1, 2009Investor
      warrants issued in May 2008private
      placement
                  
                  $
                  (3,720
                  )
                  
                  $
                  (5,670
                  )Significant
      assumptions (or ranges):Trading
      market values  (1)
                  
                  $
                  9.20
                  
                  
                  $
                  5.25Term
      (years)
                  
                  
                  4.11
                  
                  
                  
                  4.35Volatility   (1)
                  
                  
                  59.34
                  %
                  
                  
                  101.98
                  %Risk-free
      rate   (2)
                  
                  
                  1.67
                  %
                  
                  
                  1.55
                  %Effective
      Exercise price
                  
                  $
                  11.17
                  
                  
                  $
                  5.92





Fair
value hierarchy:





(1)
            Level
      1 inputs are quoted prices in active markets for identical assets and
      liabilities, or derived there from. Our trading market values and the
      volatilities that are calculated thereupon are level 1
    inputs.


(2)
            Level
      2 inputs are inputs other than quoted prices that are observable. We use
      the current published yields for zero-coupon US Treasury Securities, with
      terms nearest the remaining term of the warrants for our risk free
      rate.


(3)
            Level
      3 inputs are unobservable inputs. Inputs for which any parts are level 3
      inputs are classified as level 3 in their entirety. The remaining term
      used equals the remaining contractual term as our best estimate of the
      expected term and the effective exercise price which is based on the
      stated exercise price adjusted for anti-dilution
    provisions.





The
effects on our income (loss) associated with changes in the fair values of our
derivative financial instruments for the quarter ended March 31, 2009 was
$1,950.





(7)
Stock Issuances





On May 8,
2008, we entered into a Securities Purchase Agreement pursuant to which it sold
2,142,858 units to 35 accredited investors, each unit comprising of one share of
common stock plus one warrant to purchase one share of common stock. The
offering closed on May 8, 2008. The units were sold at a price of $7.00 per unit
for aggregate gross proceeds of $15,000. The warrants have an exercise price of
$11.90 per share and a term of five years. These warrants were valued under the
BSM method as $20,250. The warrants provide the investors with full ratchet
anti-dilution protection with relation to the exercise price of each warrant.
KIT Media was the largest investor in the May 2008 Financing, investing $7,060
for a total of 1,008,572 units. Our Chief Executive Officer, Kaleil Isaza
Tuzman, holds a controlling interest in KIT Media.





Pursuant
to the terms of the Securities Purchase Agreement entered into with each of the
accredited investors, we may be required to pay liquidated damages to the
investors based on certain criteria. Upon the our request, KIT Media has allowed
that the 1,008,572 shares of common stock and the 1,008,572 shares underlying
warrants purchased by KIT Media in the May 2008 Financing be left unregistered
to date. We failed to fulfill our obligations to file and have the registration
statement made effective in the required time periods and owe approximately $117
in liquidated damages to the investors. This amount has been accrued and is
included in accrued expenses and registration rights liquidated damages on the
balance sheet and statement of operations, respectively.




13




KIT
DIGITAL, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Amounts
in Thousands, Except Share and Per Share Data)


(Unaudited)




In
connection with the May 2008 Financing, we paid the placement agents a cash fee
of an aggregate $155. In addition, we issued to the placement agents 23,536 and
12,071 warrants to purchase shares of common stock with an exercise price of
$0.35 and $11.90 per share exercisable for a period of five years and were
valued under the BSM method as $222 and $118, respectively. In connection with
the May 2008 Financing, we received net proceeds of $14,680 after payment of
placement agents’ fees of $155, legal fees and expenses of $160 and escrow agent
fees of $5.





On
December 31, 2008, we completed the investment for $5,000 with KIT Capital as
called for under the Management Agreement for the issue of 892,858 shares of
common stock at $5.60 per share. In addition we issued to KIT Capital a warrant
to purchase 580,358 shares of our common stock (representing 65% warrant
coverage on KIT Capital’s investment, as compared to 100% warrant coverage in
the May 2008 financing transaction), for a term of five years commencing on
December 31, 2008, at an exercise price of $11.90 per share, subject to the
occurrence of certain events that could potentially reduce the exercise price to
$5.60 per share.





(8) Restructuring
Charges





In the
quarter ended March 31, 2009, we recorded restructuring charges of $119 in the
three months ended March 31, 2009. This amount is comprised of employee
termination costs related to the reorganization of the Company of $47, facility
closing costs of $72 related to the closing of one of the Melbourne, Australia
offices.





In the
quarter ended March 31, 2008, we recorded restructuring charges of $2,745 in the
three month period ended March 31, 2008. This amount is comprised of employee
termination costs related to the reorganization of the Company of $2,598 and
contract settlement and facility closing costs of $147 related to the closing of
the Clifton Park, New York office and vendor settlements related to the
reorganization. Included in the employee termination costs are $2,397
related to the settlement of separation agreements as described below. On March
26, 2008 and March 30, 2008, the Company reached negotiated settlements with
Robert Petty and Robin Smyth, respectively, restructuring their respective
employment agreements, each of which involved one-time cash severance payments.
In exchange for entering into new, "at will" employment agreements, Messrs.
Petty and Smyth received upfront cash settlements of $675 and $275 respectively,
as well as an aggregate of 7 million and 1.65 million fully vested warrants
respectively to purchase the Company's common stock, at a strike price equal to
the 3-day weighted average of closing price of the Company's common stock prior
to the effective date. These warrants have been valued under the BSM method at
$1,038. These warrants will become exercisable in 1/12 increments on a monthly
basis starting six months from the effective date. Also, Mr. Smyth is to receive
additional lump-sum payments of $200, less applicable tax withholding and
deductions. Mr. Smyth's restructured employment agreement involved certain
warrant-based incentives. Included in the $2,397 are cash payments of $1,150,
$1,088 related to the valuation of the warrants and $209 in legal fees paid on
behalf of Mr. Petty, which was part of Mr. Petty’s separation
agreement.





(9)
Other Non-Recurring Charges





In the
quarter ended March 31, 2009, we have recorded other non-recurring charges of
$244 in the three months ended March 31, 2009. This amount is related to the
redundancy in staff and consultants during reorganization for the transition of
technology infrastructure due to the centralizing of resources in our Toronto
and Prague offices.





In the
quarter ended March 31, 2008, we have recorded other non-recurring charges of
$135 related to (a) the redundancy in staff and consultants during
reorganization due to the centralizing of resources in Toronto and (b)
corporate rebranding related to the reorganization.




14




KIT
DIGITAL, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Amounts
in Thousands, Except Share and Per Share Data)


(Unaudited)




(10)
Impairment of Property and Equipment





In March
2008, we decided to downsize our office in London and move to another location
to reduce costs. This included removing and abandoning the leasehold
improvements and furniture and fixtures in the former London office. Due to this
office relocation, we recorded an impairment charge for certain property and
equipment, which totaled $229 during the year ended December 31, 2008. This
amount was recorded as a loss on impairment of property and equipment in the
Statement of Operations.





(11)
Segment Reporting





We derive
our revenue from two operating segments. These operating segments are presented
on a worldwide basis and include: Digital Media Solutions and Professional
Services.





Digital
Media Solutions includes the comprehensive delivery of IP video software
solutions, including SaaS fees, enterprise license fees, software usage fees,
storage, set-up/support services, hardware components, content delivery, content
syndication, and advertising-based monetization. Our IP digital asset management
platform, branded as “VX”, allows for management of IP video assets for
consumption on the computer browser, mobile devices and the IPTV set-top box
enabled television set. Our software is generally hosted in our facilities, and
delivered as a service, but we occasionally sell upfront enterprise licenses
which allow for hosting and deployment of our VX suite at the client
site.





Professional
Services is designed to support and complement the Digital Media Solutions
segment of our business, and includes technical integration services, interface
design, branding, strategic planning, creative production, sponsorships, online
marketing, media planning, data management and analytics.





The
emphasis of our business is the Digital Media Solutions segment. As our
operations continue to evolve, the Company will continue to regularly review the
business to determine if there is a need to make changes to these reported
segments.





In
accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and
Related Information,” the following table provides revenue and segment income
(loss) from operations for each of the segments. Segment income (loss) from
operations, as shown below, is the performance measure used by management to
assess segment performance and excludes the effects of: stock-based
compensation, amortization of intangible assets and corporate expenses.
Corporate expenses consist of those costs not directly attributable to a
segment, and include: salaries and benefits for our corporate executives,
corporate governance costs, fees for professional service providers including
audit, legal, tax, insurance, and other corporate expenses.




15




KIT
DIGITAL, INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


(Amounts
in Thousands, Except Share and Per Share Data)


(Unaudited)




Three Months
      endedMarch
      31,2009
                                        
                                        
                                        2008(unaudited)
                                        
                                        
                                        (unaudited)Revenue:Digital
      Media Solutions
                                        
                                        $
                                        8,828
                                        
                                        
                                        $
                                        2,373Professional
      Services
                                        
                                        
                                        796
                                        
                                        
                                        
                                        1,129Total
      revenue
                                        
                                        $
                                        9,624
                                        
                                        
                                        $
                                        3,502Operating
      income (loss):Digital
      Media Solutions
                                        
                                        $
                                        572
                                        
                                        
                                        $
                                        (3,379
                                        )Professional
      Services
                                        
                                        
                                        (117
                                        )
                                        
                                        
                                        13Corporate
                                        
                                        
                                        (1,961
                                        )
                                        
                                        
                                        (7,445
                                        )Total
      operating loss
                                        
                                        $
                                        (1,506
                                        )
                                        
                                        $
                                        (10,811
                                        )March
      31,
                                        
                                        
                                        December
      31,2009
                                        
                                        
                                        2008(unaudited)
                                        
                                        
                                        (unaudited)Assets:Digital
      Media Solutions
                                        
                                        $
                                        15,985
                                        
                                        
                                        $
                                        15,901Professional
      Services
                                        
                                        
                                        872
                                        
                                        
                                        
                                        836Corporate
                                        
                                        
                                        24,182
                                        
                                        
                                        
                                        24,572Total
      assets
                                        
                                        $
                                        41,039
                                        
                                        
                                        $
                                        41.309




(12)
Subsequent Events





On April
8, 2009, we acquired 100% of the operating assets and assumed current
liabilities of Narrowstep, Inc. (“Narrowstep”) in exchange for 25,000 shares of
restricted common stock, 5,000 of which have been escrowed against indemnities
entered into in connection with the Narrowstep asset purchase. Concurrently with
the closing of the Narrowstep asset purchase, Granahan McCourt Capital, LLC, a
shareholder of Narrowstep, lent $350 to us in the form of an interest-free
convertible note, which has been used to cover technical and operational
restructuring charges incurred in the asset purchase, and is convertible
at our election into a future equity financing (“Convertible Note”).
The Narrowstep assets did not have a material impact on our operations; the
revenues from former Narrowstep clients represented less than 3% of our average
monthly revenue as of May 13, 2009. KIT Media has subsequently agreed to
participate in the Convertible Note under the same terms, or terms more
favorable to us, at an amount equal or greater to $2,250.





16




ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


(Amounts
in Thousands, Except Share and Per Share Data)





Overview





Through
our operating subsidiaries, we are in the business of providing software
solutions that enable our customers to manage and distribute video content
through Internet websites, mobile devices and IPTV networks. Our core digital
asset management software suite, marketed under the “KIT VX” brand, includes
online and mobile video players, ingestion and trans-coding video content for
Internet and mobile devices, IPTV set-top box development, IPTV recording and
editing suite deployment, video content localization and syndication, digital
rights management, hosting, storage,  content delivery and content
syndication. We currently provide IP video solutions internationally through our
offices in Dubai, Melbourne (Australia), Prague, Toronto, Stockholm, New York,
London, Cairo, Singapore, Buenos Aires and Bogotá. To support IPTV enablement,
we provide technical integration and integrated marketing solutions, including
interface design services, branding, online marketing, data management and
analytics.





Set forth
below is a discussion of the financial condition and results of operations of
KIT digital, Inc. and its consolidated subsidiaries (collectively, “we,” “us,”
or “our”), for the three months ended March 31, 2009 and 2008. The following
discussion should be read in conjunction with the information set forth in the
consolidated financial statements and the related notes thereto appearing
elsewhere in this report.





As a
component of our management’s review of the financial statements, our management
recently reviewed and modified the categorization of costs in the Consolidated
Statements of Operations. Management believes these changes in classifications
present additional information to the readers of the financial statements and
previously reported amounts were re-categorized to conform to the current
presentation.





Results
of Operations - Three Months Ended March 31, 2009 Compared to Three Months Ended
March 31, 2008





Revenue. Consolidated revenue
increased by $6,122 from $3,502 for the three months ended March 31, 2008 to
$9,624 for the three months ended March 31, 2009, an increase of
175%.





Digital
Media segment revenue increased by $6,455 from $2,373 for the three months ended
March 31, 2008 to $8,828 for the three months ended March 31, 2009, an increase
of 272%. The increase was principally due to an increase in customers,
increased spending by existing customers, and revenue from the acquired
companies not included in prior period results.





Professional
Services segment revenue decreased by $333 from $1,129 for the three months
ended March 31, 2008 to $796 for the three months ended March 31, 2009, a
decrease of 29%. The decrease was primarily from the decreases in spending
by existing clients.


17


Variable
and Direct Third Party Costs





Cost of Goods and Services.
Cost of goods and services of $3,478 represents the costs by KIT digital Czech
for the supply of IPTV solutions, services and components; no such expenses were
incurred prior to the acquisition of KIT digital Czech in October
2008.





Hosting, Delivery and
Reporting. These costs decreased by $233 from $515 for the three months
ended March 31, 2009 to $282 for the three months ended March 31, 2009, a
decrease of 45%. These costs decreased primarily due to the establishment of an
internal datacenter which reduced our reliance on third party
suppliers.





Content Costs. Content costs
increased by $277 from $184 for the three months ended March 31, 2008 to $461
for the three months ended March 31, 2009, an increase of 151%. The increase is
primarily due to the inclusion of costs from Kamera (acquired May
2008) not included in prior period results.




Direct Third Party Creative
Production Costs. Direct third party creative production costs increased
by $52 from $753 for the three months ended March 31, 2008 to $805 for the three
months ended March 31, 2009, an increase of 7% attributable to higher costs in
the Professional Services segment.





General
and Administrative Expenses





Compensation, Travel and Associated
Costs (Exclusive of Non-Cash Stock-Based Compensation). These costs
decreased by $910 from $4,323 for the three months ended March 31, 2008 to
$3,413 for the three months ended March 31, 2009, a decrease of 21%. The
decrease was primarily due to the broad cost cutting measures begun in the first
quarter of 2008 which included a reduction in headcount and salary levels offset
in part by increases due to our business acquisitions.





Non-Cash Stock-Based
Compensation. Non-cash stock-based compensation expense decreased 93% by
$3,721, from $4,001 for the three months ended March 31, 2008 to $280 for the
three months ended March 31, 2009.





Legal, Accounting, Audit and Other
Professional Services Fees. These expenses decreased by $75 from $345 for
the three months ended March 31, 2008 to $270 for the three months ended March
31, 2009, a decrease of 22%, primarily due to lower legal fees.





Office, Marketing and Other Corporate
Costs. These expenses decreased by $121 from $838 for the three months
ended March 31, 2008 to $717 for the three months ended March 31, 2009, a
decrease of 14%. The decrease was primarily due to the broad cost cutting
measures begun in the first quarter of 2008 and includes a reduction in
marketing related expenses.




Merger and Acquisition and Investor
Relation Expenses. Merger and acquisition and certain investor relation
expenses were $378 for the three months ended March 31, 2009. There were no such
expenses in the three months ended March 31, 2008.





Depreciation and Amortization.
Depreciation and amortization expense increased 179% by $438 from $245 for the
three months ended March 31, 2008 to $683 for the three months ended March 31,
2009. These costs have increased primarily due to the increases related to the
acquisitions of KIT digital Czech in October 2008 and Kamera in May
2008.




Restructuring Charges.
Restructuring charges decreased 96% by $2,626, from $2,745 for the three months
ended March 31, 2008 to $119 for the three months ended March 31,
2009.





Other Non-Recurring Charges.
Other non-recurring charges increased 81% by $109 from $135 for the three months
ended March 31, 2008 to $244 for the three months ended March 31, 2009. These
charges have increased primarily due to the migration of certain technical and
operational functions from Toronto and Stockholm offices to our Prague
office.


18





Impairment of Property and
Equipment. Impairment of property and equipment was $229 for the three
months ended March 31, 2008. In 2008, the impairment related to the abandonment
of assets due to the downsizing of our London office.




Interest Income. Interest
income decreased by $60 from $61 for the three months ended March 31, 2008 to $1
for the three months ended March 31, 2009, a decrease of 98%. This decrease was
primarily due to a decrease in our cash and cash equivalents related to the
timing of the proceeds from private placements.





Interest Expense. Interest
expense increased by $125 from $14 for the three months ended March 31, 2008 to
$139 for the three months ended March 31, 2009. This increase was due to the
issuance of $1,500 of a senior secured note in November 2008 and the addition of
debt and capital lease obligations acquired in the acquisition of Visual in
October 2008




Amortization of Deferred Financing
Costs. Amortization of deferred financing costs were $164 for the three
months ended March 31, 2009. These costs result from the issuance of $1,500 of a
senior secured note in November 2008.





Derivative income. Derivative
income was $1,950 for the three months ended March 31, 2009. Under EITF 07-05
and FAS 133, the company recorded a reduction in the fair value of warrants
containing reset provisions in the three months ended March 31,
2009.





Other Income/(Expense). Other
income increased by $7. Other income was $22 for the three months ended March
31, 2008 as compared to other income of $29 for the three months
ended March 31, 2009.




Net (Loss) Income. As a result
of the factors described above, we reported net income of $168 for the three
months ended March 31, 2009 compared to net loss of ($10,743) for the three
months ended March 31, 2008, an improvement of $10,911, or 102%.





Liquidity
and Capital Resources





As of
March 31, 2009, we had cash and cash equivalents of $2,525 and a working capital
deficit of approximately $6,779, which if reduced for the acquisition
liabilities for Kamera and Visual that can be paid in stock of $2,575 and the
Derivative liability which is a non-cash valuation of $3,720, becomes a working
capital deficit of $484. Management anticipates that going-forward, KIT digital
will generate sufficient cash flows from its operating activities to meet its
capital requirements. However, the Company may choose to raise equity capital
from time to time to support general working capital needs, certain capital
expenditures or potential acquisitions. KIT Media, Ltd., an entity controlled by
Kaleil Isaza Tuzman, KIT digital's Chairman and Chief Executive Officer, has
made advances to the Company and participated in such financings in the past, at
competitive market levels, and may do so in the future.





Net cash
used in operating activities was $1,162 for the three months ended March 31,
2009, compared to $4,818 for the three months ended March 31, 2008, a decrease
of $3,656, or 76%. The decrease in net cash used in operating activities is
primarily related to an increase in revenues from clients, and the reduction in
general and administrative costs.





Net cash
used by investing activities was $1,892 for the three months ended March 31,
2009, compared to net cash provided by investing activities of $107 for the
three months ended March 31, 2008, an increase in net cash used in investing
activities of $1,999. In 2009, this primarily consisted of cash paid into an
investment of $200, cash paid in acquisition of Visual and purchase of property
and equipment of $1,512 which is mainly a purchase of software.  In
2008, this primarily consisted of the release of restricted cash of $100,
proceeds from sale of equipment of $33 and purchase of assets of
$26.


19





Net cash
used by financing activities was $170 for the three months ended March 31, 2009,
compared net cash provided by financing activities of $61 for the three months
ended March 31, 2008. In 2009, this primarily consisted of $25 in proceeds from
exercise of stock options, payments of Secured Notes of $67 and payment of
capital leases of $126. In 2008, this primarily consisted of a decrease of bank
overdraft of $89 and payment of capital leases of $28.





Off-Balance
Sheet Arrangements





We do not
have any off-balance sheet arrangements that are reasonably likely to have a
current or future effect on our financial condition, revenues, results of
operations, liquidity or capital expenditures.





Impact
of Inflation





We
believe that inflation has not had a material impact on our results of
operations for the three months ended March 31, 2009 and 2008. We cannot assure
you that future inflation will not have an adverse impact on our operating
results and financial condition.





Critical
Accounting Policies and Estimates





The
policies discussed below are considered by our management to be critical to an
understanding of our financial statements and their application places the most
significant demands on our management’s judgment of matters that are inherently
uncertain. Specific risks for these critical accounting policies are described
below. For these policies, our management cautions that future events rarely
develop as forecast, and that best estimates may routinely require
adjustment.




The SEC
has issued cautionary advice to elicit more precise disclosure about accounting
policies that management believes are most critical in portraying financial
results and that require management’s most difficult subjective or complex
judgments.





The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make judgments
and estimates. On an ongoing basis, we evaluate our estimates, the most
significant of which include establishing allowances for inventories and
doubtful accounts and determining the recoverability of our long-lived tangible
and intangible assets. The basis for our estimates are historical experience and
various assumptions that are believed to be reasonable under the circumstances,
given the available information at the time of the estimate, the results of
which form the basis for making judgments about the carrying values of assets
and liabilities that are not readily available from other sources. Actual
results may differ from the amounts estimated and recorded in our financial
statements.




We
believe the following critical accounting policies affect our more significant
judgments and estimates used in the preparation of our consolidated financial
statements.





Revenue Recognition. We
recognize revenue in accordance with the following authoritative literature:
AICPA Statement of Position (SOP) No. 97-2, SoftwareRevenue Recognition and Securities and
Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition in Financial
Statements which requires that four basic criteria be met before revenue
can be recognized: (i) persuasive evidence that an arrangement exists;
(ii) the price is fixed or determinable; (iii) collectability is
reasonably assured; and (iv) product delivery has occurred or services have
been rendered. We recognize revenue, net of sales taxes assessed by any
governmental authority.  Revenues are derived principally from the
delivery of digital media solutions and professional services. Our revenues
include fees charged for software-as-a-service (“SaaS”), enterprise licenses,
software usage, storage, software set-up/support services, hardware components,
content delivery, content syndication fees, advertising-based monetization and
professional services.  Revenue is recognized when the product and/or
service has been provided to the customer. We may enter into agreements whereby
we guarantee a minimum service level, or a minimum number of impressions,
click-throughs or other criteria on our software platform’s points of
distribution for a specified period. To the extent these guarantees are not met,
we may defer recognition of the corresponding revenue until guaranteed delivery
levels are achieved.


20





Inventories. We value
inventories at the lower of cost (first-in, first-out method) or market and are
comprised of finished goods. On a quarterly basis, we review inventory
quantities on hand and analyze the provision for excess and obsolete inventory
based primarily on product age in inventory and our estimated sales forecast,
which is based on sales history and anticipated future
demand.   Our estimates of future product demand may not be
accurate and we may understate or overstate the provision required for excess
and obsolete inventory. Accordingly, any significant unanticipated changes in
demand could have a significant impact on the value of our inventory and results
of operations. As of March 31, 2009, our reserve for excess and obsolete
inventory was $120.




Cash and Cash Equivalents. We
consider all highly liquid investments with original maturities of ninety days
or less when purchased to be cash and cash equivalents.





Allowance for Doubtful
Accounts. We maintain an allowance for doubtful accounts for estimated
losses resulting from our customers not making their required payments. Based on
historical information, we believe that our allowance is adequate. Changes in
general economic, business and market conditions could result in an impairment
in the ability of our customers to make their required payments, which would
have an adverse effect on cash flows and our results of operations. The
allowance for doubtful accounts is reviewed monthly and changes to the allowance
are updated based on actual collection experience. We use a combination of the
specific identification method and analysis of the aging of accounts receivable
to establish an allowance for losses on accounts receivable. The allowance for
doubtful accounts as of March 31, 2009 was $514.





Tangible and Intangible Asset
Impairment. We review our long-lived assets and identifiable intangibles
for impairment at least annually and whenever events or changes in circumstances
indicate that the carrying amount of an asset may not be recoverable. When such
factors and circumstances exist, we compare the projected undiscounted future
cash flows associated with the future use and disposal of the related asset or
group of assets to their respective carrying amounts. Impairment, if any, is
measured as the excess of the carrying amount over the fair value based on
market value (when available) or discounted expected cash flows of those assets,
and is recorded in the period in which the determination is made. In assessing
the recoverability of our goodwill, we review goodwill for impairment at each
reporting period to determine whether events and circumstances continue to
support the indefinite useful life of the asset. Then, we perform the first step
of the goodwill impairment test which compares the fair value of the reporting
unit with its carrying value, including goodwill. The fair value of the
reporting unit is based on expected future cash flows associated with the group
of assets. This valuation method is used if quoted market prices are not
available. If the fair value of the reporting unit exceeds the carrying amount,
goodwill is not impaired. If the carrying amount of a reporting unit exceeds its
fair value, the second step of the goodwill impairment test shall be performed.
The second step, used to measure the amount of impairment loss, compares the
implied fair value of reporting unit goodwill with the carrying amount of that
goodwill. If the carrying amount of the reporting unit goodwill exceeds the
implied fair value of that goodwill, an impairment loss is recognized in an
amount equal to the excess.





21







SPECIAL
NOTE ON FORWARD-LOOKING STATEMENTS




This
report contains forward-looking statements within the meaning of Section 21E of
the Securities Exchange Act of 1934. These forward-looking statements are based
largely on our expectations and are subject to a number of risks and
uncertainties, certain of which are beyond our control. Actual results could
differ materially from these forward-looking statements as a result of, among
other factors, risks related to our history of net losses and accumulated
deficits; integration of acquired businesses; future capital requirements;
competition and technical advances; dependence on the market for digital
advertising; and other risks. In light of these risks and uncertainties, there
can be no assurance that the forward-looking information contained in this
report will in fact occur.




ITEM
3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.





We
conduct our operations in primary functional currencies: the United States
dollar, the British pound, the Australian dollar, the Swedish krona and the
Czech koruna. We currently do not hedge any of our foreign currency exposures
and are therefore subject to the risk of exchange rate fluctuations. However, we
attempt to employ a “natural hedge” by matching as much as possible in like
currencies our client revenues with associated client delivery costs. We invoice
our international customers primarily in U.S. dollars, British pounds,
Australian dollars, Euros, Swedish kronor, Czech koruna and Australian
dollars.




We are
exposed to foreign exchange rate fluctuations as the financial results of
foreign subsidiaries are translated into U.S. dollars in consolidation and as
our foreign currency consumer receipts are converted into U.S. dollars. Our
exposure to foreign exchange rate fluctuations also arises from payables and
receivables to and from our foreign subsidiaries, vendors and
customers.


22





Financial
instruments which potentially subject us to concentrations of credit risk
consist principally of cash and cash equivalents and trade accounts receivable.
We place our cash and cash equivalents with high credit quality institutions to
limit credit exposure, and from time to time, obtain collateral for our accounts
where we deem prudent and is feasible. We believe that no significant
concentration of credit risk exists with respect to these
investments.





Concentrations
of credit risk with respect to trade accounts receivable are limited due to the
wide variety of our customers who are dispersed across many geographic regions.
We routinely assess the financial strength of customers and, based upon factors
concerning credit risk, we establish an allowance for uncollectible accounts.
Our management believes that accounts receivable credit risk exposure beyond
such allowance is limited.





ITEM
4T. CONTROLS AND PROCEDURES.





Conclusion
Regarding the Effectiveness of Disclosure Controls and Procedures





As of the
end of the period covered by this report, we conducted an evaluation, under the
supervision and with the participation of our chief executive officer and chief
financial officer of our disclosure controls and procedures (as defined in Rule
13a-15(e) and Rule 15d-15(e) of the Exchange Act). Based upon this evaluation,
our chief executive officer and chief financial officer concluded that our
disclosure controls and procedures are effective to ensure that information
required to be disclosed by us in the reports that we file or submit under the
Exchange Act is: (1) accumulated and communicated to our management, including
our chief executive officer and chief financial officer, as appropriate to allow
timely decisions regarding required disclosure; and (2) recorded, processed,
summarized and reported, within the time periods specified in the SEC's rules
and forms. There was no change to our internal controls or in other factors that
could affect these controls during our last fiscal quarter that has materially
affected, or is reasonably likely to materially affect, our internal control
over financial reporting.





Changes
in Internal Control Over Financial Reporting





During
the three months ended March 31, 2009, there were no changes in our internal
control over financial reporting that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.





23




PART
II - OTHER INFORMATION





ITEM
1. LEGAL PROCEEDINGS.





None





ITEM
1A. RISK FACTORS.





There are
no material changes in the risk factors previously disclosed in our annual
report on Form 10-K for the year ended December 31, 2008.





ITEM
2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.




None





ITEM
3. DEFAULTS UPON SENIOR SECURITIES.





None





ITEM
4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.




None





ITEM
5. OTHER INFORMATION.




None




ITEM
6. EXHIBITS.





Exhibit No.
              
              Description31.1
              
              Certification
      by Chief Executive Officer, required by Rule 13a-14(a) or Rule 15d-14(a)
      of the Exchange Act.31.2
              
              Certification
      by Chief Financial Officer, required by Rule 13a-14(a) or Rule 15d-14(a)
      of the Exchange Act.32.1
              
              Certification
      by Chief Executive Officer, required by Rule 13a-14(b) or Rule 15d-14(b)
      of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the
      United States Code.32.2
              
              Certification
      by Chief Financial Officer, required by Rule 13a-14(b) or Rule 15d-14(b)
      of the Exchange Act and Section 1350 of Chapter 63 of Title 18 of the
      United States Code.




24


SIGNATURES





In
accordance with the requirements of the Exchange Act, the registrant caused this
report to be signed on its behalf by the undersigned, thereunto duly
authorized.




KIT
      DIGITAL, INC.Dated:
       May 20, 2009
                  By:
                  /s/
      Kaleil Isaza TuzmanKaleil
      Isaza TuzmanChairman
      and Chief Executive Officer
                    (principal
      executive
officer)





Dated:
        May 20, 2009
                By:
                /s/
      Jonathan HirstJonathan
      HirstChief
      Financial Officer
                  (principal
      financial and accounting
officer)


25