UNITED
STATES SECURITIES AND EXCHANGE COMMISSION


Washington,
D.C. 20549







FORM
10-Q





(Mark
One)





þQuarterly
report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
1934.





For the
quarterly period ended December 31, 2010





 ̈    Transition
report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
1934.





For the
transition period from 
to _________





Commission
file number 001-33468




Point.360


(Exact
Name of Registrant as Specified in Its Charter)





California
              01-0893376(State
      or other jurisdiction of
              (I.R.S.
      Employer Identification No.)incorporation
      or organization)2777
      North Ontario Street, Burbank, CA
              91504(Address
      of principal executive offices)
              (Zip
      Code)




(818) 565-1400


(Registrant’s
Telephone Number, Including Area Code)


(Former
Name, Former Address and Former Fiscal Year,


if
Changed Since Last Report)




Indicate
by check mark whether the registrant: (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.




þYes                       ̈No




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 ̈No




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 the definitions of “large accelerated filer,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.  (Check one):


Large
      accelerated filer  ̈
              
              Accelerated
      filer  ̈Non-accelerated
      filer  ̈
              
              Smaller reporting companyþ




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




 ̈Yes                      þNo




As of
December 31, 2010, there were 10,763,166 shares of the registrant’s common stock
outstanding.







PART
I – FINANCIAL INFORMATION




ITEM
1.  FINANCIAL STATEMENTS


POINT.360


CONDENSED
CONSOLIDATED BALANCE SHEETS (UNAUDITED)


(in
thousands)




June
      30,
                                
                                
                                Dec. 31,2010*
                                
                                
                                2010AssetsCurrent
      assets:Cash
      and cash equivalents
                                
                                $
                                249
                                
                                
                                $
                                -Accounts
      receivable, net of allowances for doubtful accounts of  $393 and
      $408respectively
                                
                                
                                7,581
                                
                                
                                
                                7,134Inventories,
      net
                                
                                
                                548
                                
                                
                                
                                574Prepaid
      expenses and other current assets
                                
                                
                                437
                                
                                
                                
                                488Prepaid
      income taxes
                                
                                
                                1,565
                                
                                
                                
                                68Total
      current assets
                                
                                
                                10,380
                                
                                
                                
                                8,264Property
      and equipment, net
                                
                                
                                20,157
                                
                                
                                
                                19,079Other
      assets, net
                                
                                
                                607
                                
                                
                                
                                1,003Total
      assets
                                
                                $
                                31,144
                                
                                
                                $
                                28,346Liabilities
      and Shareholders’ EquityCurrent
      liabilities:Current
      portion of notes payable
                                
                                $
                                1,038
                                
                                
                                $
                                462Current
      portion of capital lease obligations
                                
                                
                                159
                                
                                
                                
                                209Line
      of credit
                                
                                
                                -
                                
                                
                                
                                225Accounts
      payable
                                
                                
                                2,828
                                
                                
                                
                                3,012Accrued
      wages and benefits
                                
                                
                                1,432
                                
                                
                                
                                1,184Other
      accrued expenses
                                
                                
                                2,300
                                
                                
                                
                                1,430Current
      portion of deferred gain on sale of real estate
                                
                                
                                178
                                
                                
                                
                                178Total
      current liabilities
                                
                                
                                7,935
                                
                                
                                
                                6,700Notes
      payable, less current portion
                                
                                
                                9,383
                                
                                
                                
                                10,033Capital
      lease obligations, less current portion
                                
                                
                                263
                                
                                
                                
                                272Deferred
      gain on sale of real estate, less current portion
                                
                                
                                1,733
                                
                                
                                
                                1,643Total
      long-term liabilities
                                
                                
                                11,379
                                
                                
                                
                                11,948Total
      liabilities
                                
                                
                                19,314
                                
                                
                                
                                18,648Commitments
      and contingencies (Note 4)
                                
                                
                                -
                                
                                
                                
                                -Shareholders’
      equityPreferred
      stock – no par value; 5,000,000 shares authorized; none
      outstanding
                                
                                
                                -
                                
                                
                                
                                -Common
      stock – no par value; 50,000,000 shares authorized; 10,513,166 and
      10,763,166shares
      issued and outstanding on June 30, 2010 and December 31, 2010,
      respectively
                                
                                
                                21,542
                                
                                
                                
                                21,857Additional
      paid-in capital
                                
                                
                                9,808
                                
                                
                                
                                9,964Accumulated
      (deficit)
                                
                                
                                (19,520
                                )
                                
                                
                                (22,123
                                )Total
      shareholders’ equity
                                
                                
                                11,830
                                
                                
                                
                                9,698Total
      liabilities and shareholders’ equity
                                
                                $
                                31,144
                                
                                
                                $
                                28,346




The
accompanying notes are an integral part of these condensed consolidated
financial statements.


*Amounts
derived from audited financial statements


2




POINT.360





CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS


(Unaudited)





Three Months Ended
                          December 31,
                        
                        
                        Six Months Ended
                          December 31,2009
                        
                        
                        2010
                        
                        
                        2009
                        
                        
                        2010Revenues
                        
                        $
                        10,254,000
                        
                        
                        $
                        9,070,000
                        
                        
                        $
                        19,673,000
                        
                        
                        $
                        17,342,000Cost
      of services sold
                        
                        
                        (6,981,000
                        )
                        
                        
                        (6,090,000
                        )
                        
                        
                        (14,341,000
                        )
                        
                        
                        (12,495,000
                        )Gross
      profit
                        
                        
                        3,273,000
                        
                        
                        
                        2,980,000
                        
                        
                        
                        5,332,000
                        
                        
                        
                        4,847,000Selling,
      general and administrative expense
                        
                        
                        (3,704,000
                        )
                        
                        
                        (3,319,000
                        )
                        
                        
                        (7,493,000
                        )
                        
                        
                        (6,961,000
                        )Research
      and development expense
                        
                        
                        (282,000
                        )
                        
                        
                        (60,000
                        )
                        
                        
                        (390,000
                        )
                        
                        
                        (334,000
                        )Operating
      (loss)
                        
                        
                        (713,000
                        )
                        
                        
                        (399,000
                        )
                        
                        
                        (2,551,000
                        )
                        
                        
                        (2,448,000
                        )Interest
      expense
                        
                        
                        (227,000
                        )
                        
                        
                        (194,000
                        )
                        
                        
                        (449,000
                        )
                        
                        
                        (395,000
                        )Interest
      income
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        9,000
                        
                        
                        
                        62,000Other
      income
                        
                        
                        187,000
                        
                        
                        
                        4
                        
                        
                        
                        266,000
                        
                        
                        
                        178,000Loss
      before income taxes
                        
                        
                        (753,000
                        )
                        
                        
                        (589,000
                        )
                        
                        
                        (2,725,000
                        )
                        
                        
                        (2,603,000
                        )Provision
      for income taxes
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -Net
      loss
                        
                        $
                        (753,000
                        )
                        
                        $
                        (589,000
                        )
                        
                        $
                        (2,725,000
                        )
                        
                        $
                        (2,603,000
                        )Loss
      per share:Basic:Net
      loss
                        
                        $
                        (0.07
                        )
                        
                        $
                        (0.05
                        )
                        
                        $
                        (0.26
                        )
                        
                        $
                        (0.24
                        )Weighted
      average number of shares
                        
                        
                        10,491,166
                        
                        
                        
                        10,763,166
                        
                        
                        
                        10,321,794
                        
                        
                        
                        10,647,677Diluted:Net
      loss
                        
                        $
                        (0.07
                        )
                        
                        $
                        (0.05
                        )
                        
                        $
                        (0.26
                        )
                        
                        $
                        (0.24
                        )Weighted
      average number of shares including the dilutive effect of stock
      options
                        
                        
                        10,491,166
                        
                        
                        
                        10,763,166
                        
                        
                        
                        10,321,794
                        
                        
                        
                        10,647,677




See
accompanying notes to condensed consolidated financial
statements.


3


POINT.360




CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS


(Unaudited)





Six Months Ended
                          December 31,(in thousands)2009
                        
                        
                        2010Cash
      flows from operating activities:Net
      loss
                        
                        $
                        (2,725
                        )
                        
                        $
                        (2,603
                        )Adjustments
      to reconcile net loss to net cash provided by operating
      activities:(Gain)
      on sale of fixed assets
                        
                        
                        (112
                        )
                        
                        
                        (124
                        )Depreciation
      and amortization
                        
                        
                        1,834
                        
                        
                        
                        1,863Amortization
      of deferred gain on real estate
                        
                        
                        (89
                        )
                        
                        
                        (89
                        )Provision
      for (recovery of) doubtful accounts
                        
                        
                        (9
                        )
                        
                        
                        15Stock
      compensation expense
                        
                        
                        127
                        
                        
                        
                        156Amortization
      of non-compete agreement
                        
                        
                        7
                        
                        
                        
                        3Changes
      in operating assets and liabilities (net of acquisitions):Decrease
      in accounts receivable
                        
                        
                        1,566
                        
                        
                        
                        431(Increase)
      in inventories
                        
                        
                        (86
                        )
                        
                        
                        (26
                        )(Increase)
      decrease in prepaid expenses and other current assets
                        
                        
                        154
                        
                        
                        
                        (50
                        )Decrease
      in prepaid income taxes
                        
                        
                        -
                        
                        
                        
                        1,497(Increase)
      in other assets
                        
                        
                        (646
                        )
                        
                        
                        (396
                        )(Decrease)
      increase in accounts payable
                        
                        
                        (147
                        )
                        
                        
                        184Decrease
      in accrued wages and benefits
                        
                        
                        (235
                        )
                        
                        
                        (249
                        )Decrease
      in other accrued expenses
                        
                        
                        -
                        
                        
                        
                        (557
                        )Net
      cash and cash equivalents provided by (used in) operating
      activities
                        
                        
                        (361
                        )
                        
                        
                        55Cash
      flows from investing activities:Capital
      expenditures
                        
                        
                        (766
                        )
                        
                        
                        (639
                        )Proceeds
      from sale of equipment or realestate
                        
                        
                        112
                        
                        
                        
                        124Investment
      in acquisitions
                        
                        
                        (200
                        )
                        
                        
                        -Net
      cash and cash equivalents (used in) investing activities
                        
                        
                        (854
                        )
                        
                        
                        (515
                        )Cash
      flows from financing activities:Proceeds
      from line of credit, net
                        
                        
                        -
                        
                        
                        
                        225Borrowing/(Repayment)
      of notes payable
                        
                        
                        (957
                        )
                        
                        
                        73(Repayment)
      of capital lease obligations
                        
                        
                        (74
                        )
                        
                        
                        (87
                        )Net
      cash (used in) provided by financing activities
                        
                        
                        (1,031
                        )
                        
                        
                        211Net  (decrease)
      in cash and cash equivalents
                        
                        
                        (2,246
                        )
                        
                        
                        (249
                        )Cash
      and cash equivalents at beginning of period
                        
                        
                        5,235
                        
                        
                        
                        249Cash
      and cash equivalents at end of period
                        
                        $
                        2,989
                        
                        
                        $
                        -




4




Selected
cash payments and non-cash activities were as follows (in
thousands):




Six Months EndedDecember 31,2009
                      
                      
                      2010Cash
      payments for income taxes (net of refunds)
                      
                      $
                      (312
                      )
                      
                      $
                      (1,497
                      )Cash
      payments for interest
                      
                      $
                      338
                      
                      
                      $
                      371Settlement
      of a lawsuit for common stock
                      
                      $
                      -
                      
                      
                      $
                      315Fixed
      assets purchased for common stock
                      
                      $
                      500
                      
                      
                      $
                      -Assets
      acquired through capital lease obligations
                      
                      $
                      54
                      
                      
                      $
                      146




See
accompanying notes to condensed consolidated financial
statements.


5


POINT.360




NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)


December
31, 2010





NOTE
1 - THE COMPANY




The
Company provides high definition and standard definition digital mastering, data
conversion, video and film asset management and sophisticated computer graphics
services to owners, producers and distributors of entertainment and advertising
content.  The Company provides the services necessary to edit, master,
reformat, convert, archive and ultimately distribute its clients’ film and video
content, including television programming feature films and movie trailers. The
Company’s interconnected facilities provide service coverage to all major U.S.
media centers. Clients include major motion picture studios and independent
producers.  The Company also rents and sells DVDs and video games
directly to consumers through its Movie>Q retail stores.




The
Company operates in two business segments from six post production and three
Movie>Q locations.  Each post production location is electronically
tied to the others and serves the same customer base.  Depending on
the location size, the production equipment consists of tape duplication,
feature movie and commercial ad editing, encoding, standards conversion, and
other machinery.  Each location employs personnel with the skills
required to efficiently run the equipment and handle customer
requirements.  While all locations are not exactly the same, an order
received at one location may be fulfilled at one or more “sister” facilities to
use resources in the most efficient manner.




Typically,
a feature film or television show or related material will be submitted to a
facility by a motion picture studio, independent producer, advertising agency,
or corporation for processing and distribution.  A common sales force
markets the Company’s capability for all facilities.  Once an order is
received, the local customer service representative determines the most
cost-effective way to perform the services considering geographical logistics
and facility capabilities.




In fiscal
2010, the Company purchased assets and intellectual property for a research and
development project to address the viability of the DVD and video game rental
business being abandoned by the closure of Movie Gallery/Hollywood Video and
Blockbuster stores.  The DVD rental market consists principally of
online services (Netflix), vending machines (Redbox) and large video
stores.




As of
December 31, 2010, the Company had opened three Movie>Q “proof-of-concept”
stores in Southern California.  The stores employ an automated
inventory management (“AIM”) system in a 1,200-1,600 square foot
facility.  By saving space and personnel costs which caused the big
box stores to be uncompetitive with lower priced online and vending machine
rental alternatives, Movie>Q can offer up to 10,000 unit selections to a
customer at competitive rental rates.  Movie>Q provides online
reservations, an in-store destination experience, first run movie and game
titles and a large unit selection (as opposed to 400-700 for a Redbox vending
machine).




Based on
the success of the proof-of-concept, the Company may seek to rapidly expand the
number of Movie>Q stores while further streamlining the design and production
of the AIM system.  Movie>Q provides the Company with a content
distribution capability complimentary to the Company’s post production
business.




The
accompanying unaudited Condensed Consolidated Financial Statements include the
accounts and transactions of the Company, including those of the Company’s
subsidiaries.  The accompanying Condensed Consolidated Financial
Statements have been prepared in accordance with accounting principles generally
accepted in the United States of America.  All intercompany balances
and transactions have been eliminated in the Condensed Consolidated Financial
Statements.




The accompanying unaudited Condensed
Consolidated Financial Statements have been prepared in accordance with
generally accepted accounting principles and the Securities and Exchange
Commission’s rules and regulations for reporting interim financial statements
and footnotes.  In the opinion of management, all adjustments
(consisting of normal recurring adjustments) considered necessary for a fair
presentation have been included.  Operating results for the three and
six month periods ended December 31, 2010 are not necessarily indicative of the
results that may be expected for the fiscal year ending June 30,
2011.  These financial statements should be read in conjunction with
the financial statements and related notes contained in the Company’s Form 10-K
for the period ended June 30, 2010.  Certain immaterial
reclassifications have been made to the prior period’s financial statements to
conform to the current year presentation.


6





Earnings
Per Share




A reconciliation of the denominator of
the basic EPS computation to the denominator of the diluted EPS computation is
as follows (in thousands):


Three Months
                    Ended
                    December 31,
                  
                  
                  Three Months
                    Ended
                    December 31,
                  
                  
                  Six Months
                    Ended
                    December 31,
                  
                  
                  Six Months
                    Ended
                    December 31,2009
                  
                  
                  2010
                  
                  
                  2009
                  
                  
                  2010Pro
      forma weighted average of number of sharesWeighted
      average number of common shares outstanding used in computation of basic
      EPS
                  
                  
                  10,491
                  
                  
                  
                  10,763
                  
                  
                  
                  10,322
                  
                  
                  
                  10,648Dilutive
      effect of outstanding stock options
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Weighted
      average number of common and potential Common shares outstanding used in
      computation of Diluted EPS
                  
                  
                  10,491
                  
                  
                  
                  10,763
                  
                  
                  
                  10,322
                  
                  
                  
                  10,648Effect
      of dilutive options excluded in the computation  of diluted EPS
      due to net loss
                  
                  
                  10
                  
                  
                  
                  2
                  
                  
                  
                  19
                  
                  
                  
                  25




The weighted average number of common
shares outstanding was the same amount for both basic and diluted income or loss
per share in each of the periods presented.  The effect of potentially
dilutive securities at December 31, 2010 and 2009 were excluded from the
computation of diluted earnings per share because the Company reported a net
loss, and the effect of inclusion would be anti-dilutive (i.e., including such
securities would result in a lower loss per share).  These potentially
dilutive securities consist of stock options whose exercise price is less than
the Company’s stock price at December 31, 2010.  The number of
potentially dilutive shares at December 31,  2010 was
651,675.





Fair
Value Measurements





The
Company follows a framework for consistently measuring fair value under
generally accepted accounting principles, and the disclosures of fair value
measurements. The framework provides a fair value hierarchy to classify the
source of the information.





The
fair value hierarchy is based on three levels of inputs, of which the first two
are considered observable and the last unobservable, that may be used to measure
fair value and include the following:





Level 1 –
Quoted prices in active markets for identical assets or
liabilities.





Level 2 –
Inputs other than Level 1 that are observable, either directly or indirectly,
such as quoted prices for similar assets or liabilities; quoted prices in
markets that are not active; or other inputs that are observable or can be
corroborated by observable market data for substantially the full term of the
assets or liabilities.





Level 3 –
Unobservable inputs that are supported by little or no market activity and that
are significant to the fair value of the assets or liabilities.





Cash, the only Level 1 input applicable
to the Company (there are no Level 2 or 3 inputs), is stated on the Condensed
Consolidated Balance Sheet at fair value.




As of December 31, 2010 and June 30,
2010, the carrying value of cash, accounts receivable, accounts payable, accrued
expenses and interest payable approximates fair value due to the short-term
nature of such instruments.  The carrying value of other long-term
liabilities approximates fair value as the related interest rates approximate
rates currently available to the Company.





Recent
Accounting Pronouncements





In
October 2009, the FASB issued Accounting Standards Update 2009-13, “Multiple – Deliverable Revenue
Arrangements.” The updated accounting standard requires an entity to
allocate arrangement consideration at the inception of an arrangement to all of
its deliverables based on their relative selling prices.  The guidance
also eliminates the residual method of allocation and requires use of the
relative-selling-price method in all circumstances in which an entity recognizes
revenue for an arrangement with multiple deliverables.  The guidance
is effective for revenue arrangement entered into or materially modified in
fiscal years beginning on or after June 15, 2010 with early adoption permitted.
We adopted the provisions of the guidance as of July 1, 2010 which did not have
a material impact on our financial statements.


7





In
January 2010, the FASB issued Accounting Standards Update 2010-06, “Fair Value Measurements and
Disclosures (Topic 820): Improving Disclosures about Fair Value
Measurements.”This guidance amends the disclosure
requirements related to recurring and nonrecurring fair value measurements and
requires new disclosures on the transfers of assets and liabilities between
Level 1 (quoted prices in active market for identical assets or liabilities) and
Level 2 (significant other observable inputs) of the fair value measurement
hierarchy, including the reasons and the timing of the transfers. Additionally,
the guidance requires a roll forward of activities on purchases, sales, issuance
and settlements of the assets and liabilities measured using significant
unobservable inputs (Level 3 fair value measurements). The guidance became
effective for the reporting period beginning July 1, 2011, except for the
disclosure on the roll forward activities for Level 3 fair value measurements,
which will become effective for the reporting period beginning July 1, 2012.
Other than requiring additional disclosures, adoption of this new guidance will
not have a material impact on our financial statements.




NOTE
2 - LONG TERM DEBT AND NOTES PAYABLE





In
January 2011, the Company entered into a new loan and security
agreement.  See Note 10-Subsequent Event.





In August
2009 the Company entered into a credit agreement which provides up to $5 million
of revolving credit based on 80% of acceptable accounts receivables, as
defined.  The 15 month agreement provides for interest of either (1)
prime (3.25% at December 31, 2010)  minus .5% - plus .5% or (2) LIBOR
plus 2.0% - 3.0% depending on the level of the Company’s ratio of outstanding
debt to fixed charges (as defined), or 3.75% or 3.46%, respectively, on December
31, 2010.  The facility is secured by all of the Company’s accounts
receivable and inventory.  As of December 31, 2010, the Company owed
$225,000 under the credit agreement.  The amount outstanding under the
credit agreement is the result of a $500,000 draw made on a standby letter of
credit by our Media Center landlord, net of $275,000 of payments made by the
Company.  The $500,000 has been recorded as a deposit in “Other
assets, net” in the Condensed Consolidated Balance Sheet as of December 31,
2010.




Our bank
revolving credit agreement requires us to maintain a minimum “leverage ratio”
and “fixed charge coverage ratio.” The leverage ratio compares tangible assets
to total liabilities (excluding the deferred real estate gain).  Our
fixed charge coverage ratio compares, on a rolling twelve-month basis, (i)
EBITDA plus rent expense and non-cash charges less income tax payments, to (ii)
interest expense plus rent expense, the current portion of long term debt and
maintenance capital expenditures.  As of December 31, 2010, the
leverage ratio was 1.68 compared to a minimum requirement of 1.75, and the fixed
charge coverage ratio was 0.25 as compared to a minimum requirement of
1.10.  As of December 31, 2010, the Company was not in compliance with
the leverage and fixed charge ratios, and received a forbearance from the
bank.  The entire $225,000 balance was paid in January
2011.





In July
2008, the Company entered into a Promissory Note with a bank (the “note”) in
order to purchase land and a building that had been occupied by the Company
since 1998 (the total purchase price was approximately $8.1
million).  Pursuant to the note, the company borrowed $6,000,000
payable in monthly installments of principal and interest on a fully amortized
base over 30 years at an initial five-year interest rate of 7.1% and thereafter
at a variable rate equal to LIBOR plus 3.6% (6.4% as of the purchase
date).  The mortgage debt is secured by the land and
building.





In
June 2009, the Company entered into a $3,562,500 Purchase Money Promissory Note
secured by a Deed of Trust for the purchase of land and a
building.  The note bears interest at 7% fixed for ten
years.  The principal amount of the note is payable on June 12,
2019.  The note is secured by the property.





On
December 30, 2005, the Company entered into a $10 million term loan
agreement.  The term loan provides for interest at LIBOR (0.46% as of
December 31, 2010) plus 3.15%, or 3.61% on that date, and is secured by
equipment.  The term loan will be repaid in 60 equal monthly principal
payments plus interest.  In March 2006, $4 million of the term loan
was prepaid.  Monthly principal payments were subsequently reduced pro
rata.  On March 30, 2007, the Company entered into an additional $2.5
million term loan agreement.  The Loan provides for interest at 8.35%
per annum and is secured by equipment.  The loan will be repaid in 45
equal monthly installments of principal and interest.  The term loans
of $0.6 million were repaid in full in January 2011.





In
November 2010, the Company converted approximately $1 million of accounts
payable into a note secured by a lien of all the Company’s
assets.  The note is due in 48 monthly installments of $20,000 plus
interest at 3% per annum.  The total amount due under the note is
subject to a 12.5% or 6% discount if completely paid within 12 months or 18
months, respectively.





NOTE
3- PROPERTY AND EQUIPMENT




In March 2006, the Company entered into
a sale and leaseback transaction with respect to its Media Center vaulting real
estate.  The real estate was sold for approximately $14.0 million
resulting in a $1.3 million after tax gain.  Additionally, the Company
received $0.5 million from the purchaser for improvements.  In
accordance with the Accounting Standards Codification, the gain will be
amortized over the initial 15-year lease term as reduced rent.  Net
proceeds at the closing of the sale and improvement advance (approximately $13.8
million) were used to pay off the mortgage and other outstanding
debt.


8




The lease is treated as an operating
lease for financial reporting purposes.  After the initial lease term,
the Company has four five-year options to extend the lease. Minimum annual rent
payments for the initial five years of the lease are $1,111,000, increasing
annually thereafter based on the Consumer Price Index change from year to
year.





Property
and equipment consist of the following as of December 31, 2010:




Land
                    
                    $
                    3,985,000Buildings
                    
                    
                    9,247,000Machinery
      and equipment
                    
                    
                    36,670,000Leasehold
      improvements
                    
                    
                    6,843,000Computer
      equipment
                    
                    
                    7,348,000Equipment
      under capital lease
                    
                    
                    671,000Office
      equipment, CIP
                    
                    
                    1,454,000Less
      accumulated depreciation and amortization
                    
                    
                    (47,139,000
                    )Property
      and equipment, net
                    
                    $
                    19,079,000




NOTE
4- CONTINGENCIES




In July 2008, the Company was served
with a complaint filed in the Superior court of the State of California for the
County of Los Angeles by Aryana Farshad and Aryana F. Productions,
Inc.  (“Farshad”).  The complaint alleged that Point.360 and
its janitorial cleaning company failed to exercise reasonable care for the
protection and preservation of Farshad’s film footage which was
lost.  As a result of the defendants’ negligence, Farshad claimed to
have suffered damages in excess of $2 million and additional unquantified
general and special damages.  The lawsuit was settled in October 2010
for $120,000.




On
October 6, 2009, DG FastChannel, Inc. (“DGFC”) filed a claim in the United
States District Court Central District of California, alleging that the Company
violated certain provisions of agreements governing transactions related to the
August 13, 2007 sale of the Company’s advertising distribution business to
DGFC.  DGFC alleged that (i) the Company did not fulfill its
obligation to restrict a former employee from competing against DGFC subsequent
to the transaction and, therefore, DGFC did not owe the Company $412,500 related
to that portion of the transaction; (ii) the Company violated the noncompetition
agreement between DGFC and the Company by distributing advertising content after
the transaction; (iii) due to the violation of the noncompetition agreement, the
post production services agreement that required DGFC to continue to vault its
customers’ physical elements at the Company’s Media Center became null and void;
and (iv) the Company must return all of DGFC’s vaulted material to
DGFC.  DGFC also sought unspecified monetary damages.




In
September 2010, a settlement between the parties included the
following:  (1) The Company will be subject to a permanent injunction
(until August 13, 2012) from competing in the commercial spot
advertising  business (as defined), (2) the Company will deliver to
DGFC vaulted elements which will result in an annual reduction of vaulting
revenues of approximately $0.9 million, (3) the Company will not be entitled to
$412,500 (relating to the working capital reconciliation), (4) the Company will
issue 250,000 shares of common stock to DGFC and (5) the parties will enter into
full mutual releases and will dismiss their respective claims with
prejudice.  In connection with the settlement, the Company has
indemnified its Chief Executive Officer against possible losses should DGFC
exercise its right to put the stock to the related party on a specified future
date, and there is a negative difference between the stated $500,000 value of
the stock ($2.00 per share) and the market value on the date of the
put.  The put may be exercised on the six-month anniversary of the
settlement agreement. As of December 31, 2010 the Company has issued the 250,000
shares of common stock to DGFC and accrued approximately $0.2 million of
estimated legal and other costs associated with the settlement.  The
fair value of the put option recorded in other accrued expenses is $280,000 at
December 31, 2010, with $95,000 expensed as a component of other income (loss)
in the Condensed Consolidated Statement of Operations.





In November 2010, DGFC filed an ex parte application for
enforcement of the settlement agreement and related stipulated injunction
alleging that the Company violated the terms thereof and seeking an order
enforcing the settlement agreement, an order to assess civil contempt charges
and other remedies, and an order referring criminal allegations against the
Company to the U.S. Attorney’s Office.  The Company believes it has
substantially performed its obligations under the settlement agreement and
intends to defend its position.  Potential liability related to the
outcome of the ex parte
application cannot be determined at this time.  The Company has
accrued estimated legal fees associated with this action.





Fromtime to time, the
Company may become a party to other legal actions and complaints arising in the
ordinary course of business, although it is not currently involved in any such
material legal proceedings except as described above.


9


NOTE
5- INCOME TAXES





The Company reviewed its ASC 740-10
documentation for the periods through December 31, 2010 to ascertain if any
changes should be made with respect to tax positions previously taken. In
addition, the Company reviewed its income tax reporting through December 31,
2010.  Based on Company’s review of its tax positions as of December
31, 2010, no new uncertain tax positions have resulted nor has new information
become available that would change management’s judgment with respect to tax
positions previously taken.




As of December 31, 2010, the Company's
net deferred tax assets were nil.  No tax benefit was recorded during the
three  and six month periods ended December 31, 2010 because future
realizability of such benefit was not considered to be more likely than
not.  At December 31, 2010, the Company had a gross deferred tax asset of
$10.2 million, and a corresponding valuation allowance of $10.2
million.  At June 30, 2010, the Company had a gross deferred tax asset
of $7.6 million, and a corresponding valuation allowance of $7.6
million.





The Accounting Standards Codification
prescribes a recognition and measurement of a tax position taken or expected to
be taken in a tax return and provides guidance on derecognition of tax benefits,
classification on the balance sheet, interest and penalties, accounting in
interim periods, disclosure, and transition.





The Company files income tax returns in
the U.S. federal jurisdiction, and various state jurisdictions. With few
exceptions, the Company is no longer subject to U.S. federal state or local
income tax examinations by tax authorities for years before 2002. The Company
has analyzed its filing positions in all of the federal and state jurisdictions
where it is required to file income tax returns. The Company was last audited by
New York taxing authorities for the years 2002 through 2004 resulting in no
change.  The Company was previously notified by the U.S Internal
Revenue Service of its intent to audit the calendar 2005 tax
return.  The audit has since been cancelled by the IRS without change;
however, the audit could be reopened at the IRS’ discretion.





The Company was notified by the IRS in
September 2009 of its intent to audit federal tax returns for calendar year 2006
and the period from January 1 to August 13, 2007.





The Company was notified by the IRS in
November 2009 of its intent to audit the federal tax return for the fiscal ended
June 30, 2008.  The audit was subsequently withdrawn.





During fiscal 2010, the Company
received a federal tax refund of approximately $0.4 million related to refunds
due for tax year 2005.  In July 2010, the Company received a refund of
$1.5 million related to tax year 2006.





NOTE
6- STOCK OPTION PLAN, STOCK-BASED COMPENSATION





In May
2007, the Board of Directors approved the 2007 Equity Incentive Plan (the “2007
Plan”).  The 2007 Plan provides for the award of options to purchase
up to 2,000,000 shares of common stock, appreciation rights and restricted stock
awards.




Under the
2007 Plan, the stock option price per share for options granted is determined by
the Board of Directors and is based on the market price of the Company’s common
stock on the date of grant, and each option is exercisable within the period and
in the increments as determined by the Board, except that no option can be
exercised later than ten years from the grant date.  The stock options
generally vest in one to five years.




In
November 2010, the shareholders approved the 2010 Incentive Plan (the “2010
Plan”).  The 2010 Plan provides for the award of options to purchase
up to 4,000,000 shares of common stock, appreciation rights and restricted stock
and performance awards.




Under the
2010 Plan, the stock option price per share for options granted is determined by
the Board of Directors and is based on the market price of the Company’s common
stock on the date of grant, and each option is exercisable within the period and
in the increments as determined by the Board, except that no option can be
exercised later than ten years from the grant date.  The stock options
generally vest in one to five years.




The
Company measures and recognizes compensation expense for all share-based payment
awards made to employees and directors based on estimated fair
values.  We also estimate the fair value of the award that is
ultimately expected to vest to be recognized as expense over the requisite
service periods in our Condensed Consolidated Statements of
Operations.


10


We estimate the fair value of
share-based payment awards to employees and directors on the date of grant using
an option-pricing model. The value of the portion of the award that is
ultimately expected to vest is recognized as expense over the requisite service
periods in the Company’s Condensed Consolidated Statements of
Operations.  Stock-based compensation expense recognized in the
Condensed Consolidated Statements of Operations for the three and six month
periods ended December 31, 2010 included compensation expense for the
share-based payment awards based on the grant date fair value.  For
stock-based awards issued to employees and directors, stock-based compensation
is attributed to expense using the straight-line single option
method.  As stock-based compensation expense recognized in the
Condensed Consolidated Statements of Operations for the periods reported in this
Form 10-Q is based on awards expected to vest, forfeitures are also estimated at
the time of grant and revised, if necessary, in subsequent periods if actual
forfeitures differ from those estimates. For the periods being reported in this
Form 10-Q, expected forfeitures are immaterial. The Company will re-assess the
impact of forfeitures if actual forfeitures increase in future
quarters.  Stock-based compensation expense related to employee or
director stock options recognized for the three and six month periods ended
December 31, 2010 was $89,000 and $156,000, respectively.




The Company’s determination of fair
value of share-based payment awards to employees and directors on the date of
grant uses the Black-Scholes model, which is affected by the Company’s stock
price as well as assumptions regarding a number of complex and subjective
variables.  These variables include, but are not limited to, the
expected stock price volatility over the expected term of the awards, and actual
and projected employee stock options exercise behaviors. The Company estimates
expected volatility using historical data. The expected term is estimated using
the “safe harbor” provisions provided by the SEC.





During the three and six month periods
ended December 31, 2009, the Company granted stock awards of 30,000 shares at
average market prices of $1.05.  During the three and six month
periods ended December 31, 2010, the Company granted stock awards of 30,000 and
45,000 shares at average market prices of $1.15 and $1.19,
respectively.  All awards were under the 2007 Plan.  No
awards have been granted under the 2010 Plan as of December 31,
2010.





As of December 31, 2010, there were
options outstanding to acquire 1,658,125 shares at an average exercise price of
$1.56 per share.  The estimated fair value of all awards granted
during the six-month 2010 period was $29,000.  For the 2010 period,
the fair value of each option was estimated on the date of grant using the
Black-Scholes option-pricing model with the following weighted average
assumptions:





Risk-free
      interest rate
                  
                  
                  1.46
                  %Expected
      term (years)
                  
                  
                  5.0Volatility
                  
                  
                  67
                  %Expected
      annual dividends
                  
                  
                  -





The
following table summarizes the status of the 2007and 2010 Plan as of December
31, 2010:





2007 Plan
                    
                    
                    2010 Plan
                    
                    
                    TotalOptions
      originally available
                    
                    
                    2,000,000
                    
                    
                    
                    4,000,000
                    
                    
                    
                    6,000,000Stock
      options outstanding
                    
                    
                    1,658,125
                    
                    
                    
                    -
                    
                    
                    
                    1,658,125Options
      available for grant
                    
                    
                    329,875
                    
                    
                    
                    4,000,000
                    
                    
                    
                    4,329,875





Transactions involving stock options
are summarized as follows:


Number
                    of Shares
                  
                  
                  Weighted
                    Average
                    Exercise Price
                  
                  
                  Weighted
                    Average Grant
                    Date
                    Fair ValueBalance
      at June 30, 2010
                  
                  
                  1,631,075
                  
                  
                  $
                  1.58
                  
                  
                  $
                  0.71Granted
                  
                  
                  15,000
                  
                  
                  
                  1.27
                  
                  
                  
                  0.66Exercised
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Cancelled
                  
                  
                  (12,825
                  )
                  
                  
                  2.06
                  
                  
                  
                  1.06Balance
      at September 30, 2010
                  
                  
                  1,633,250
                  
                  
                  $
                  1.56
                  
                  
                  $
                  0.71Granted
                  
                  
                  30,000
                  
                  
                  
                  1.15
                  
                  
                  
                  0.65Exercised
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Cancelled
                  
                  
                  (5,125
                  )
                  
                  
                  1.54
                  
                  
                  
                  0.68Balance
      at December 31, 2010
                  
                  
                  1,658,125
                  
                  
                  $
                  1.56
                  
                  
                  $
                  0.71




As of December 31, 2010, the total
compensation costs related to non-vested awards yet to be expensed was
approximately $0.5 million to be amortized over the next four
years.




The weighted average exercise prices
for options granted and exercisable and the weighted average remaining
contractual life for options outstanding as of December 31, 2010 were as
follows:


11


Number of
                        Shares
                      
                      
                      Weighted Average
                        Exercise Price
                      
                      
                      Weighted Average
                        Remaining
                        Contractual Life
                        (Years)
                      
                      
                      Intrinsic
                        ValueAs of December
      31,  2010Employees
      – Outstanding
                      
                      
                      1,453,125
                      
                      
                      $
                      1.58
                      
                      
                      
                      2.73
                      
                      
                      $
                      -Employees
      – Expected to Vest
                      
                      
                      1,364,233
                      
                      
                      $
                      1.58
                      
                      
                      
                      2.70
                      
                      
                      $
                      -Employees
      – Exercisable
                      
                      
                      497,813
                      
                      
                      $
                      1.72
                      
                      
                      
                      2.24
                      
                      
                      $
                      -Non-Employees
      – Outstanding
                      
                      
                      205,000
                      
                      
                      $
                      1.49
                      
                      
                      
                      3.08
                      
                      
                      $
                      -Non-Employees
      – Vested
                      
                      
                      140,000
                      
                      
                      $
                      1.40
                      
                      
                      
                      3.25
                      
                      
                      $
                      -Non-Employees
      – Exercisable
                      
                      
                      140,000
                      
                      
                      $
                      1.40
                      
                      
                      
                      3.25
                      
                      
                      $
                      -




The aggregate intrinsic value in the
table above is the sum of the amounts by which the quoted market price of our
common stock exceeded the exercise price of the options at December 31, 2010,
for those options for which the quoted market price was in excess of the
exercise price.




Additional information with respect to
outstanding options as of December 31, 2010 is as follows (shares in
thousands):





Options Outstanding
                          
                          Options ExercisableOptions Exercise
                            Price Range
                          
                          
                          Number of
                            Shares
                          
                          Weighted
                            Average
                            Remaining
                            Contractual Life
                          
                          Weighted
                            Average
                            Exercise Price
                          
                          
                          Number of
                            Shares
                          
                          
                          Weighted
                            Average Exercise
                            Price$
                          1.79
                          
                          
                          
                          976
                          
                          2.1
      Years
                          
                          $
                          1.79
                          
                          
                          
                          488
                          
                          
                          $
                          1.79$
                          1.37
                          
                          
                          
                          30
                          
                          2.9
      Years
                          
                          $
                          1.37
                          
                          
                          
                          30
                          
                          
                          $
                          1.37$
                          1.29
                          
                          
                          
                          313
                          
                          4.1
      Years
                          
                          $
                          1.29
                          
                          
                          
                          -
                          
                          
                          $
                          1.29$
                          1.27
                          
                          
                          
                          15
                          
                          4.7
      Years
                          
                          $
                          1.27
                          
                          
                          
                          -
                          
                          
                          $
                          1.27$
                          1.20
                          
                          
                          
                          264
                          
                          3.1
      Years
                          
                          $
                          1.20
                          
                          
                          
                          60
                          
                          
                          $
                          1.20$
                          1.15
                          
                          
                          
                          30
                          
                          4.9
      Years
                          
                          $
                          1.15
                          
                          
                          
                          30
                          
                          
                          $
                          1.15$
                          1.05
                          
                          
                          
                          30
                          
                          3.9
      Years
                          
                          $
                          1.05
                          
                          
                          
                          30
                          
                          
                          $
                          1.05




In addition to the above 2007 Plan, the
Company issued 10,000 shares of restricted stock during fiscal year ended June
30, 2010 with a weighted average fair value of $0.58 per share.





We use the detailed method provided in
ASC 718 for calculating the beginning balance of the additional paid-in capital
pool (APIC pool) related to the tax effects of employee stock-based
compensation, and to determine the subsequent impact on the APIC pool and
Consolidated Statements of Cash Flows of the tax effects of employee stock-based
compensation awards that are outstanding upon adoption of ASC 718.





NOTE
7- STOCK RIGHTS PLAN





In July 2007, the Company implemented a
stock rights program.  Pursuant to the program, stockholders of record
on August 7, 2007, received a dividend of one right to purchase for $10 one
one-hundredth of a share of a newly created Series A Junior Participating
Preferred Stock.  The rights are attached to the Company’s Common
Stock and will also become attached to shares issued subsequent to August 7,
2007.  The rights will not be traded separately and will not become
exercisable until the occurrence of a triggering event, defined as an
accumulation by a single person or group of 20% or more of the Company’s Common
Stock.  The rights will expire on August 6, 2017 and are redeemable at
$0.0001 per right.





After a triggering event, the rights
will detach from the Common Stock.  If the Company is then merged
into, or is acquired by, another corporation, the Company has the opportunity to
either (i) redeem the rights or (ii) permit the rights holder to receive in the
merger stock of the Company or the acquiring company equal to two times the
exercise price of the right (i.e., $20).  In the latter instance, the
rights attached to the acquirer’s stock become null and void.  The
effect of the rights program is to make a potential acquisition of the Company
more expensive for the acquirer if, in the opinion of the Company’s Board of
Directors, the offer is inadequate.


12




No triggering events occurred in the
six months ended December 31, 2010.





NOTE
8- SHAREHOLDER’S EQUITY





The following table analyzes the
components of shareholders’ equity from June 30, 2010 to December 31, 2010 (in
thousands):




Common
                    Stock
                  
                  
                  Paid-in
                    Capital
                  
                  
                  Retained
                    (Deficit)
                  
                  
                  Shareholders’
                    EquityBalance,
      June 30, 2010
                  
                  
                  21,542
                  
                  
                  $
                  9,808
                  
                  
                  $
                  (19,520
                  )
                  
                  $
                  11,830Stock-based
      compensation expense
                  
                  
                  -
                  
                  
                  
                  67
                  
                  
                  
                  -
                  
                  
                  
                  67Net
      income (loss)
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (2,014
                  )
                  
                  
                  (2,014
                  )Stock
      issuance
                  
                  
                  500
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  500Balance,
      September 30, 2010
                  
                  
                  22,042
                  
                  
                  
                  9,875
                  
                  
                  
                  (21,534
                  )
                  
                  
                  10,383Stock
      issuance reclassification
                  
                  
                  (185
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (185
                  )Stock-based
      compensation expense
                  
                  
                  
                  
                  
                  
                  89
                  
                  
                  
                  
                  
                  
                  
                  89Net
      income (loss)
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (589
                  )
                  
                  
                  (589
                  )Balance,
      December 31, 2010
                  
                  
                  21,857
                  
                  
                  $
                  9,964
                  
                  
                  $
                  (22,123
                  )
                  
                  $
                  9,698





NOTE
9- STOCK REPURCHASE PLAN





In February 2008, the Company’s Board
of Directors authorized a stock repurchase program.  Under the stock
repurchase program, the Company may purchase outstanding shares of its common
stock on the open market at such times and prices determined in the sole
discretion of management.   No shares were acquired pursuant to
the repurchase program during the three and six month periods ended December 31,
2010 or 2009.





NOTE
10- SEGMENT INFORMATION





In its operation of the business,
management reviews certain financial information, including segmented internal
profit and loss statements prepared on a basis consistent with U.S. generally
accepted accounting principles.  Our two segments are Point.360 and
Movie>Q.  The two segments discussed in this analysis are presented
in the way we internally managed and monitored performance for the six months
ended December 31, 2010 and 2009.  Allocations for internal resources
were made for the six months ended December 31, 2010 and 2009.  The
Movie>Q segment tracks certain assets separately, and all others are recorded
in the Point.360 segment for internal reporting presentations.  Cash
was not segregated between the two segments but retained in the Point.360
segment.





The types
of services provided by each segment are summarized below:





Point.360 -The Point.360
segment provides high definition and standard definition digital mastering, data
conversion, video and film asset management and sophisticated computer graphics
services to owners, producers and distributors of entertainment and advertising
content.  The Company provides the services necessary to edit, master,
reformat, convert, archive and ultimately distribute its clients’ film and video
content, including television programming feature films and movie trailers. The
Company’s interconnected facilities provide service coverage to all major U.S.
media centers. Clients include major motion picture studios and independent
producers.





Movie>Q -The Movie>Q
segment rents and sells DVDs and video games directly to consumers though its
retail stores.  The stores employ an automated inventory management
(“AIM”) system in a 1,200-1,600 square foot facility.  By saving space
and personnel costs which caused the big box stores to be uncompetitive with
lower priced online and vending machine rental alternatives, Movie>Q can
offer up to 10,000 unit selections to a customer at competitive rental
rates.  Movie>Q provides online reservations, an in-store
destination experience, first run movie and game titles and a large unit
selection.




Segment
revenues, operating loss and total assets were as follows (in
thousands):


13


Revenue
                    
                    Three Months
                      Ended
                      December 31,
                    
                    
                    Six Months
                      Ended
                      December 31,2010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009Point.360
                    
                    $
                    8,932
                    
                    
                    $
                    10,254
                    
                    
                    $
                    17,069
                    
                    
                    $
                    19,673Movie>Q
                    
                    
                    138
                    
                    
                    
                    -
                    
                    
                    
                    273
                    
                    
                    
                    -Consolidated
      revenue
                    
                    $
                    9,070
                    
                    
                    $
                    10,254
                    
                    
                    $
                    17,342
                    
                    
                    $
                    19,673





Operating loss(1)
                    
                    Three Months
                      Ended
                      December 31,
                    
                    
                    Six Months
                      Ended
                      December 31,2010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009Point.360
                    
                    $
                    (158
                    )
                    
                    $
                    (713
                    )
                    
                    $
                    (1,689
                    )
                    
                    $
                    (2,551
                    )Movie>Q
                    
                    
                    (241
                    )
                    
                    
                    -
                    
                    
                    
                    (759
                    )
                    
                    
                    -Operating
      loss
                    
                    $
                    (399
                    )
                    
                    $
                    (713
                    )
                    
                    $
                    (2,448
                    )
                    
                    $
                    (2,551
                    )





Total Assets
                    
                    June 30,
                    
                    
                    December 31,2010
                    
                    
                    2010Point.360
                    
                    $
                    28,413
                    
                    
                    $
                    25,400Movie>Q
                    
                    
                    2,731
                    
                    
                    
                    2,946Consolidated
      assets
                    
                    $
                    31,144
                    
                    
                    $
                    28,346





(1)Includes R&D expenses
related to the Movie>Q project





NOTE
11- SUBSEQUENT EVENT




In January 2011, the Company entered
into a credit agreement which provides $1 million of credit based on 85% of
acceptable accounts receivable, as defined.  The loan and security
agreement provides for interest at prime rate plus 2% (currently 5.25%), with an
interest floor of 5.25%.  In addition, the Company will pay a monthly
“maintenance” fee of 0.6% of the outstanding daily loan balance (an equivalent
annual fee of 7.2%), and an annual commitment fee of 1% of the amount of the
credit facility.  Amounts outstanding under the agreement will be
secured by all of the Company’s assets other than real estate.  The
Company will seek to increase the credit limit to $3 million.





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





Except
for the historical information contained herein, certain statements in this
quarterly report are "forward-looking statements" as defined in the Private
Securities Litigation Reform Act of 1995, which involve certain risks and
uncertainties, which could cause actual results to differ materially from those
discussed herein, including but not limited to competition, customer and
industry concentration, depending on technological developments, risks related
to expansion, dependence on key personnel, fluctuating results and seasonality
and control by management. See the relevant portions of  the Company's
documents filed with the Securities and Exchange Commission, including the Risk
Factors section of the Company’s most recent annual report on Form 10-K, and
Risk Factors in Item 1A of Part II of this Form 10-Q, for a further discussion
of these and other risks and uncertainties applicable to the Company's
business.




Overview




Point.360
is one of the largest providers of video and film asset management services to
owners, producers and distributors of entertainment content.  We provide
the services necessary to edit, master, reformat and archive our clients’ film
and video content, including television programming, feature films and movie
trailers using electronic and physical means. Clients include major motion
picture studios and independent producers.  The Company also rents and
sells DVDs and video games directly to consumers through its Movie>Q retail
stores.


14





We
operate in a highly competitive environment in which customers desire a broad
range of services at a reasonable price.  There are many competitors
offering some or all of the services provided by us.  Additionally, some of
our customers are large studios, which also have in-house capabilities that may
influence the amount of work outsourced to companies like Point.360. We attract
and retain customers by maintaining a high service level at reasonable
prices.




The
market for our services is primarily dependent on our customers’ desire and
ability to monetize their entertainment content.  The major studios
derive revenues from re-releases and/or syndication of motion pictures and
television content.  While the size of this market is not
quantifiable, we believe studios will continue to repurpose library content to
augment uncertain revenues from new releases.  The current uncertain
economic environment has negatively impacted the ability and willingness of
independent producers to create new content.




The
demand for entertainment content should continue to expand through web-based
applications.  We believe long and short form content will be sought
by users of personal computers, hand-held devices and home entertainment
technology.  Additionally, changing formats from standard definition,
to high definition, to Blu-Ray and perhaps to 3D will continue to give us the
opportunity to provide new services with respect to library
content.  We also believe that a potentially large consumer market
exists for the rental of DVDs and video games, which market is being abandoned
by “big box” DVD rental stores.




To meet
these needs, we must be prepared to invest in technology and equipment, and
attract the talent needed to serve our client needs.  Labor, facility
and depreciation expenses constitute approximately 87% of our
revenues.  Our goals include maximizing facility and labor usage, and
maintaining sufficient cash flow for capital expenditures and acquisitions of
complementary businesses to enhance our service offerings.




We
continue to look for opportunities to solidify and expand our
businesses.  During the fiscal year ending June 30, 2010 and the six
months ended December 31, 2010, we have completed the following:




·
            We
      consolidated our former Hollywood and Eden FX facilities into another
      Company location.




·
            We
      purchased assets and intellectual property in conjunction with a research
      and development project to create three “proof-of-concept” Movie>Q
      stores.




·
            We
      developed the Movie>Q automated inventory
  system.




·
            We
      closed down our New York facility due to continuing economic uncertainty
      in that market.




We have
an opportunity to expand our business by establishing closer relationships with
our customers through excellent service at a competitive price and adding to our
service offering.  Our success is also dependent on attracting and
maintaining employees capable of maintaining such relationships.  Also,
growth can be achieved by acquiring similar businesses (for example, the
acquisitions of IVC in July 2004, Eden FX in March 2007 and others) that can
increase revenues by adding new customers, or expanding current services to
existing customers. Additionally, we are looking to capitalize on the Movie>Q
retail opportunity.




Our
business generally involves the immediate servicing needs of our
customers.  Most orders are fulfilled within several days, with occasional
larger orders spanning weeks or months.  At any particular time, we have
little firm backlog.




We
believe that our interconnected facilities provide the ability to better service
customers than single-location competitors.  We will look to expand both
our service offering and geographical presence through acquisition of other
businesses or opening additional facilities.





Three
Months Ended December 31, 2010 Compared to Three Months Ended December 31,
2009





Revenues.  Revenues
were $9.1 million for the three months ended December 31, 2010, compared to
$10.3 million for the three months ended December 31,
2009.  Approximately $1.0 million of the decline in revenues in the
current quarter was due to the move of the operations of one of our Hollywood
facilities (“Highland”) to another Company location.   We expect
to sustain the current revenue levels at the combined West Los Angeles
location.  Content storage revenues for the current quarter were
reduced by $0.2 million due to the settlement of a lawsuit, which reduction will
be ongoing.   As of June 30, 2010, we decided to close down our
New York facility, which generated $0.3 million of revenue in the prior year
quarter.  Although physical moves adversely affected revenues, we will
continue to search for operating efficiencies to increase income.  We
are continuing to invest in high definition and digital capabilities where
demand is expected to grow.   We believe our high definition and
digital service platform will attract additional business in the
future.


15


Cost of Services. Costs of
services consist principally of wages and benefits, facility costs and
depreciation of physical assets.  During the quarter ended December
31, 2010, total costs of services were 67% of sales compared to 68% in the prior
year.   Our combined West Los Angeles operational costs were
reduced by $0.6 million due to lower sales.  Additional cost
reductions of $0.5 million were realized in the current quarter with the closure
of our New York facility in June 2010.  Other costs remained
consistent with the prior year period due to the fixed nature of our service
infrastructure.





Gross Profit.  In
the three months ended December 31, 2010, gross margin was 33% of sales,
compared to 32% for the same period last year. The increase in gross profit
percentage is due to the factors cited above.  From time to time, we
will increase staff capabilities to satisfy potential customer demand. If the
expected demand does not materialize, we will adjust personnel
levels.  We expect gross margins to fluctuate in the future as the
sales mix changes.




Selling, General and Administrative
Expense.SG&A expense was $3.3 million (37% of sales) in
the three months ended December 31, 2010 as compared to $3.7 million (36% of
sales) in the same period last year.  SG&A personnel costs
decreased $0.4 million in the current period when compared to last year’s
period.




Research and Development
Expense.During the fiscal year ended June 30, 2010, the
Company undertook a research and development project to evaluate, develop and
commercialize “automated” stores to rent and sell digital video discs
(DVDs).  The Movie>Q stores will contain up to 10,000 DVDs for rent
or sale via a software-controlled automated inventory management
system  contained in 1,200 to 1,600 square feet of retail space for
each store.  As of December 31, 2010, three Movie>Q stores were
completed.  We are evaluating performance to further validate our
cost/revenue assumptions.Expenses associated with
R&D activities were $0.1 million for the quarter ended December 31,
2010.




Operating (Loss).Operating
losses were $0.4 million in the fiscal 2011 period compared to $0.7 million in
the fiscal 2010 period.




Interest
Expense.   Net interest expense was $0.2 million in both
the 2011 and 2010 periods.




Other Income. Other income
represents principally sublease income and gain on sale of fixed assets, offset
by the change in fair value relating to the put option agreement.




Net Loss.Net losses were
$0.6 million and $0.8 million in the fiscal 2011 and 2010 periods,
respectively.




Six
Months Ended December 31, 2010 Compared to Six Months Ended December 31,
2009





Revenues.  Revenues
were $17.3 million for the six months ended December 31, 2010, compared to $19.7
million for the six months ended December 31, 2009.  Approximately
$2.0 million of the decline in revenues in the current quarter were due to the
move of the operations of one of our Hollywood facilities (“Highland”) to
another Company location.   We expect to sustain recent revenue
levels at the combined West Los Angeles facility.  Content storage
revenues for the current period were reduced by $0.5 million due to the
settlement of a lawsuit, which reduction will be ongoing.   As of
June 30, 2010, we decided to close down our New York facility, which generated
$0.5 million of revenue in the prior year period.  Although physical
moves adversely affected revenues, we will continue to search for operating
efficiencies to increase income.  We are continuing to invest in high
definition and digital capabilities where demand is expected to
grow.   Our Point.360 Digital Film Lab (formerly IVC) revenues
increased $0.5 million over the prior year period.  We believe our
high definition and digital service platform will attract additional business in
the future.





Cost of Services. Costs of
services consist principally of wages and benefits, facility costs and
depreciation of physical assets.  During the six months ended December
31, 2010, total costs of services were 72% of sales compared to 73% in the prior
year.   Our combined West Los Angeles operational costs were
reduced by $1.1 million due to lower sales.  Additional cost
reductions of $0.9 million were realized in the current period with the closure
of our New York facility in June 2010.  Other costs remained
consistent with the prior year period due to the fixed nature of our service
infrastructure.





Gross Profit.  In
the six months ended December 31, 2010, gross margin was 28% of sales, compared
to 27% for the same period last year. The increase in gross profit percentage is
due to the factors cited above.  From time to time, we will increase
staff capabilities to satisfy potential customer demand. If the expected demand
does not materialize, we will adjust personnel levels.  We expect
gross margins to fluctuate in the future as the sales mix changes.





Selling, General and Administrative
Expense.SG&A expense was $7.0 million (40% of sales) in
the six months ended December 31, 2010 as compared to $7.5 million (38% of
sales) in the same period last year.  SG&A personnel costs
decreased $0.4 million in the current period when compared to last year’s
period.


16


Research and Development
Expense.During the fiscal year ended June 30, 2010, the
Company undertook a research and development project to evaluate, develop and
commercialize “automated” stores to rent and sell digital video discs
(DVDs).  The Movie>Q stores will contain up to 10,000 DVDs for rent
or sale via a software-controlled automated inventory management
system  contained in 1,200 to 1,600 square feet of retail space for
each store.  As of December 31, 2010, three Movie>Q stores were
completed.  We are evaluating store performance to further test and
validate our cost/revenue assumptions.Expenses associated with
R&D activities were $0.3 million and $0.4 million for the periods ended
December 31, 2010 and 2009 respectively.




Operating (Loss).Operating
losses were $2.4 million in the fiscal 2011 period compared to $2.6 million in
the fiscal 2010 period.




Interest
Expense.   Net interest expense was $0.4 million in both
the 2011 and 2010 periods.




Other Income. Other income
represents principally sublease income and gain on sale of fixed assets, offset
by the change in fair value relating to the put option agreement.




Net Loss.Net losses were
$2.6 million and $2.7 million in the fiscal 2011 and 2010 periods.




LIQUIDITY
AND CAPITAL RESOURCES




This
discussion should be read in conjunction with the notes to the financial
statements and the corresponding information more fully described elsewhere in
this Form 10-Q.




On
December 30, 2005, the Company entered into a $10 million term loan agreement.
The term loan provides for interest at LIBOR (0.46% at December 31, 2010) plus
3.15% (3.61% on that date) and is secured by the Company’s equipment. The term
loan will be repaid in 60 equal principal payments plus interest.  On
March 30, 2007, the Company entered into an additional $2.5 million term loan
agreement. The loan provides for interest at 8.35% per annum and is secured by
the Company’s equipment. The loan is being repaid in 45 equal monthly
installments of principal and interest.  Both loans were repaid in
full in January 2011.




In March
2006, the Company entered into a sale and leaseback transaction with respect to
its Media Center vaulting real estate. The real estate was sold for $13,946,000
resulting in a $1.3 million after tax gain. Additionally, Old Point.360 received
$500,000 from the purchaser for improvements.  In accordance with the
Accounting Standards Codification (ASC) 840 “Accounting for Leases”, the gain
and the improvement allowance will be amortized over the initial 15-year lease
term as reduced rent. The mortgage debt is secured by the land and
building.




In July
2008, the Company entered into a Promissory Note with a bank (the “Note”) in
order to purchase land and a building that has been occupied by the Company
since 1998 (the total purchase price was approximately $8.1
million).  Pursuant to the Note, the Company borrowed $6,000,000
payable in monthly installments of principal and interest on a fully amortized
basis over 30 years at an initial five-year interest rate of 7.1% and thereafter
at a variable rate equal to LIBOR plus 3.6% (6.4% as of the purchase date). The
mortgage debt is secured by the land and building.




In June
2009, the Company entered into a $3,562,500 million Purchase Money Promissory
Note secured by a Deed of Trust for the purchase of land and a building (“Vine
Property”).  The note bears interest at 7% fixed for ten
years.  The principal amount of the note is payable on June 12,
2019.  The note is secured by the property.




In
November 2010, the Company converted approximately $1 million of accounts
payable into a note secured by a lien of all the Company’s
assets.  The note is due in 48 monthly installments of $20,000 plus
interest at 3% per annum.  The total amount due under the note is
subject to a 12.5% or 6% discount if totally paid within 12 months or 18 months,
respectively.




Monthly
and annual principal and interest payments due under the term debt and mortgages
are approximately $264,000 and $3.1 million, respectively, assuming no change in
interest rates.





In August
2009 the Company entered into a credit agreement which provides up to $5 million
of revolving credit based on 80% of acceptable accounts receivables, as
defined.  The 15 month agreement provides for interest of either (1)
prime (3.25% at December 31, 2010)  minus .5% - plus .5% or (2) LIBOR
plus 2.0% - 3.0% depending on the level of the Company’s ratio of outstanding
debt to fixed charges (as defined), or 3.75% or 3.46%, respectively, on December
31,  2010.  The facility is secured by all of the Company’s
accounts receivable and inventory. As of December 31, 2010, the Company owed
$225,000 under the credit agreement.


17


Our bank
revolving credit agreement requires us to maintain a minimum “leverage ratio”
and “fixed charge coverage ratio.” The leverage ratio compares tangible assets
to total liabilities (excluding the deferred real estate gain).  Our
fixed charge coverage ratio compares, on a rolling twelve-month basis, (i)
EBITDA plus rent expense and non-cash charges less income tax payments, to (ii)
interest expense plus rent expense, the current portion of long term debt and
maintenance capital expenditures.  As of December 31, 2010, the
leverage ratio was 1.68 compared to a minimum requirement of 1.75, and the fixed
charge coverage ratio was 0.25 as compared to a minimum requirement of
1.10.  As of December 31, 2010, the Company was not in compliance with
the ratios and received a forbearance from the bank.  The forbearance
period extends to January 31, 2011, during which time the amount available under
the credit agreement will be limited to the outstanding $225,000.  The
entire balance was paid in January 2011.





In January 2011, the Company entered
into a credit agreement which provides $1 million of credit based on 85% of
acceptable accounts receivable, as defined.  The loan and security
agreement provides for interest at prime rate plus 2% (currently 5.25%), with an
interest floor of 5.25%.  In addition, the Company will pay a monthly
“maintenance” fee of 0.6% of the outstanding daily loan balance (an equivalent
annual fee of 7.2%), and an annual commitment fee of 1% of the amount of the
credit facility.  Amounts outstanding under the agreement will be
secured by all of the Company’s assets other than real estate.  The
Company will seek to increase the credit limit to $3 million.




The
following table summarizes the December 31, 2010 amounts outstanding under our
revolving line of credit, and term (including capital lease obligations) and
mortgage loans:




Revolving
      credit
                            
                            $
                            225,000Current
      portion of term loans, capital leases  and
    mortgages
                            
                            
                            670,000Long-term
      portion of term loans, capital leases  and
    mortgages
                            
                            
                            10,305,000Total
                            
                            $
                            11,200,000




The
Company’s cash balance decreased from $249,000 on July 1, 2010 to $0 on December
31, 2010, due to the following:




Balance
      July 1, 2010
                  
                  $
                  249,000Capital
      expenditures for equipment
                  
                  
                  (639,000
                  )Debt
      principal and interest payments
                  
                  
                  (1,278,000
                  )Income
      tax refund (including interest)
                  
                  
                  1,553,000Research
      and development costs
                  
                  
                  (334,000
                  )Changes
      in other assets and liabilities
                  
                  
                  449,000Balance
      December 31, 2010
                  
                  $
                  -




Cash
generated by operating activities is directly dependent upon sales levels and
gross margins achieved. We generally receive payments from customers in 60-120
days after services are performed. The larger payroll and facilities components
of our cost structure must be paid currently.  Payment terms of other
liabilities vary by vendor and type.   Fluctuations in sales
levels will generally affect cash flow negatively or positively in early periods
of growth or contraction, respectively, because of operating cash
receipt/payment timing.  Other investing and financing cash flows also
affect cash availability.





In the
first six months of fiscal 2011, the underlying drivers of operating cash flows
(sales, receivable collections, the timing of vendor payments, facility costs
and employment levels) have been consistent.  Sales outstanding in
accounts receivable have increased from approximately 69 days to 76 days within
the last 12 months, indicating major studios may delay payments in response to
the general economic slowdown.  However, we do not expect days sales
outstanding to materially fluctuate in the future.





As of
December 31, 2010, our facility costs consisted of building rent, maintenance
and communication expenses.  In July 2008, rents were reduced by the
purchase of our Hollywood Way facility in Burbank, CA, eliminating approximately
$625,000 of annual rent expense.  The real estate purchase involved a
down payment of $2.1 million and $6 million of mortgage debt.  The
mortgage payments are approximately $489,000 per year.


18


In March
2009, the lease on one of our facilities in Hollywood, CA (“Highland”) expired
and the Company became a holdover tenant.  The landlord issued a
Notice to Quit which required us to move out of the facility.  The
Highland operations have been housed at another Company facility.  Our
Eden FX facility was moved to our West Los Angeles location in September
2010.  No further rent was due on the closed New York facility as of
December 31, 2010.





The
Company purchased the Vine Property in June 2009.  The purchase price
of the Vine Property was $4.75 million, $1.2 million of which was paid in cash
with the balance being financed by the seller over ten years, interest only at
7% for the entire term, with the principal amount being due at the end of the
term.  Building renovations will cost about $1.5
million.  Renovations have been postponed for the foreseeable
future.





The
mortgage payments are approximately $738,000 per year.  We believe our
current cash position and a difficult economy may provide us with the
opportunity to invest in facility assets that will not only help fix our
operating costs, but give us the potential to own appreciating real estate
assets.  We will continue to evaluate opportunities to reduce facility
costs.





The
following table summarizes contractual obligations as of December 31, 2010 due
in the future:





Payment due by PeriodContractual Obligations
                
                Total
                
                
                Less than 1 Year
                
                
                Years
                  2 and 3
                
                
                Years
                  4 and 5
                
                
                ThereafterLong
      Term Debt  Principal Obligations
                
                $
                10,720,000
                
                
                $
                687,000
                
                
                $
                608,000
                
                
                $
                431,000
                
                
                $
                8,994,000Long
      Term Debt Interest Obligations (1)
                
                
                9,076,000
                
                
                
                694,000
                
                
                
                1,341,000
                
                
                
                1,220,000
                
                
                
                5,821,000Capital
      Lease Obligations
                
                
                481,000
                
                
                
                209,000
                
                
                
                272,000
                
                
                
                -
                
                
                
                -Capital
      Lease Interest Obligations
                
                
                47,000
                
                
                
                31,000
                
                
                
                16,000
                
                
                
                -
                
                
                
                -Operating
      Lease Obligations
                
                
                17,048,000
                
                
                
                2,652,000
                
                
                
                3,396,000
                
                
                
                3,134,000
                
                
                
                7,866,000Total
                
                $
                37,372,000
                
                
                $
                4,273,000
                
                
                $
                5,633,000
                
                
                $
                4,785,000
                
                
                $
                22,681,000




(1)
Interest on variable rate debt has been computed using the rate on the latest
balance sheet date.





As described in the Notes to
Consolidated Financial Statements in this Form 10-Q, the Company began a
research and development project in Fiscal 2010 to create “proof of concept”
stores to distribute digital video discs (DVDs) to consumers.  The
Company hopes to capture a portion of the DVD rental market being vacated by the
closure of many larger distribution vendors (e.g., Blockbuster and Hollywood
Video) locations.  The Company has initially issued stock (valued at
$500,000) and cash for assets and intellectual property, and has spent $3.7
million in Fiscal 2010 and $1.0 million in Fiscal 2011 to test the
concept.  We expect to spend up to an additional $0.5 million in
Fiscal 2011 to finalize the proof-of-concept.




In September 2010, the Company entered
into a settlement agreement with respect to a lawsuit (see Note 4 of Notes to
Condensed Consolidated Financial Statements (Unaudited) in this Form
10-Q).  As of December 31, 2010, the Company has recorded a $280,000
liability for a potential cash payment pursuant to a put agreement associated
with the settlement, which payment will be due on March 21, 2011.  The
payment amount will be adjusted based on the market value of the Company’s
common stock on that date.  The potential obligation may be satisfied
by a cash payment or issuance of additional shares of common stock at the option
of the holder of the put option.




During the past year, the Company has
generated sufficient cash to meet operating, capital expenditure and debt
service needs and most of its other obligations.  The Company also
received in July 2010, a refund of $1.5 million in federal income taxes for the
tax year 2006.  When preparing estimates of future cash flows, we
consider historical performance, technological changes, market factors, industry
trends and other criteria.  In our opinion, the Company will continue
to be able to fund its needs for the foreseeable future.




We will
continue to consider the acquisition of businesses which compliment our current
operations and possible real estate transactions.  Consummation of any
acquisition, real estate or other expansion transaction by the Company may be
subject to the Company securing additional financing, perhaps at a cost higher
than our existing term loans.  In the current economic climate,
additional financing may not be available.  Currently, we do not have
cash availability under a bank line of credit but believe similar financing is
available.   Future earnings and cash flow may be negatively
impacted to the extent that any acquired entities do not generate sufficient
earnings and cash flow to offset the increased financing costs.


19


CRITICAL
ACCOUNTING POLICIES AND ESTIMATES




Our
discussion and analysis of our financial condition and results of operations are
based upon our consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States of
America. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosure of contingent assets and
liabilities.  On an on-going basis, we evaluate our estimates and
judgments, including those related to allowance for doubtful accounts, valuation
of long-lived assets, and accounting for income taxes.  We base our
estimates on historical experience and on various other assumptions that we
believe to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results may differ from
these estimates under different assumptions and conditions. We believe the
following critical accounting policies affect our more significant judgments and
estimates used in the preparation of our consolidated financial
statements.




Critical
accounting policies are those that are important to the portrayal of the
Company’s financial condition and results, and which require management to make
difficult, subjective and/or complex judgments. Critical accounting policies
cover accounting matters that are inherently uncertain because the future
resolution of such matters is unknown.  We have made critical
estimates in the following areas:




Revenues.We
perform a multitude of services for our clients, including film-to-tape
transfer, video and audio editing, standards conversions, adding special
effects, duplication, distribution, etc. A customer orders one or more of these
services with respect to an element (movie, trailer, electronic press kit,
etc.). The sum total of services performed on a particular element (a “package”)
becomes the deliverable (i.e., the customer will pay for the services ordered in
total when the entire job is completed). Occasionally, a major studio will
request that package services be performed on multiple elements.  Each
element creates a separate revenue stream which is recognized only when all
requested services have been performed on that element.  At the end of
an accounting period, revenue is accrued for un-invoiced but shipped
work.





Certain
jobs specify that many discrete tasks must be performed which require up to four
months to complete.  In such cases, we use the proportional
performance method for recognizing revenue.  Under the proportional
performance method, revenue is recognized based on the value of each stand-alone
service completed.




In some instances, a client will
request that we store (or “vault”) an element for a period ranging from a day to
indefinitely.  The Company attempts to bill customers a nominal amount
for storage, but some customers, especially major movie studios, will not pay
for this service.  In the latter instance, storage is an accommodation
to foster additional business with respect to the related element.  It
is impossible to estimate (i) the length of time we may house the element, or
(ii) the amount of additional services we may be called upon to perform on an
element.   Because these variables are not reasonably estimable
and revenues from vaulting are not material, we do not treat vaulting as a
separate deliverable in those instances in which the customer does not
pay.





The Company records all revenues when
all of the following criteria are met: (i) there is persuasive evidence that an
arrangement exists; (ii) delivery has occurred or the services have been
rendered; (iii) the Company’s price to the customer is fixed or determinable;
and (iv) collectability is reasonably assured.  Additionally, in
instances where package services are performed on multiple elements or where the
proportional performance method is applied, revenue is recognized based on the
value of each stand-alone service completed.





Allowance for doubtful
accounts.   We are required to make judgments, based on
historical experience and future expectations, as to the collectability of
accounts receivable.  The allowances for doubtful accounts and sales
returns represent allowances for customer trade accounts receivable that are
estimated to be partially or entirely uncollectible.  These allowances
are used to reduce gross trade receivables to their net realizable value. The
Company records these allowances as a charge to selling, general and
administrative expenses based on estimates related to the following factors: (i)
customer specific allowance; (ii) amounts based upon an aging schedule and (iii)
an estimated amount, based on the Company’s historical experience, for issues
not yet identified.




Valuation of long-lived and
intangible assets.   Long-lived assets, consisting
primarily of property, plant and equipment and intangibles, comprise a
significant portion of the Company’s total assets. Long-lived assets, including
goodwill are reviewed for impairment whenever events or changes in circumstances
have indicated that their carrying amounts may not be
recoverable.  Recoverability of assets is measured by comparing the
carrying amount of an asset to its fair value in a current transaction between
willing parties, other than in a forced liquidation sale.




Factors
we consider important which could trigger an impairment review include the
following:




·
            Significant
      underperformance relative to expected historical or projected future
      operating results;




·
            Significant
      changes in the manner of our use of the acquired assets or the strategy of
      our overall business;




·
            Significant
      negative industry or economic
trends;




·
            Significant
      decline in our stock price for a sustained period;
  and


20


·
            Our
      market capitalization relative to net book
  value.




When we determine that the carrying
value of  intangibles, long-lived assets and related goodwill and
enterprise level goodwill may not be recoverable based upon the existence of one
or more of the above indicators of impairment, we measure any impairment based
on comparing the carrying amount of the asset to its fair value in a current
transaction between willing parties or, in the absence of such measurement, on a
projected discounted cash flow method using a discount rate determined by our
management to be  commensurate  with the risk inherent in
our current business model. Any amount of impairment so determined would be
written off as a charge to the statement of operations, together with an equal
reduction of the related asset. Net long-lived assets amounted to approximately
$19.1 million as of December 31, 2010.




Research and
Development.  Research and development costs include
expenditures for planned search and investigation aimed at discovery of new
knowledge to be used to develop new services or processes or significantly
enhance existing processes.  Research and development costs also
include the implementation of the new knowledge through design, testing of
service alternatives, or construction of prototypes. The cost of materials and
equipment or facilities that are acquired or constructed for research and
development activities and that have alternative future uses are capitalized as
tangible assets when acquired or constructed.  All other research and
development costs are expensed as incurred.




Accounting for income
taxes.   As part of the process of preparing our
consolidated financial statements, we are required to estimate our income taxes
in each of the jurisdictions in which we operate.  This process
involves us estimating our actual current tax exposure together with assessing
temporary differences resulting from differing treatment of items, such as
deferred revenue, for tax and accounting purposes.  These differences
result in deferred tax assets and liabilities, which are included within our
consolidated balance sheet.  We must then assess the likelihood that
our deferred tax assets will be recovered from future taxable income and to the
extent we believe that recovery is not likely, we must establish a valuation
allowance. To the extent we establish a valuation allowance or increase this
allowance in a period, we must include an expense within the tax provision in
the statement of operations.




At December 31, 2010, the Company
has no uncertain tax positions.  Significant management judgment is
required in determining our provision for income taxes, our deferred tax assets
and liabilities and any valuation allowance recorded against our net deferred
tax assets.  The deferred tax assets are fully reserved at December
31, 2010.





ITEM
3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK




Market
Risk.The Company had borrowings of $11.2 million on
December 31, 2010 under term loan and mortgage agreements.  One term
loan was subject to variable interest rates.  The weighted average
interest rate paid during the first three months of fiscal 2011 was
6.8%.  For variable rate debt outstanding at December 31, 2010, a .25%
increase in interest rates will increase annual interest expense by
approximately $1,000.  Amounts that may become outstanding under the
revolving credit facility provide for interest at the banks’ prime rate minus
..5% to plus .5% or LIBOR plus 2.0% to 3.0% and LIBOR plus 3.15% for the variable
rate term loan.  The Company’s market risk exposure with respect to
financial instruments is to changes in prime or LIBOR rates.




ITEM
4. CONTROLS AND PROCEDURES




Disclosure
Controls and Procedures





Pursuant
to Rule 13a-15(b) under the Securities Exchange Act of 1934 (the “Exchange
Act”), the Company’s management, with the participation of the Chief Executive
Officer and Chief Financial Officer, evaluated the effectiveness of the
Company’s disclosure controls and procedures as of the end of the period covered
by this report.  Based on that evaluation, the Chief Executive Officer
and Chief Financial Officer concluded that the Company’s disclosure controls and
procedures were effective as of December 31, 2010.





Changes
in Internal Control over Financial Reporting





The Chief Executive Officer and
President and the Chief Financial Officer conducted an evaluation of our
internal control over financial reporting (as defined in Exchange Act Rule
13a-15(f)) to determine whether any changes in internal control over financial
reporting occurred during the quarter ended December 31, 2010 that have
materially affected or which are reasonably likely to materially affect internal
control over financial reporting.  Based on the evaluation, no such
change occurred during such period.





Internal control over financial
reporting refers to a process designed by, or under the supervision of, our
Chief Executive Officer and Chief Financial Officer and effected by our board of
directors, management and other personnel, to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with generally accepted
accounting principles and includes those policies and procedures
that:


21


·
            Pertain
      to the maintenance of records that in reasonable detail accurately and
      fairly reflect the transactions and dispositions of our
      assets;





·
            Provide
      reasonable assurance that transactions are recorded as necessary to permit
      the preparation of financial statements in accordance with generally
      accepted accounting principles, and that our receipts and expenditures are
      being made only in accordance with authorizations of our management and
      members of our board of directors;
and





·
            Provide
      reasonable assurance regarding the prevention or timely detection of
      unauthorized acquisition, use, or disposition of our assets that could
      have a material effect on our financial
  statements.





PART
II – OTHER INFORMATION





ITEM
1.  LEGAL PROCEEDINGS





In July
2008, the Company was served with a complaint filed in the Superior court of the
State of California for the County of Los Angeles by Aryana Farshad and Aryana
F. Productions, Inc.  (“Farshad”).  The complaint alleged
that Point.360 and its janitorial cleaning company failed to exercise reasonable
care for the protection and preservation of Farshad’s film footage which was
lost.  As a result of the defendants’ negligence, Farshad claimed to
have suffered damages in excess of $2 million and additional unquantified
general and special damages.  The lawsuit was settled in October 2010
for $120,000.




On
October 6, 2009, DG FastChannel, Inc. (“DGFC”) filed a claim in the United
States District Court Central District of California, alleging that the Company
violated certain provisions of agreements governing transactions related to the
August 13, 2007 sale of the Company’s advertising distribution business to
DGFC.  DGFC alleged that (i) the Company did not fulfill its
obligation to restrict a former employee from competing against DGFC subsequent
to the transaction and, therefore, DGFC did not owe the Company $412,500 related
to that portion of the transaction; (ii) the Company violated the noncompetition
agreement between DGFC and the Company by distributing advertising content after
the transaction; (iii) due to the violation of the noncompetition agreement, the
post production services agreement that required DGFC to continue to vault its
customers’ physical elements at the Company’s Media Center became null and void;
and (iv) the Company must return all of DGFC’s vaulted material to
DGFC.  DGFC also sought unspecified monetary damages.




In
September 2010, a settlement between the parties included the
following:  (1) The Company will be subject to a permanent injunction
(until August 13, 2012) from competing in the commercial spot
advertising  business (as defined), (2) the Company will deliver to
DGFC vaulted elements which will result in an annual reduction of vaulting
revenues of approximately $0.9 million, (3) the Company will not be entitled to
$412,500 (relating to the working capital reconciliation), (4) the Company will
issue 250,000 shares of common stock to DGFC and (5) the parties will enter into
full mutual releases and will dismiss their respective claims with
prejudice.  In connection with the settlement, the Company has
indemnified its Chief Executive Officer against possible losses should DGFC
exercise its right to put the stock to the related party on a specified future
date, and there is a negative difference between the stated $500,000 value of
the stock ($2.00 per share) and the market value on the date of the
put.  The put may be exercised on the six-month anniversary of the
settlement agreement. As of December 31, 2010 the Company has issued the 250,000
shares of common stock to DGFC and accrued approximately $0.2 million of
estimated legal and other costs associated with the settlement.  The
fair value of the put option recorded in other accrued expenses is $280,000 at
December 31, 2010, with $95,000 expensed as a component of other income (loss)
in the Condensed Consolidated Statement of Operations.





In November 2010, DGFC filed an ex parte application for
enforcement of the settlement agreement and related stipulated injunction
alleging that the Company violated the terms thereof and seeking an order
enforcing the settlement agreement, an order to assess civil contempt charges
and other remedies, and an order referring criminal allegations against the
Company to the U.S. Attorney’s Office.  The Company believes it has
substantially performed its obligations under the settlement agreement and
intends to defend its position.  Potential liability related to the
outcome of the ex parte
application cannot be determined at this time.  The Company has
accrued estimated legal fees associated with this action.





Fromtime to time, the
Company may become a party to other legal actions and complaints arising in the
ordinary course of business, although it is not currently involved in any such
material legal proceedings except as described above.





ITEM
1A.  RISK FACTORS




In our capacity as Company management,
we may from time to time make written or oral forward-looking statements with
respect to our long-term objectives or expectations which may be included in our
filings with the Securities and Exchange Commission (the “SEC”), reports to
stockholders and information provided on our web site.


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The words or phrases “will likely,”
“are expected to,” “is anticipated,” “is predicted,” “forecast,” “estimate,”
“project,” “plans to continue,” “believes,” or similar expressions identify
“forward-looking statements.”  Such forward-looking statements are
subject to certain risks and uncertainties that could cause actual results to
differ materially from historical earnings and those presently anticipated or
projected.  We wish to caution you not to place undue reliance on any
such forward-looking statements, which speak only as of the date
made.  We are calling to your attention important factors that could
affect our financial performance and could cause actual results for future
periods to differ materially from any opinions or statements expressed with
respect to future periods in any current statements.




The
following list of important factors may not be all-inclusive, and we
specifically decline to undertake an obligation to publicly revise any
forward-looking statements that have been made to reflect events or
circumstances after the date of such statements or to reflect the occurrence of
anticipated or unanticipated events.  Among the factors that could
have an impact on our ability to achieve expected operating results and growth
plan goals and/or affect the market price of our stock are:




l
            Recent
      history of losses.


l
            Prior
      breaches and changes in credit agreements and ongoing
      liquidity.


l
            Our
      highly competitive marketplace.


l
            The
      risks associated with dependence upon significant
    customers.


l
            Our
      ability to execute our expansion
strategy.


l
            The
      uncertain ability to manage in a changing
  environment.


l
            Our
      dependence upon and our ability to adapt to technological
      developments.


l
            Dependence
      on key personnel.


l
            Our
      ability to maintain and improve service
quality.


l
            Fluctuation
      in quarterly operating results and seasonality in certain of our
      markets.


l
            Possible
      significant influence over corporate affairs by significant
      shareholders.


l
            Our
      ability to operate effectively as a stand-alone, publicly traded
      company.





l
            The
      cost associated with becoming compliant with the Sarbanes-Oxley Act of
      2002, and the


consequences
of failing to implement effective internal controls over financial reporting
as


required
by Section 404 of the Sarbanes-Oxley Act of 2002.





Other factors not identified above,
including the risk factors described in the “Risk Factors” section of the
Company’s June 30, 2010, Form 10-K filed with the Securities and Exchange
Commission, may also cause actual results to differ materially from those
projected by our forward-looking statements.  Most of these factors
are difficult to anticipate and are generally beyond our control.  You
should consider these areas of risk in connection with considering any
forward-looking statements that may be made in this Form 10-Q and elsewhere by
us and our business generally.  Except to the extent of any obligation
to disclose material information under the federal securities laws or the rules
of the NASDAQ Global Market, we undertake no obligation to release publicly any
revisions to any forward-looking statements, to report events or to report the
occurrence of unanticipated events.




ITEM  6.  EXHIBITS





(a)
                Exhibits10.1
                2010
      Incentive Plan of Point.360 (incorporated by reference to Exhibit 10.1 to
      the Form 8-K filed by the Company on November 18,
2010).10.2
                Loan
      and Security Agreement dated January 14, 2011 between the Company and
      Crestmark Bank (incorporated by reference to Exhibit 10.1 to the Form 8-K
      filed by the Company on January 14, 2011).10.3
                Promissory
      Note dated January 14, 2011 of the Company to Crestmark Bank (incorporated
      by reference to Exhibit 10.2 to the Form 8-K filed by the Company on
      January 14, 2011).31.1
                Certification
      of Chief Executive Officer Pursuant to 15 U.S.C. § 7241, as Adopted
      Pursuant to Section 302 of the Sarbanes-Oxley Act of
  2002.31.2
                Certification
      of Chief Financial Officer Pursuant to 15 U.S.C. § 7241, as Adopted
      Pursuant to Section 302 of the Sarbanes-Oxley Act of
  2002.32.1
                Certification
      of Chief Executive Officer Pursuant to 18 U.S.C. § 1350, as Adopted
      Pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002.


23





32.2
              Certification
      of Chief Financial Officer Pursuant to 18 U.S.C. § 1350, as Adopted
      Pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002.





SIGNATURES




Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.





POINT.360DATE:  February
      11, 2011
              BY:
              /s/  Alan R.
SteelAlan
      R. SteelExecutive
      Vice President,Finance
      and Administration(duly
      authorized officer and principal financial
  officer)




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