UNITED
STATES SECURITIES AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q





(Mark
One)





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





For the
quarterly period ended December 31, 2009 or





o
            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 company   þ





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





oYes                    
þNo





As of
December 31, 2009, there were 10,491,166 shares of the registrant’s common stock
outstanding.








PART
I – FINANCIAL INFORMATION




ITEM
1. FINANCIAL STATEMENTS


POINT.360


CONDENSED
CONSOLIDATED BALANCE SHEETS


(in
thousands)





June 30,
                              2009*
                            
                            
                            December 31,
                              2009
                              (unaudited)AssetsCurrent
      assets:Cash
      and cash equivalents
                            
                            $
                            5,235
                            
                            
                            $
                            2,989Accounts
      receivable, net of allowances for doubtful accounts of  $537 and
      $527, respectively
                            
                            
                            8,347
                            
                            
                            
                            6,790Inventories,
      net
                            
                            
                            401
                            
                            
                            
                            487Prepaid
      expenses and other current assets.
                            
                            
                            524
                            
                            
                            
                            681Prepaid
      income taxes
                            
                            
                            1,877
                            
                            
                            
                            1,565Total
      current assets
                            
                            
                            16,384
                            
                            
                            
                            12,512Property
      and equipment, net
                            
                            
                            20,417
                            
                            
                            
                            19,865Other
      assets, net
                            
                            
                            593
                            
                            
                            
                            1,470Total
      assets
                            
                            $
                            37,394
                            
                            
                            $
                            33,847Liabilities
      and Shareholders’ EquityCurrent
      liabilities:Current
      portion of borrowings under notes payable
                            
                            $
                            2,086
                            
                            
                            $
                            2,137Accounts
      payable
                            
                            
                            1,708
                            
                            
                            
                            1,561Accrued
      wages and benefits
                            
                            
                            1,438
                            
                            
                            
                            1,033Other
      accrued expenses.
                            
                            
                            1,220
                            
                            
                            
                            1,390Current
      portion of deferred gain on sale of real estate
                            
                            
                            178
                            
                            
                            
                            178Total
      current liabilities
                            
                            
                            6,630
                            
                            
                            
                            6,299Notes
      payable, less current portion
                            
                            
                            10,844
                            
                            
                            
                            9,761Deferred
      gain on sale of real estate, less current portion, and other long-term
      liabilities
                            
                            
                            1,911
                            
                            
                            
                            1,876Total
      long-term liabilities
                            
                            
                            12,755
                            
                            
                            
                            11,637Total
      liabilities
                            
                            
                            19,385
                            
                            
                            
                            17,936Commitments
      and contingencies
                            
                            
                            -
                            
                            
                            
                            -Shareholders’
      equityParent
      company’s invested equity
                            
                            
                            -
                            
                            
                            
                            -Preferred
      stock – no par value; 5,000,000 shares authorized; none
      outstanding
                            
                            
                            -
                            
                            
                            
                            -Common
      stock – no par value; 50,000,000 shares authorized; 10,148,700 and
      10,491,166 shares issued and outstanding on June 30 and December 31, 2009,
      respectively
                            
                            
                            21,025
                            
                            
                            
                            21,525Additional
      paid-in capital
                            
                            
                            9,547
                            
                            
                            
                            9,674Retained
      (deficit)
                            
                            
                            (12,563
                            )
                            
                            
                            (15,288
                            )Total
      shareholders’ equity
                            
                            
                            18,009
                            
                            
                            
                            15,911Total
      liabilities and shareholders’ equity
                            
                            $
                            37,394
                            
                            
                            $
                            33,847





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 INCOME (LOSS)


(Unaudited)





Three Months Ended
                  December 31,
                
                
                Six Months Ended
                  December 31,2008
                
                
                2009
                
                
                2008
                
                
                2009Revenues
                
                $
                11,802,000
                
                
                $
                10,254,000
                
                
                $
                23,358,000
                
                
                $
                19,673,000Cost
      of services
                
                
                (7,820,000
                )
                
                
                (6,981,000
                )
                
                
                (15,458,000
                )
                
                
                (14,341,000
                )Gross
      profit
                
                
                3,982,000
                
                
                
                3,273,000
                
                
                
                7,900,000
                
                
                
                5,332,000Selling,
      general and administrative expense
                
                
                (4,001,000
                )
                
                
                (3,704,000
                )
                
                
                (7,709,000
                )
                
                
                (7,493,000
                )Research
      and development expense
                
                
                -
                
                
                
                (282,000
                )
                
                
                -
                
                
                
                (390,000
                )Operating
      income (loss)
                
                
                (19,000
                )
                
                
                (713,000
                )
                
                
                191,000
                
                
                
                (2,551,000
                )Interest
      expense
                
                
                (195,000
                )
                
                
                (227,000
                )
                
                
                (325,000
                )
                
                
                (449,000
                )Interest
      income
                
                
                20,000
                
                
                
                -
                
                
                
                44,000
                
                
                
                9,000Other
      Income
                
                
                213,000
                
                
                
                187,000
                
                
                
                215,000
                
                
                
                266,000Income
      (loss) before income taxes
                
                
                19,000
                
                
                
                (753,000
                )
                
                
                125,000
                
                
                
                (2,725,000
                )Provision
      for income taxes
                
                
                76,000
                
                
                
                -
                
                
                
                29,000
                
                
                
                -Net
      income (loss)
                
                $
                95,000
                
                
                $
                (753,000
                )
                
                $
                154,000
                
                
                $
                (2,725,000
                )Earnings
      (loss) per share:Basic:Net
      income (loss)
                
                $
                0.01
                
                
                $
                (0.07
                )
                
                $
                0.01
                
                
                $
                (0.26
                )Weighted
      average number of shares
                
                
                10,437,323
                
                
                
                10,491,166
                
                
                
                10,470,947
                
                
                
                10,321,794Diluted:Net
      income (loss)
                
                $
                0.01
                
                
                $
                (0.07
                )
                
                $
                0.01
                
                
                $
                (0.26
                )Weighted
      average number of shares including the dilutive effect of stock
      options
                
                
                10,437,787
                
                
                
                10,491,166
                
                
                
                10,471,473
                
                
                
                10,321,794





See
accompanying notes to condensed consolidated financial
statements.


3


POINT.360





CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS


(Unaudited)




Six Months Ended
                    December 31,2008
                  
                  
                  2009Cash
      flows from operating activities:Net
      income (loss)
                  
                  $
                  154,000
                  
                  
                  $
                  (2,725,000
                  )Adjustments
      to reconcile net income  to net cash provided by operating
      activities:Stock
      based compensation expense
                  
                  
                  117,000
                  
                  
                  
                  127,000Depreciation
      and amortization
                  
                  
                  2,457,000
                  
                  
                  
                  1,834,000Gain
      on sale of fixed assets
                  
                  
                  (138,000
                  )
                  
                  
                  (112,000
                  )Provision
      (benefit from) for doubtful accounts
                  
                  
                  14,000
                  
                  
                  
                  (9,000
                  )Amortization
      of deferred gain on sale of real estate
                  
                  
                  (89,000
                  )
                  
                  
                  (89,000
                  )Amortization
      of non-compete agreement
                  
                  
                  -
                  
                  
                  
                  7,000Changes
      in assets and liabilities:(Increase)
      decrease in accounts receivable
                  
                  
                  (2,227.000
                  )
                  
                  
                  1,566,000(Increase)
      decrease in inventories
                  
                  
                  100,000
                  
                  
                  
                  (86,000
                  )(Increase)
      decrease in prepaid expenses and other current assets
                  
                  
                  (107,000
                  )
                  
                  
                  154,000(Increase)
      in other assets
                  
                  
                  (70,000
                  )
                  
                  
                  (646,000
                  )(Increase)
      in deferred tax asset
                  
                  
                  (336,000
                  )
                  
                  
                  -Increase
      (decrease) in accounts payable
                  
                  
                  (90,000
                  )
                  
                  
                  (147,000
                  )Increase
      (decrease) in accrued expenses
                  
                  
                  (657,000
                  )
                  
                  
                  (235,000
                  )Increase
      (decrease) in income taxes payable
                  
                  
                  270,000
                  
                  
                  
                  -Net
      cash provided by (used in) operating activities
                  
                  
                  (602,000
                  )
                  
                  
                  (361,000
                  )Cash
      used in investing activities:Capital
      expenditures
                  
                  
                  (8,834,000
                  )
                  
                  
                  (820,000
                  )Proceeds
      from sale of fixed assets
                  
                  
                  138,000
                  
                  
                  
                  112,000Investment
      in acquisitions
                  
                  
                  (440,000
                  )
                  
                  
                  (200,000
                  )Net
      cash used in investing activities
                  
                  
                  (9,136,000
                  )
                  
                  
                  (908,000
                  )Cash
      flows provided by  (used in) financing
    activities:Stock
      buyback
                  
                  
                  (245,000
                  )
                  
                  
                  -Increase
      (decrease) in notes payable
                  
                  
                  5,082,000
                  
                  
                  
                  (957,000
                  )Repayment
      of capital lease and other obligations
                  
                  
                  (1,000
                  )
                  
                  
                  (74,000
                  )Acquisition
      of capital lease and other obligations
                  
                  
                  98,000
                  
                  
                  
                  54,000Net
      cash provided by (used in) financing activities
                  
                  
                  4,934,000
                  
                  
                  
                  (977,000
                  )Net
      (decrease) in cash
                  
                  
                  (4,804,000
                  )
                  
                  
                  (2,246,000
                  )Cash
      and cash equivalents at beginning of period
                  
                  
                  13,056,000
                  
                  
                  
                  5,235,000Cash
      and cash equivalents at end of period
                  
                  $
                  8,252,000
                  
                  
                  $
                  2,989,000Supplemental
      disclosure of cash flow information  - Cash paid
      for:Interest
                  
                  $
                  260,000
                  
                  
                  $
                  338,000Income
      tax
                  
                  $
                  375,000
                  
                  
                  $
                  (312,000
                  )Non-cash
      investing activities:Capital
      stock issued for acquisition
                  
                  $
                  -
                  
                  
                  $
                  500,000





See
accompanying notes to condensed consolidated financial
statements.


4


POINT.360





NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)





December
31, 2009





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.




The
Company seeks to capitalize on growth in demand for the services related to the
distribution of entertainment content, without assuming the production or
ownership risk of any specific television program, feature film or other form of
content.  The primary users of the Company’s services are
entertainment studios and advertising agencies that choose to outsource such
services due to the sporadic demand of any single customer for such services and
the fixed costs of maintaining a high-volume physical plant.




The accompanying 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 consolidated Financial Statements.




The accompanying Condensed Consolidated
Financial Statements have been prepared on a going concern basis, which
contemplates the realization of assets and liquidation of liabilities in the
normal course of business.  The Company has incurred net losses of
$2,725,000 in the six months ended December 31, 2009, and $12,640,000 the fiscal
year ended June 30, 2009 (including a goodwill impairment charge of $9,961,000).
The Company has used cash in operations of $361,000 in the six months ended
December 31, 2009, and generated cash from operations of $1,373,000 for the year
ended June 30, 2009.  As of December 31, 2009, we had an accumulated
deficit of $15.3 million, cash of $2,989,000 and long-term debt of
$9,761,000.




Based on the Company’s current
operating plans, management believes that the Company’s existing cash resources
and cash forecasted by management to be generated by operations will be
sufficient to meet working capital and capital requirements through at least the
next twelve months. In this regard, the Company will complete certain research
and development projects and bring them to market.  The Company has
also been working to secure additional financing; however, there is no assurance
that the Company will be successful in these endeavors.  The Company
is also planning to reduce operating expenses in some of its
facilities.  Management believes that current resources, and actions
taken and to be taken provide the opportunity for the Company to continue as a
going concern.




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, 2009 are not necessarily indicative of the
results that may be expected for the fiscal year ending June 30,
2010.  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, 2009.  Certain immaterial
reclassifications have been made to the prior period’s financial statements to
conform to the current year presentation.


5




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 31,2008
                  
                  
                  2009
                  
                  
                  2008
                  
                  
                  2009Pro
      forma weighted average of number of sharesWeighted
      average number of common shares outstanding used in computation of basic
      EPS
                  
                  
                  10,437
                  
                  
                  
                  10,491
                  
                  
                  
                  10,471
                  
                  
                  
                  10,322Dilutive
      effect of outstanding stock options......................
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Weighted
      average number of common and potential Common shares outstanding used in
      computation of Diluted EPS
                  
                  
                  10,437
                  
                  
                  
                  10,491
                  
                  
                  
                  10,471
                  
                  
                  
                  10,322Effect
      of dilutive options excluded in the computation of diluted EPS due to net
      loss
                  
                  
                  -
                  
                  
                  
                  10
                  
                  
                  
                  -
                  
                  
                  
                  19




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, 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 antidilutive (i.e., including such securities would
result in a lower loss per share).  These potentially dilutive
securities consist of stock options.




Fair
Value Measurements




As of December 31, 2009 and June 30,
2009, 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.





Fair
Value Measurement





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.




The carrying amounts reported in the
balance sheets for cash and cash equivalents, short-term marketable securities,
accounts receivable and accounts payable approximate their fair values due to
the short term nature of these financial instruments.




Recent
Accounting Pronouncements





On
September 30, 2009, the Company adopted updates issued by the Financial
Accounting Standards Board (FASB) to the authoritative hierarchy of GAAP. These
changes establish the FASB Accounting Standards Codification (ASC) as the source of
authoritative accounting principles recognized by the FASB to be applied by
nongovernmental entities in the preparation of financial statements in
conformity with GAAP. Rules and interpretive releases of the Securities and
Exchange Commission (SEC) under authority of federal securities laws are also
sources of authoritative GAAP for SEC registrants. The FASB will no longer issue
new standards in the form of Statements, FASB Staff Positions, or Emerging
Issues Task Force Abstracts; instead the FASB will issue Accounting Standards
Updates. Accounting Standards Updates will not be authoritative in their own
right as they will only serve to update the Codification. These changes and the
Codification itself do not change GAAP. Other than the manner in which new
accounting guidance is referenced, the adoption of these changes had no impact
on the financial statements.


6




On
June 30, 2009, the Company adopted updates issued by the FASB to accounting
for and disclosure of events that occur after the balance sheet date but before
financial statements are issued or are available to be issued, otherwise known
as “subsequent events.” Specifically, these changes set forth the period after
the balance sheet date during which management of a reporting entity should
evaluate events or transactions that may occur for potential recognition or
disclosure in the financial statements, the circumstances under which an entity
should recognize events or transactions occurring after the balance sheet date
in its financial statements, and the disclosures that an entity should make
about events or transactions that occurred after the balance sheet date. The
adoption of these changes had no impact on the financial
statements.





On
June 30, 2009, the Company adopted updates issued by the FASB to fair value
accounting. These changes provide additional guidance for estimating fair value
when the volume and level of activity for an asset or liability have
significantly decreased and includes guidance for identifying circumstances that
indicate a transaction is not orderly. This guidance is necessary to maintain
the overall objective of fair value measurements, which is that fair value is
the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date under current market conditions. The adoption of these changes
had no impact on the financial statements.





On July
1, 2009, the Company adopted updates issued by the FASB to the recognition and
presentation of other-than-temporary impairments. These changes amend existing
other-than-temporary impairment guidance for debt securities to make the
guidance more operational and to improve the presentation and disclosure of
other-than-temporary impairments on debt and equity securities. The recognition
provision applies only to fixed maturity investments that are subject to the
other-than-temporary impairments. If an entity intends to sell, or if it is more
likely than not that it will be required to sell an impaired security prior to
recovery of its cost basis, the security is other-than-temporarily impaired and
the full amount of the impairment is recognized as a loss through earnings.
Otherwise, losses on securities which are other-than-temporarily impaired are
separated into: (i) the portion of loss which represents the credit loss; or
(ii) the portion which is due to other factors. The credit loss portion is
recognized as a loss through earnings, while the loss due to other factors is
recognized in other comprehensive income (loss), net of taxes and related
amortization. A cumulative effect adjustment is required to accumulated earnings
and a corresponding adjustment to accumulated other comprehensive income (loss)
to reclassify the non-credit portion of previously other-than-temporarily
impaired securities which were held at the beginning of the period of adoption
and for which the Company does not intend to sell and it is more likely than not
that the Company will not be required to sell such securities before recovery of
the amortized cost basis. These changes were effective for interim and annual
periods ending after June 15, 2009, with early adoption permitted for periods
ending after March 15, 2009. The Company adopted these changes effective July 1,
2009. The impact of adopting these updates did not have an effect on the
Company’s financial statements.





On
June 30, 2009, the Company adopted updates issued by the FASB to fair value
disclosures of financial instruments. These changes require a publicly traded
company to include disclosures about the fair value of its financial instruments
whenever it issues summarized financial information for interim reporting
periods. Such disclosures include the fair value of all financial instruments,
for which it is practicable to estimate that value, whether recognized or not
recognized in the statement of financial position; the related carrying amount
of these financial instruments; and the method(s) and significant assumptions
used to estimate the fair value. Other than the required disclosures, the
adoption of these changes had no impact on the financial
statements.





On
September 30, 2008, the Company adopted updates issued by the FASB to fair value
accounting and reporting as it relates to nonfinancial assets and nonfinancial
liabilities that are not recognized or disclosed at fair value in the financial
statements on at least an annual basis. These changes define fair value,
establish a framework for measuring fair value in GAAP, and expand disclosures
about fair value measurements. This guidance applies to other GAAP that require
or permit fair value measurements and is to be applied prospectively with
limited exceptions. The adoption of these changes, as it relates to nonfinancial
assets and nonfinancial liabilities, had no impact on the financial
statements.




On
July 1, 2009, the Company adopted updates issued by the FASB to accounting
for intangible assets. These changes amend the factors that should be considered
in developing renewal or extension assumptions used to determine the useful life
of a recognized intangible asset in order to improve the consistency between the
useful life of a recognized intangible asset outside of a business combination
and the period of expected cash flows used to measure the fair value of an
intangible asset in a business combination. The adoption of these changes had no
impact on the financial statements.




On
July 1, 2009, the Company adopted updates issued by the FASB to the
calculation of earnings per share. These changes state that unvested share-based
payment awards that contain nonforfeitable rights to dividends or dividend
equivalents (whether paid or unpaid) are participating securities and shall be
included in the computation of earnings per share pursuant to the two-class
method for all periods presented. The adoption of these changes had no impact on
the financial statements.


7




NOTE
2 - LONG TERM DEBT AND NOTES PAYABLE





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, 2009)  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 3.45%, respectively, on December
31, 2009.  The facility is secured by all of the Company’s assets,
except for equipment securing new term loans as described below and real
property securing mortgages. As of June 30, 2009 and December 31, 2009, the
Company had secured a $500,000 standby letter of credit related to a building
lease which reduces the amount available under the credit agreement. No other
amounts were outstanding under the credit agreement on that date.




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, 2009, the
leverage ratio was 2.12 compared to a minimum requirement of 1.75, and the fixed
charge coverage ratio was 0.79 as compared to a minimum requirement of
1.10.  As of December 31, 2009, the Company was not in compliance with
the fixed charge rate and received a forbearance from the bank.  The
forbearance period extends to March 31, 2010, during which time the amount
available under the credit agreement will be limited to the $0.5 million letter
of credit, after which date the entire revolving credit agreement will
terminate.





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.  The resulting annual mortgage and interest payments on the
Note will be approximately $0.2 million less than the annual rent payments on
the property at the time of the transaction.





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.  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 (0.45% as of
December 31, 2009) plus 3.15%, or 3.60% 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 are scheduled to be repaid completely by December 31, 2010.





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.




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.


8


Property
and equipment consist of the following as of December 31, 2009:




Land
                  
                  $
                  3,985,000Building
                  
                  
                  9,093,000Machinery
      and equipment
                  
                  
                  36,475,000Leasehold
      improvements
                  
                  
                  6,443,000Computer
      equipment
                  
                  
                  6,809,000Equipment
      under capital lease
                  
                  
                  671,000Office
      equipment, CIP
                  
                  
                  709,000Less
      accumulated depreciation and Amortization
                  
                  
                  (44,320,000
                  )Property
      and equipment, net
                  
                  $
                  19,865,000





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 alleges
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 claims to
have suffered damages in excess of $2 million and additional unquantified
general and special damages.  Management does not believe that the
outcome will have a material effect on the financial condition or results of
operation of the Company.




On May 1,
2009 the Company was served with a Verified Unlawful Detainer Complaint” by 1220
Highland, LLC, the landlord of the facility in Hollywood, CA that had been
rented by the Company for many years.  The Company’s lease on the
facility expired in March 2009.  The Complaint seeks possession of the
property, damages for each day of the Company’s possession from May 1, 2009, and
other damages and legal fees.  Management does not believe that the
outcome will have a material effect on the financial condition of the Company,
especially since full rent was paid until the property was returned to the
landlord on June 30, 2009.




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 alleges 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 does not owe the Company $500,000
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 seeks unspecified monetary
damages.




If DGFC
is successful in its claims, the possibility exists that the Company must return
the DGFC vaulted elements which will result in a future decline in annual
revenues of approximately $0.7 million, partially offset in the first year by
“pull” charges.  The Company believes it has adequate defenses against
the claims.




From time 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.





NOTE
5- INCOME TAXES





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.


9




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.





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.




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 Consolidated Statements of Income (Loss).




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 Income
(Loss).  Stock-based compensation expense recognized in the Condensed
Consolidated Statements of Income (Loss) for the three and six months ended
December 31, 2009 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
Income (Loss) 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-asses 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, 2009 were $70,000 and
$126,000, 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 each of the quarters and six
month periods ended December 31, 2008 and 2009, the Company granted awards of
stock options for 30,000 shares at a market price of $1.37 and $1.05 per share,
respectively.  As of December 31, 2009, there were options outstanding
to acquire 1,326,425 shares at an average exercise price of $1.64 per
share.  The estimated fair value of all awards granted during the 2008
and 2009 periods was $16,000 and $13,000 respectively.  For the 2009
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
                  
                  
                  0.12
                  %Expected
      term (years)
                  
                  
                  5.0Volatility
                  
                  
                  49
                  %Expected
      annual dividends
                  
                  
                  -




The following table summarizes the
status of the 2007 Plan as of December 31, 2009:





Options
      originally available
                  
                  
                  2,000,000Stock
      options outstanding
                  
                  
                  1,326,425Options
      available for grant
                  
                  
                  673,525





10




Transactions
involving stock options are summarized as follows:




Number
                        of Shares
                      
                      
                      Weighted Average
                        Exercise PriceBalance
      at June 30, 2009
                      
                      
                      1,322,025
                      
                      
                      $
                      1.66GrantedExercised
                      
                      
                      -
                      
                      
                      
                      -Cancelled
                      
                      
                      (8,725
                      )
                      
                      
                      1.66Balance
      at September 30, 2009
                      
                      
                      1,313,300
                      
                      
                      $
                      1.66Granted
                      
                      
                      30,000
                      
                      
                      
                      1.05Exercised
                      
                      
                      -
                      
                      
                      
                      -Cancelled
                      
                      
                      (16,875
                      )
                      
                      
                      1.74Balance
      at December 31, 2009
                      
                      
                      1,326,425
                      
                      
                      $
                      1.64




As of
December 31, 2009, 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, 2009 were as follows:





Number of
                          Shares
                        
                        
                        Weighted Average
                          Exercise Price
                        
                        
                        Weighted Average
                          Remaining
                          Contractual Life
                          (Years)
                        
                        
                        Intrinsic
                          ValueAs of December 31, 2009Employees
      – Outstanding
                        
                        
                        1,166,425
                        
                        
                        $
                        1.65
                        
                        
                        
                        3.36
                        
                        
                        $
                        -Employees
      – Expected to Vest
                        
                        
                        1,102,545
                        
                        
                        $
                        1.65
                        
                        
                        
                        3.36
                        
                        
                        $
                        -Employees
      – Exercisable
                        
                        
                        225,900
                        
                        
                        $
                        1.79
                        
                        
                        
                        3.12
                        
                        
                        $
                        -Non-Employees
      – Outstanding
                        
                        
                        160,000
                        
                        
                        $
                        1.57
                        
                        
                        
                        3.59
                        
                        
                        $
                        4,000Non-Employees
      – Vested
                        
                        
                        85,000
                        
                        
                        $
                        1.38
                        
                        
                        
                        4.01
                        
                        
                        $
                        4,000Non-Employees
      – Exercisable
                        
                        
                        85,000
                        
                        
                        $
                        1.38
                        
                        
                        
                        4.01
                        
                        
                        $
                        4,000





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, 2009, 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, 2009 is as follows (shares in
thousands):





Options Outstanding
                      
                      Options ExercisableOptionsExercise
                        Price Range
                      
                      
                      Number of
                        Shares
                      
                      Weighted
                        Average
                        Remaining
                        ContractualLife
                      
                      Weighted
                        Average
                        Exercise Price
                      
                      
                      Number of
                        Shares
                      
                      
                      Weighted
                        AverageExercise
                        Price$
                      1.79
                      
                      
                      
                      992
                      
                      3.1
      Years
                      
                      $
                      1.79
                      
                      
                      
                      251
                      
                      
                      $
                      1.79$
                      1.37
                      
                      
                      
                      30
                      
                      3.9
      Years
                      
                      $
                      1.37
                      
                      
                      
                      30
                      
                      
                      $
                      1.37$
                      1.20
                      
                      
                      
                      274
                      
                      4.1
      Years
                      
                      $
                      1.20
                      
                      
                      
                      -
                      
                      
                      $
                      1.20$
                      1.05
                      
                      
                      
                      30
                      
                      4.9
      Years
                      
                      $
                      1.05
                      
                      
                      
                      30
                      
                      
                      $
                      1.05




11




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.





No triggering events occurred in the
six months ended December 31, 2009.





NOTE
8- SHAREHOLDER’S EQUITY





The following table analyzes the
components of shareholders’ equity from June 30, 2009 to December 31, 2009 (in
thousands):




Common
                        Stock
                      
                      
                      Paid-in
                        Capital
                      
                      
                      Retained
                        (Deficit)
                      
                      
                      Shareholders’
                        EquityBalance,
      June 30, 2009
                      
                      $
                      21,025
                      
                      
                      $
                      9,547
                      
                      
                      $
                      (12,563
                      )
                      
                      $
                      18,009FAS
      123R option expense
                      
                      
                      -
                      
                      
                      
                      57
                      
                      
                      
                      -
                      
                      
                      
                      57Net
      income (loss)
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (1,972
                      )
                      
                      
                      (1,972
                      )Stock
      Issuance
                      
                      
                      500
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      500Balance,
      September 30, 2009
                      
                      $
                      21,525
                      
                      
                      $
                      9,604
                      
                      
                      $
                      (14,535
                      )
                      
                      $
                      16,594FAS
      123R option expense
                      
                      
                      -
                      
                      
                      
                      70
                      
                      
                      
                      -
                      
                      
                      
                      70Net
      income (loss)
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (753
                      )
                      
                      
                      (753
                      )Stock
      buyback
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Balance,
      December 31, 2009
                      
                      $
                      21,525
                      
                      
                      $
                      9,674
                      
                      
                      $
                      (15,288
                      )
                      
                      $
                      15,911





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 six months ended December 31,
2009.




NOTE
10- ACQUISITIONS




On September 29, 2009, the Company
acquired the assets of Kiosk Concepts, a general partnership for a purchase
price of approximately $500,000 through the issuance of 342,466 shares of its
common stock. The purchase price included $0.3 million of property and equipment
and $0.2 million of deposits acquired. Substantially all of the assets purchased
were new and had not been placed in service as of the acquisition date.  No
liabilities were assumed.  The acquisition will enable to the Company to
expand its service offerings by using the assets to develop and commercialize
“automated” stores to rent and sell digital video discs (DVDs).  The DVD
stores will contain up to 10,000 DVDs for rent or sale via software-controlled
automated dispensers contained in 1,000 to 1,500 square feet of retail space for
each store.





The Company expects to spend $1.5 million to $2 million prior to April 1, 2010
to create three “proof of concept” locations.  The Company expects to seek
expansion capital to increase the number of stores depending on the success of
the “test” stores.  The new stores will provide consumers with an
alternative to renting or acquiring DVDs from big box stores (e.g.,
Blockbuster), on-line vendors (e.g., Netflix), and stand-alone kiosks (e.g.,
Redbox).





In a separate transaction, on November
15, 2009, the Company purchased the stock of DVDs On the Run, Inc. (“DOR”) for
$650,000 ($200,000 paid at closing and $450,000 placed in escrow pending
completion of certain services).  The assets of DOR consisted of
intellectual property (“IP”) related to mechanical receipt, storage and
dispensing of DVDs.  The purchased IP will be modified pursuant to a
related Services Agreement.  If the software and certain physical
mechanical design goals are achieved within a specified period, the seller will
receive the $450,000 placed in escrow on the transaction date.





The enhanced software and mechanical
designs are intended to form the backbone of the automated store DVD
system.





12




The
$200,000 purchase price of DOR stock was assigned to IP, the estimated fair
value.  The $450,000 placed in escrow was recorded as a deposit
pending satisfactory completion of the services to be rendered by the
seller.  Upon satisfactory completion of the services, the $450,000
will be released to the seller and reclassified to fixed assets
(IP).





These
acquisitions were accounted for as a business combination. On the date of
acquisition, the transaction was not material to the Company’s financial
position.  Accordingly, pro forma financial amounts are not
presented.  The allocation of the purchase price to the tangible assets
acquired is based on the replacement cost and estimates from management to
calculate fair value.





During the three and six months ended
December 31, 2009, the Company incurred $282,000 and $390,000 of costs
associated with the acquisitions, consisting of transaction expenses ($22,000
and  $55,000, respectively) and project consulting costs ($260,000 and
$335,000, respectively) associated with the automated stores.  These
expenses are reflected as research and development expenses in the
Consolidated Statements of Income (Loss).




NOTE
I1- SUBSEQUENT EVENTS





Management evaluated all activity of
the Company through the issue date of these Consolidated Financial Statements
and concluded that no subsequent events have occurred that would require
recognition in the Consolidated Financial Statements or disclosure in Notes to
Consolidated Financial Statements.


13




POINT.360




MANAGEMENT’S
DISCUSSION AND ANALYSIS


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 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.




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 and intermittent entertainment industry labor unrest have
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.




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 75% of our cost of
sales.  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 our businesses.  During
the fiscal year ended June 30, 2009 and the six months ended December 31, 2009,
we have completed the following:




·
            We
      purchased the 32,000 square foot Burbank facility to enhance future cash
      flow and secure that operational capability for the
  future.




·
            We
      purchased the assets of Video Box Studios and consolidated its operations
      into our West Los Angeles location.




·
            We
      purchased the assets of MI Post providing the Company with an East Coast
      presence.





·
            We
      purchased an 18,300 square foot building in Hollywood into which we will
      move operations that have previously occupied 37,000 square feet of rented
      space.





·
            We
      purchased physical assets and intellectual property and hired personnel to
      test a content distribution business
model.





14




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 International Video Conversions, Inc., in July 2004, Eden FX in
March 2007 and those described above) that can increase revenues by adding new
customers, or expanding current services to existing customers.




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, 2009 Compared to Three Months Ended December 31,
2008





Revenues.  Revenues
were $10.3 million for the quarter ended December 31, 2009, compared to $11.8
million for the quarter ended December 31, 2008.  Revenues may
continue to come under some downward pressure in the future if major studios
reduce output due to current difficult financial conditions and other
competitors reduce prices to compete for our business.  Additionally,
revenues for the second quarter of fiscal 2010 were lower than prior quarters by
approximately $0.9 million principally due to the move of the operations to one
of our Hollywood facilities (“Highland”) to two of our other locations as we
renovate the Vine Property to house both Highland and Eden FX.  We
expect the negative effect on revenues to continue as we consolidate
approximately 37,000 square feet of operating space into approximately 20,000
square feet by June 2010.  We are continuing to invest in high
definition capabilities where demand is expected to grow. We believe our high
definition 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 quarter ended December
31, 2009, total costs of services were 68.1% of sales compared to 66.3% in the
prior year.    Material (tape stock) and delivery costs
declined $0.3 million due to lower volume.  Other reductions included
a lowering of facility costs at our Hollywood facility resulting from the Vine
building purchase, offset by the addition of the New York
facility.  Other costs remained relatively consistent with the prior
year period due to the fixed nature of our service infrastructure.





Gross Profit.  In
2009, gross margin was 31.9% of sales, compared to 33.7% for the same period
last year. The decrease 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 $3.7 million (36.1% of sales) in
2009 as compared to $4.0 million (33.9% of sales) in
2008.  Depreciation expense declined $0.2 million, offset by an
increase in professional fees associated with managing and upgrading our
information technology network.




Research and Development
Expense.During the quarter ended December 31, 2009, the
Company undertook a research and development project to evaluate, develop and
commercialize “automated” stores to rent and sell digital video discs
(DVDs).  The DVD stores will contain up to 10,000 DVDs for rent or
sale via software-controlled automated dispensers contained in 1,000 to 1,500
square feet of retail space for each store.  Expenses associated with
R&D activities were $0.3 million for the quarter.




Operating Income (Loss).Operating loss was $0.7 million in 2009 compared to break-even results in
2008.




Interest Expense. Net
interest expense for 2009 was $0.2 million, the same as in 2008.




Other Income. Other income
represents sublease income beginning in September 2008.




Net Income (Loss).Net loss
for 2009 was $0.8 million compared to an income of $0.1 million in
2008.




15




Six
Months Ended December 31, 2009 Compared to Six Months Ended December 31,
2008





Revenues.  Revenues
were $19.7 million for the six months ended December 31, 2009, compared to $23.4
million for the six months ended December 31, 2008.  Revenues from
several studio customers declined due to reduced ordering of our services
resulting from current difficult financial conditions.  Additionally,
$1.5 million of the decline in revenues for the first six months of fiscal 2010
was due to the move of the operations to one of our Hollywood facilities
(“Highland”) to two of our other locations as we renovate the Vine Property to
house both Highland and Eden FX.  We expect the negative effect on
revenues to continue as we consolidate approximately 37,000 square feet of
operating space into approximately 20,000 square feet by June
2010.  We are continuing to invest in high definition capabilities
where demand is expected to grow. We believe our high definition 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, 2009, total costs of services were 72.9% of sales compared to 66.2% in the
prior year.    Material (tape stock) and delivery costs
declined $0.4 million due to lower sales volume.  Our Hollywood
facility costs were reduced by the move, offset by an increase in facility costs
by the addition of our New York space.  Other costs remained
consistent with the prior year period due to the fixed nature of our service
infrastructure.





Gross Profit.  In
2009, gross margin was 27.1% of sales, compared to 33.8% for the same period
last year. The decrease 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 $7.5 million (38.1% of sales) in
2009 as compared to $7.7 million (33.0% of sales) in
2008.  Administrative personnel costs declined $0.2 million, offset by
an increase in professional fees associated with managing and upgrading our
information technology.




Research and Development
Expense.During the six months ended December 31, 2009, the
Company undertook a research and development project to evaluate, develop and
commercialize “automated” stores to rent and sell digital video discs
(DVDs).  The DVD stores will contain up to 10,000 DVDs for rent or
sale via software-controlled automated dispensers contained in 1,000 to 1,500
square feet of retail space for each store.  Expenses associated with
R&D activities were $0.4 million for the six month period.




Operating Income (Loss).Operating loss was $2.6 million in 2009 compared to income of $0.2
million in 2008.




Interest Expense. Net
interest expense for 2009 was $0.4 million, an increase of $0.1 million from
2008. The increase was due to a mortgage related to real estate purchased in
June 2009.




Other Income. Other income
represents sublease income beginning in September 2008.




Net Income (Loss).Net loss
for 2009 was $2.7 million compared to an income of $0.2 million in
2008




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 (0.45% at December 31, 2009) plus
3.15% (3.60% 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 are scheduled to
be repaid fully by December 31, 2010.




In March
2006, Old Point.360 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) 840-25, the gain and
the improvement allowance will be amortized over the initial 15-year lease term
as reduced rent.




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% (4.05% as of December 31,
2009).




16




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.




Monthly
and annual principal and interest payments due under the term debt and mortgages
are approximately $244,000 and $2.9 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 agreement provides for interest of either (i) prime (3.25% at
December 31, 2009) minus .5% - to plus .5% or (ii) LIBOR plus 2.0% - 3.00%
depending on the level of the Company’s ratio of outstanding debt to fixed
charges (as defined), or 3.75% or 3.45%, respectively, at December 31,
2009.  The facility is secured by all of the Company’s accounts
receivable.





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, 2009, the
leverage ratio was 2.12 compared to a minimum requirement of 1.75, and the fixed
charge coverage ratio was 0.79 as compared to a minimum requirement of
1.10.  As of December 31, 2009, the Company was not in compliance with
the fixed charge ratio and received forbearance from the bank. The forbearance
period extends to March 31, 2010, during which time the amount available under
the credit agreement will be limited to the $0.5 million standby letter of
credit related to building lease. As of March 31, 2010, the revolving credit
agreement will terminate, and the Company must either replace or fully
collateralize the letter of credit.  Thereafter, no amounts will be
available under the revolving credit agreement. No other amounts were
outstanding under the credit agreement on December 31, 2009.




The
following table summarizes the December 31, 2009 amounts outstanding under our
revolving line of credit, and term (including capital lease obligations) and
mortgage loans:




Revolving
      credit
                              
                              $
                              -Current
      portion of term loan and mortgages
                              
                              
                              2,122,000Long-term
      portion of term loan and mortgages
                              
                              
                              9,776,000Total
                              
                              $
                              11,898,000





We expect
that availability of bank or institutional credit from new sources and cash
generated from operations will be sufficient to fund debt service, operating
needs and about $2.0 – $3.0 million of capital expenditures for the next twelve
months including approximately $1.5 million to complete the renovation of the
Vine Property.




The
Company’s cash balance decreased from $5,235,000 on July 1, 2009 to $2,989,000
at December 31, 2009, principally due to the following:





Balance
      July 1, 2009
                  
                  $
                  5,235,000Capital
      expenditures for equipment
                  
                  
                  (820,000
                  )Acquisitions
                  
                  
                  (200,000
                  )Debt
      principal and interest payments
                  
                  
                  (1,295,000
                  )Other
      cash activities
                  
                  
                  69,000Balance
      December 31, 2009
                  
                  $
                  2,989,000





Cash
generated by operating activities is directly dependent upon sales levels and
gross margins achieved. We generally receive payments from customers in 50-90
days after services are performed. The larger payroll component of cost of sales
must be paid currently.  Payment terms of other liabilities vary by
vendor and type. Income taxes must be paid quarterly. 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.





17




In recent
quarters, the underlying drivers of operating cash flows (sales, receivable
collections, the timing of vendor payments, facility costs and employment
levels) have been consistent, except that days sales outstanding in accounts
receivable have decreased from approximately 67 days to 65 days within the last
12 months.  Generally major studios have delayed 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, 2009, 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 $488,000 per year.





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 temporarily housed at several other of our
facilities.





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.  After renovation, we expect to move our Eden FX and Highland
operations into the Vine Property by January 2010.





When
Highland and Eden FX are moved into the Vine Property, annual cash outlays for
the two operations will be reduced from $1.1 million of rent payments to about
$250,000 of interest payments.  While we will spend about $2.7 million
for the down payment and renovation of the Vine Property, annual cash flow will
improve by approximately $600,000 (rent payments less interest and other
incremental operating costs).





The
mortgage payments are approximately $488,000 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.




18


The
following table summarizes contractual obligations as of December 31, 2009 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
                  
                  $
                  11,396,000
                  
                  
                  $
                  1,962,000
                  
                  
                  $
                  143,000
                  
                  
                  $
                  179,000
                  
                  
                  $
                  9,112,000Long
      Term Debt Interest Obligations (1)
                  
                  
                  9,757,000
                  
                  
                  
                  739,000
                  
                  
                  
                  1,333,000
                  
                  
                  
                  1,259,000
                  
                  
                  
                  6,426,000Capital
      Lease Obligations
                  
                  
                  502,000
                  
                  
                  
                  160,000
                  
                  
                  
                  320,000
                  
                  
                  
                  22,000
                  
                  
                  
                  -Capital
      Lease Interest Obligations
                  
                  
                  55,000
                  
                  
                  
                  29,000
                  
                  
                  
                  26,000
                  
                  
                  
                  -
                  
                  
                  
                  -Operating
      Lease Obligations
                  
                  
                  21,831,000
                  
                  
                  
                  3,186,000
                  
                  
                  
                  5,605,000
                  
                  
                  
                  4,990,000
                  
                  
                  
                  8,050,000Total
                  
                  $
                  43,541,000
                  
                  
                  $
                  6,076,000
                  
                  
                  $
                  7,427,000
                  
                  
                  $
                  6,450,000
                  
                  
                  $
                  23,588,000




(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 and cash for
assets and intellectual property, and will spend $1 to $1.5 million in the last
half of Fiscal 2010 to test the concept.




During the past year, the Company has
generated sufficient cash to meet operating, capital expenditure and debt
service needs and obligations, as well as to provide sufficient cash reserves to
address contingencies.  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.  Additionally, our current
bank line of credit might not be renewed upon its November 2010 expiration due
to recent changes in the bank lending environment.  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.




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.


19




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 (billed
vaulting revenues are approximately 3% of sales), 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




·
            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 income statement, together with an equal
reduction of the related asset. Net long-lived assets amounted to approximately
$19.9 million as of December 31, 2009.




In accounting for goodwill, the Company
historically performed an annual impairment review. On August 14, 2007, the
Company was formed by a spin-off transaction, and a certain portion of Old
Point.360’s goodwill was assigned to the Company.  In the 2009 test
performed as of June 30, 2009, the discounted cash flow method was used to
evaluate goodwill impairment and included cash flow estimates for fiscal 2010
and subsequent years.  As a result, the Company recorded a goodwill
impairment charge of $10 million as of June 30, 2009.




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.




20




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.




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 net deferred tax assets as of December 31, 2009 were
$0.0 million.





ITEM
3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK




Market
Risk.The Company had borrowings of $11.9 million on
December 31, 2009 under term loan and mortgage agreements.  One term
loan was subject to variable interest rates.  The weighted average
interest rate paid during the first six months of fiscal 2010 was
6.7%.  For variable rate debt outstanding at December 31, 2009, a .25%
increase in interest rates will increase annual interest expense by
approximately $3,000.  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





Pursuant to Rules 13a-15(b) and
15d-15(b) under the Exchange Act, an evaluation was performed under the
supervision and with the participation of the Company’s management, including
the Chief Executive Officer and President and the Chief Financial Officer, of
the effectiveness of the design and operation of the Company’s disclosure
controls and procedures as of the end of the period covered by this
report.  Based on the evaluation, the Chief Executive Officer and
President and the Chief Financial Officer, concluded that the Company’s
disclosure controls and procedures were effective as of the end of the period
covered by the report.





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, 2009 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:





·
            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.





Remediation of Previously Disclosed Material
Weakness





Management
previously concluded that, as of June 30, 2009, we did not maintain effective
controls regarding the timing of revenue recognition under the proportional
performance method. This control deficiency resulted in the restatement of our
interim consolidated financial statements for the three months ended September
30, 2008, the six months ended December 31, 2008 and the nine months ended March
31, 2009.  Accordingly, management determined that this control
deficiency constituted a material weakness in internal control over financial
reporting as of June 30, 2009.




21




We
have since reviewed and documented the controls regarding the proportional
performance method and have trained personnel involved in such
controls.  The material weakness has also been remediated by an
additional level of review by senior personnel at the Company. We tested the
newly implemented controls and found them to be effective and have concluded as
of December 31, 2009, this material weakness has been remediated.





Limitations
on Internal Control over Financial Reporting





Internal control over financial
reporting cannot provide absolute assurance of achieving financial reporting
objectives because of its inherent limitations.  Internal control over
financial reporting is a process that involves human diligence and compliance
and is subject to lapses in judgment and breakdowns resulting from human
failures.  Internal control over financial reporting also can be
circumvented by collusion or improper override.  Because of such
limitations, there is a risk that material misstatements may not be prevented or
detected on a timely basis by internal control over financial
reporting.  However, these inherent limitations are known features of
the financial reporting process, and it is possible to design into the process
safeguards to reduce, though not eliminate, this risk.


22





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 alleges
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 claims to
have suffered damages in excess of $2 million and additional unquantified
general and special damages.  While the outcome of this claim cannot
be predicted with certainty, management does not believe that the outcome will
have a material effect on the financial condition or results of operation of the
Company.





On May 1,
2009 the Company was served with a Verified Unlawful Detainer Complaint” by 1220
Highland, LLC, the landlord of the facility in Hollywood, CA that had been
rented by the Company for many years.  The Company’s lease on the
facility expired in March 2009.  The Complaint seeks possession of the
property, damages for each day of the Company’s possession from May 1, 2009, and
other damages and legal fees.  While the outcome of the claim cannot
be predicted with certainty, management does not believe that the outcome will
have a material effect on the financial condition of the Company, especially
since full rent was paid until the property was returned to the landlord on June
30, 2009.





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 alleges 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, does not owe the Company $500,000
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 seeks unspecified monetary
damages.




If DGFC
is successful in its claims, the possibility exists that the Company must return
the DGFC vaulted elements which will result in a future decline in annual
revenues of approximately $0.7 million, partially offset in the first year by
“pull” charges. The Company believes it has adequate defenses against the
claims.




From time 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.





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.




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:




·
              Recent
      history of losses.
 ·
              Prior
      breaches and changes in credit agreements and ongoing
      liquidity.
 ·
              Our
      highly competitive marketplace.
 ·
              The
      risks associated with dependence upon significant
    customers.
 ·
              Our
      ability to execute our expansion
strategy.
 ·
                The
      uncertain ability to manage in a changing
  environment.
  23
  ·
              Our
      dependence upon and our ability to adapt to technological
      developments.
 ·
              Dependence
      on key personnel.
 ·
              Our
      ability to maintain and improve service
quality.
 ·
              Fluctuation
      in quarterly operating results and seasonality in certain of our
      markets.
 ·
              Possible
      significant influence over corporate affairs by significant
      shareholders.
 ·
              Our
      ability to operate effectively as a stand-alone, publicly traded
      company.
 ·
              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 by the date that we must comply with that
      section of the Sarbanes-Oxley
Act.





ITEM
1B.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS





The Company’s Annual meeting of
Shareholders was held on November 19, 2009 after a solicitation of proxies
pursuant to Regualtion 14A of he Securities Exchange Act of 1934.  At
the meeting, shareholders voted on the election of directors to hold office
until the next annual meeting of shareholders of the Company or until their
successors are duly elected and qualified. The results of shareholder voting
were as follows:




Name
                            
                            Votes For
                            
                            Votes WithheldHaig
      S. Bagerdjian
                            
                            8,959,797
                            
                            121,101Robert
      A. Baker
                            
                            9,039,395
                            
                            41,503Greggory
      J. Hutchins
                            
                            8,597,993
                            
                            482,905Sam
      P. Bell
                            
                            9,039,395
                            
                            41,503G.
      Samuel Oki
                            
                            9,039,395
                            
                            41,503




Other factors not identified above,
including the risk factors described in the “Risk Factors” section of the
Company’s June 30, 2009, 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)
              Exhibits





10.1
            Amendment
      No. 1 to 2007 Equity Incentive Plan of Point.360 dated February 10,
      2010.





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.





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.




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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
      12, 2010
                BY:
                /s/  Alan R.
  SteelAlan
      R. SteelExecutive
      Vice President,Finance
      and Administration(duly
      authorized officer and principal financial
  officer)


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