**UNITED
      STATES SECURITIES AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**


**___________**





**FORM
      10-K**





**ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE**


**SECURITIES
      EXCHANGE ACT OF 1934**





**For
      the fiscal year ended December 31, 2005**





**OR**





**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 0-21917**


**___________**


**POINT.360**


(Exact
      name of registrant as specified in its charter)





**California**
              (State
                or other jurisdiction of
              incorporation
                or organization)
            **95-4272619**
              (I.R.S.
                Employer Identification No.)**2777
                North Ontario Street, Burbank, CA**
              (Address
                of principal executive offices)
            **91504**
              (Zip
                Code)





Registrant's
      telephone number, including area code (818) 565-1400





Securities
      registered pursuant to Section 12(b) of the Act:


None





Securities
      registered pursuant to Section 12(g) of the Act:


Common
      Stock, no par value.


___________





Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act.


Yes
      [ ]
      No [X]





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Act.


Yes
      [ ]
      No [X]





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.


Yes X  No
      ___




Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K is not contained herein, and will not be contained, to the best
      of registrant’s knowledge, in definitive proxy or information statements
      incorporated by reference in Part III of this Form 10-K or any amendment to
      this
      Form 10-K. ___




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


Large
      accelerated filer   ̈   Accelerated
      filer   ̈  Non-accelerated
      filer  ý





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


Yes
      [ ]
      No [X]





The
      aggregate market value of the voting common equity held by non-affiliates of
      the
      registrant as of the last business day of the registrant’s most recently
      completed second fiscal quarter (June 30, 2005) was approximately $22,941,000.
      As of February 28, 2006, there were 9,371,357 shares of Common Stock
      outstanding.





DOCUMENTS
      INCORPORATED BY REFERENCE





Portions
      of the definitive Proxy Statement relating to the Company’s Annual Meeting of
      Shareholders to be held on May 3, 2006 are incorporated by reference in Part
      III
      of this report.








**CAUTIONARY
      STATEMENT**




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 in 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” within the meaning of the
      Private Securities Litigation Reform Act of 1995. 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.
      In
      connection with the “Safe Harbor” provisions of the Private Securities
      Litigation Reform Act of 1995, we are calling to your attention important
      factors that could affect our financial performance and could cause actual
      results for future periods to differ materially from any opinions or statements
      expressed with respect to future periods in any current statements.




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




l
            Recent
                history of losses.


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


l
            Our
                highly competitive marketplace.


l
            The
                risks associated with dependence upon significant
                customers.


l
            Our
                ability to execute our expansion
                strategy.


l
            The
                uncertain ability to manage in a changing
                environment.


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


l
            Dependence
                on key personnel.


l
            Our
                ability to maintain and improve service
                quality.


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


l
            Possible
                significant influence over corporate affairs by significant
                shareholders.




1


**PART
      I**





**ITEM
      1. BUSINESS**





**General**




Point.360
      ("Point.360" or the "Company") is a leading integrated media management services
      company providing film, video and audio post production, archival, duplication
      and distribution services to motion picture studios, television networks,
      advertising agencies, independent production companies and multinational
      companies. The Company provides the services necessary to edit, master,
      reformat, archive and ultimately distribute its clients’ audio and video
      content, including television programming, feature films, spot advertising
      and
      movie trailers.




The
      Company provides worldwide electronic and physical distribution using fiber
      optics, satellite, Internet and air and ground transportation. The Company
      delivers commercials, movie trailers, electronic press kits, infomercials and
      syndicated programming, by both physical and electronic means, to thousands
      of
      broadcast outlets worldwide.




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




Since
      January 1, 1997, the Company has successfully completed ten acquisitions of
      companies providing similar services. The Company will continue to evaluate
      acquisition opportunities to enhance its operations and profitability. As a
      result of these acquisitions, the Company is one of the largest and most
      diversified providers of technical and distribution services in its markets,
      and
      therefore is able to offer its customers a single source for such services
      at
      prices that reflect the Company’s scale economies.




The
      Company was incorporated in California in 1990.
      The Company's executive offices are located at 2777 N. Ontario Street, Burbank,
      California 91504, and its telephone number is (818) 565-1400. The Company’s
      website address is *www.point360.com.*





**Markets**




The
      Company derives revenues primarily from (i) the entertainment industry,
      consisting of major and independent motion picture and television studios,
      cable
      television program suppliers and television program syndicators, and (ii) the
      advertising industry, consisting of advertising agencies and corporate
      advertisers. On a more limited basis, the Company also services national
      television networks, local television stations, corporate or instructional
      video
      providers, infomercial advertisers and educational institutions.





*Entertainment
      Industry* .
      The
      entertainment industry creates motion pictures, television programming, and
      interactive multimedia content for distribution through theatrical exhibition,
      home video, pay and basic cable television, direct-to-home, private cable,
      broadcast television, on-line services and video games. Content is released
      into
      a "first-run" distribution channel, and later into one or more additional
      channels or media. In addition to newly produced content, film and television
      libraries may be released repeatedly into distribution. Entertainment content
      produced in the United States is exported and is in increasingly high demand
      internationally. The Company believes that several trends in the entertainment
      industry have and will continue to have a positive impact on the Company's
      business. These trends include growth in worldwide demand for original
      entertainment content, the development of new markets for existing content
      libraries, increased demand for innovation and creative quality in domestic
      and
      foreign markets, and wider application of digital technologies for content
      manipulation and distribution, including the emergence of new distribution
      channels.





*Advertising
      Industry* .
      The
      advertising industry distributes video and audio commercials, or spots, to
      radio
      and television broadcast outlets worldwide. Advertising content is developed
      either by the originating company or in conjunction with an advertising agency.
      The Company receives orders with specific routing and timing instructions
      provided by the customer. These orders are then entered into the Company's
      computer system and scheduled for electronic or physical delivery. When a video
      spot is received, the Company's quality control personnel inspect the video
      to
      ensure that it meets customer specifications and then initiate the sequence
      to
      distribute the video to the designated television stations either
      electronically, over fiber optic lines and/or satellite, or via the most
      suitable package carrier. The Company believes that the growth in the number
      of
      video advertising outlets, driven by expansion in the number of broadcast,
      cable, Internet and satellite channels worldwide, will have a positive impact
      on
      the Company’s businesses.





**Value-Added
      Services**




The
      Company maintains video and audio post-production and editing facilities as
      components of its full service, value-added approach to its customers. The
      following summarizes the value- added post-production services that the Company provides to its customers:




2


*Film-To-Tape
      Transfer.* Substantially all film content ultimately is distributed to the home video,
      broadcast, cable or pay-per-view television markets, requiring that film images
      be transferred electronically to a video format. Each frame must be color
      corrected and adapted to the size and aspect ratio of a television screen in
      order to ensure the highest level of conformity to the original film version.
      The Company transfers film to videotape using Spirit, URSA and Cintel MK-3
      telecine equipment and DaVinci® digital color correction systems. In 2000, the
      Company added high definition television (“HDTV”) services to this product line.
      The remastering of studio film and television libraries to this new broadcast
      standard has begun to contribute to the growth of the Company's film transfer
      business, as well as affiliated services such as foreign language mastering,
      duplication and distribution.




*Video
      Editing.* The
      Company provides digital editing services in Hollywood, Burbank and West Los
      Angeles. The editing suites are equipped with (i) state-of-the-art digital
      editing equipment, including the Avid® 9000, that provides precise and
      repeatable electronic transfer of video and/or audio information from one or
      more sources to a new master video and (ii) large production switchers to
      effect complex transitions from source to source while simultaneously inserting
      titles and/or digital effects over background video. Video is edited into
      completed programs such as television shows, infomercials, commercials, movie
      trailers, electronic press kits, specials, and corporate and educational
      presentations.




*Standards
      Conversion.* Throughout the world there are several different broadcasting "standards" in
      use. To permit a program recorded in one standard to be broadcast in another,
      it
      is necessary for the recorded program to be converted to the applicable
      standard. This process involves changing the number of video lines per frame,
      the number of frames per second, and the color system. The Company is able
      to
      convert video between all international formats, including NTSC, PAL and SECAM.
      The Company's competitive advantages in this service line include its
      state-of-the-art systems and its detailed knowledge of the international markets
      with respect to quality-control requirements and technical
      specifications.




*Broadcast
      Encoding.* The
      Company provides encoding services for tracking broadcast airplay of spots
      or
      television programming. Using a process called VEIL encoding, a code is placed
      within the video portion of an advertisement or an electronic press kit. Such
      codes can be monitored from standard television broadcasts to determine which
      advertisements or portions of electronic press kits are shown on or during
      specific television programs, providing customers direct feedback on allotted
      air time. The Company provides VEIL encoding services for a number of its motion
      picture studio clients to enable them to customize their promotional material.
      The Company also provides ICE encoding services which enable it to place codes
      within the audio portion of a video, thereby enhancing the overall quality
      of
      the encoded video.




*Audio
      Post-Production.* Through
      its facilities in Burbank, Hollywood and West Los Angeles, the Company digitally
      edits and creates sound effects, assists in replacing dialog and re-records
      audio elements for integration with film and video elements. The Company designs
      sound effects to give life to the visual images with a library of sound effects.
      Dialog replacement is sometimes required to improve quality, replace lost dialog
      or eliminate extraneous noise from the original recording. Re-recording combines
      sound effects, dialog, music and laughter or applause to complete the final
      product. In addition, the re-recording process allows the enhancement of the
      listening experience by adding specialized sound treatments, such as stereo,
      Dolby Digital®, SDDS®, THX® and Surround Sound®.




*Audio
      Layback.* Audio
      layback is the process of creating duplicate videotape masters with sound tracks
      that are different from the original recorded master sound track. Content owners
      selling their assets in foreign markets require the replacement of dialog with
      voices speaking local languages. In some cases, all of the audio elements,
      including dialog, sound effects, music and laughs, must be recreated, remixed
      and synchronized with the original videotape. Audio sources are premixed foreign
      language tracks or tracks that contain music and effects only. The latter is
      used to make a final videotape product that will be sent to a foreign country
      to
      permit addition of a foreign dialogue track to the existing music and effects
      track.




*Foreign
      Language Mastering.* Programming designed for distribution in markets other than those for which
      it
      was originally produced is prepared for export through language translation
      and
      either subtitling or voice dubbing. The Company provides dubbed language
      versioning with an audio layback and conform service that supports various
      audio
      and videotape formats to create an international language-specific master
      videotape. The Company's Burbank facility also creates music and effects tracks
      from programming shot before an audience to prepare television sitcoms for
      dialog recording and international distribution.




*Syndication.* The
      Company offers a broad range of technical services to domestic and international
      programmers. The Company services the basic and premium cable, broadcast
      syndication and direct-to-home market segments by providing the facilities
      and
      services necessary to assemble and distribute programming via satellite to
      viewers in the United States, Canada and Europe. The Company provides facilities
      and services for the delivery of syndicated television programming in the United
      States and Canada. The Company's customer base consists of the major studios
      and
      independent distributors offering network programming, world-wide independent
      content owners offering niche market programming, and pay-per-view services
      marketing movies and special events to the cable industry and direct-to-home
      viewers. Broadcast and syndication operations are conducted in Hollywood and
      West Los Angeles.




3


*Archival
      Services.* The
      Company currently stores approximately one million videotape and film elements
      in a protected environment. The storage and handling of videotape and film
      elements require specialized security and environmental control procedures.
      The
      Company performs secure management archival services in all of its operating
      facilities as well as four vault specific locations in Los Angeles. The Company
      offers on-line access to archival information for advertising clients, and
      may
      offer this service to other clients in the future.




**Distribution
      Network**




The
      Company operates
      a full service distribution network providing its customers with reliable,
      timely and high quality distribution services. The Company's historical customer
      base consists of advertising agencies, multinational companies, motion picture
      and television studios and post-production facilities .




Commercials,
      trailers, electronic press kits and related distribution instructions are
      typically collected at one of the Company's regional facilities and are
      processed locally or transmitted to another regional facility for processing.
      Orders are routinely received into the evening hours for delivery the next
      morning. The Company has the ability to process customer orders from receipt
      to
      transmission in less than one hour. Customer orders that require immediate,
      multiple deliveries in remote markets are often delivered electronically to
      and
      serviced by third parties with duplication and delivery services in such
      markets. The Company provides the advantage of being able to service customers
      from both of its primary markets (entertainment and advertising) in all of
      its
      facilities to achieve the most efficient project turnaround. The Company's
      network operates 24 hours a day.




For
      electronic distribution, a video master is digitized and delivered by fiber
      optic, Internet, ISDN or satellite transmission to television stations equipped
      to receive such transmissions. All of the Company’s electronic, fiber optic,
      satellite and internet deliveries are made using third party vendors. The
      Company currently derives approximately one-half of its distribution revenues
      from electronic deliveries and anticipates that this percentage will increase
      as
      such technologies become more widely adopted.




The
      Company intends to add new methods of distribution as technologies become both
      standardized and cost-effective. The Company currently operates facilities
      in
      Los Angeles (seven locations), New York, Chicago, Dallas and San Francisco.
      By
      capitalizing on electronic technologies to link instantaneously all of the
      Company's facilities, the Company is able to optimize delivery, thus extending
      the deadline for same- or next-day delivery of time-sensitive
      material.




The
      Company's network and facilities are designed to serve, cost-effectively, the
      time-sensitive distribution needs of its clients. Management believes that
      the
      Company's success is based on its strong customer relationships that are
      maintained through the reliability, quality and cost-effectiveness of its
      services, and its extended deadline for processing customer orders.




**New
      Markets**




The
      Company believes that the development of its network and its array of
      value-added services will provide the Company with the opportunity to enter
      or
      increase its presence in several new or expanding markets.




*International.* The
      Company currently provides electronic and physical duplication and distribution
      services for rich media content providers. Further, the Company believes that
      electronic distribution methods will facilitate further expansion into the
      international distribution arena as such technologies become standardized and
      cost-effective. In addition, the Company believes that the growth in the
      distribution of domestic content into international markets will create
      increased demand for value-added services currently provided by the Company
      such
      as standards conversion and audio and digital mastering.




*High
      Definition Television (HDTV).* The
      Company is focused on capitalizing on opportunities created by emerging industry
      trends such as the emergence of digital television and its more advanced
      variant, high-definition television. HDTV has quickly become the mastering
      standard for domestic content providers. The Company believes that the
      aggressive timetable associated with such conversion, which has resulted both
      from mandates by the Federal Communications Commission (the "FCC") for digital
      television and high-definition television as well as competitive forces in
      the
      marketplace, is likely to accelerate the rate of increase in the demand for
      these services. The Company maintains a state-of-the-art HDTV
      capability.




*DVD
      Authoring* .
      Digital
      formats, such as DVD, have the potential to overtake VHS videocassettes in
      the
      home video market. Industry research shows that DVD sales surpassed VHS
      videocassettes in 2003. The Company believes that there are significant
      opportunities in this market. With the increasing rate of conversion of existing
      analog libraries, as well as new content being mastered to digital formats,
      we
      believe that the Company has positioned itself well to provide value-added
      services to new and existing clients. The Company has made capital investments
      to expand and upgrade its current DVD and digital compression operations in
      anticipation of the increasing demand for DVD and video encoding
      services.





4


**Sales
      and Marketing**




The
      Company markets its services through a combination of industry referrals, formal
      advertising, trade show participation, special client events, and its Internet
      website. While the
      Company relies
      primarily on its reputation and business contacts within the industry for the
      marketing of its services, the Company also maintains a direct sales force
      to
      communicate the capabilities and competitive advantages of the Company's
      services to potential new customers. In addition, the Company's sales force
      solicits corporate advertisers who may be in a position to influence
      agencies in directing deliveries through the Company. The Company currently
      has
      sales personnel located in Los Angeles, San Francisco, Chicago, Dallas and
      New
      York. The Company's marketing programs are directed toward communicating its
      unique capabilities and establishing itself as the predominant value-added
      distribution network for the motion picture and advertising industries.




In
      addition to its traditional sales efforts directed at those individuals
      responsible for placing orders with the Company’s facilities, the Company also
      strives to negotiate “preferred vendor” relationships with its major customers.
      Through this process, the Company negotiates discounted rates with large volume
      clients in return for being promoted within the client’s organization as an
      established and accepted vendor. This selection process tends to favor larger
      service providers such as the Company that (i) offer lower prices through scale
      economies; (ii) have the capacity to handle large
      orders without outsourcing to other vendors; and (iii) can offer a strategic
      partnership on technological and other industry-specific issues. The Company
      negotiates such agreements periodically with major entertainment studios and
      national broadcast networks.




**Customers**




Since
      its
      inception in 1990, the Company has added customers and increased its sales
      through acquisitions and by delivering a favorable mix of reliability,
      timeliness, quality and price. The integration of the Company's regional
      facilities has given its customers a time advantage in the ability to deliver
      broadcast quality material. The Company markets its services to major and
      independent motion picture and television production companies, advertising
      agencies, television program suppliers and, on a more limited basis, national
      television networks, infomercial providers, local television stations,
      television program syndicators, corporations and educational institutions.
      The
      Company's motion picture clients include Disney, Sony Pictures Entertainment,
      Twentieth Century Fox, Universal Studios, Warner Bros., Metro-Goldwyn-Mayer
      and
      Paramount Pictures. The Company's advertising agency customers include
      TBWA/Chiat Day, Young & Rubicam and Saatchi & Saatchi.




The
      Company solicits the motion picture and television industries, advertisers
      and
      their agencies to generate revenues. In the year ended December 31, 2005,
      ten major motion picture studios and advertising agencies accounted for
      approximately 47% of the Company's revenues, while sales to Twentieth Century
      Fox and affiliates comprised 17% of 2005 revenues. Sales to Twentieth Century
      Fox and affiliates were made to approximately 50 individual customers within
      the
      group.




The
      Company generally does not have exclusive service agreements with its clients.
      Because clients generally do not make arrangements with the Company until
      shortly before its facilities and services are required, the Company usually
      does not have any significant backlog of service orders. The Company's services
      are generally offered on an hourly or per unit basis based on volume.




**Customer
      Service**




The
      Company believes
      it has built its strong reputation in the market with a commitment to customer
      service. The
      Company receives
      customer orders via courier services, telephone, telecopier and the
      Internet. The sales and customer service staff develops strong relationships
      with clients within the studios and advertising agencies and is trained to
      emphasize the Company's ability to confirm delivery, meet difficult delivery
      time frames and provide reliable and cost-effective service. Several studios
      are
      customers because of the Company's ability to meet often changing or rush
      delivery schedules.




The
      Company has a sales and customer service staff of
      approximately 92 people, at least one member of which is available 24 hours
      a day. This staff serves as a single point of problem resolution and supports
      not only the Company's customers, but also the television stations and cable
      systems to which the Company delivers.




**Competition**




The
      manipulation, duplication and distribution of rich media assets is a highly
      competitive service-oriented business. Certain competitors (both independent
      companies and divisions of large companies) provide all or most of the services
      provided by the Company, while others specialize in one or several of these
      services. Substantially all of the Company's competitors have a presence in
      the
      Los Angeles area, which is currently the largest market for the Company's
      services. Due to the current and anticipated future demand for video duplication
      and distribution services in the Los Angeles area, the Company believes that
      both existing and new competitors may expand or establish video service
      facilities in this area.




5


The
      Company believes that it maintains a competitive position in its market by
      virtue of the quality and scope of the services it provides, and its ability
      to
      provide timely and accurate delivery of these services. The Company believes
      that prices for its services are competitive within its industry, although
      some
      competitors may offer certain of their services at lower rates than the Company.




The
      principal competitive factors affecting this market are reliability, timeliness,
      quality and price. The Company competes with a variety of duplication and
      distribution firms, certain post-production companies and, to a lesser extent,
      the in-house operations of major motion picture studios and ad
      agencies. Some of these competitors have long-standing ties to clients that
      will
      be difficult for the Company to change. Several companies have systems for
      delivering video content electronically. Moreover, some of these firms, such
      as
      Vyvx (a unit of Level 3 Communications, Inc.), Digital Generation
      Systems, Inc., Liberty Media Inc. (formerly Ascent Media Group, Inc.) and
      other post-production companies may have greater financial, operational and
      marketing resources, and may have achieved a higher level of brand recognition
      than the Company. As a result, there is no assurance that the Company will
      be
      able to compete effectively against these competitors merely on the basis of
      reliability, timeliness, quality, price or otherwise.




**Employees**




The
      Company had 464 full-time employees as of December 31, 2005. The Company's
      employees are not represented by any collective bargaining organization, and
      the
      Company has never experienced a work stoppage. The Company believes that its
      relations with its employees are good.




**ITEM
      1A. RISK FACTORS**




**We
      have a recent history of losses, and we may incur losses in the
      future** .
      The
      Company reported losses in each of the five fiscal quarters ended December
      31,
      2001 and in several quarters thereafter due, in part, to lower gross margins
      and
      lower sales levels and a number of unusual charges. Although we achieved
      profitability in Fiscal 2000 and prior years, as well as in most fiscal quarters
      between March 31, 2002 and December 31, 2005, there can be no assurance as
      to
      future profitability on a quarterly or annual basis.




**We
      have previously breached our credit agreements and may do so in the
      future** **.** Due to
      lower operating cash amounts resulting from reduced sales levels in 2001 and
      the
      consequential net losses, the Company breached certain covenants of its credit
      facility. The breaches were temporarily cured based on amendments and
      forbearance agreements among the Company and the banks which called for, among
      other provisions, scheduled payments to reduce amounts owed to the banks to
      the
      permitted borrowing base. In August 2001, the Company failed to meet the
      principal repayment schedule and was once again in breach of the credit
      facility. The banks ended their formal commitment to the Company in December
      2001.





In
      May
      2002, we entered into an agreement with the banks to restructure the credit
      facility to a term loan maturing on December 31, 2004. As part of this
      restructuring, the banks waived all existing defaults and the Company was
      required to make principal payments of $5.5 million, $5.0 million and $18.5
      million in 2002, 2003, and 2004, respectively.





In
      March
      2004, we entered into a revised agreement with the banks providing revolving
      and
      term loan facilities. Annual principal payments for the term loan were to be
      $1.6 million each for five years. Any principal outstanding under the revolver
      was to be due in March 2006.





In
      July
      and August 2004, the credit agreement was amended in connection with the
      acquisition of IVC to increase the amounts that can be borrowed under the
      revolving and term loan portions of the arrangement. Approximately $4.7 million
      was borrowed to consummate the transaction. Also, in August 2004, we borrowed
      $6,435,000 to purchase land and a building to house our Los Angeles area media
      storage capability.





During
      the second quarter of 2005, we entered into discussions with the banks to amend
      certain financial covenants contained in our credit agreement to more closely
      track our changing business environment which has contributed to lower sales
      and
      profits in previous quarters. As of June 30, 2005, our credit agreement was
      changed to shorten the due date of the outstanding revolving loan from March
      12,
      2006 to January 31, 2006 (subsequently extended to March 31, 2006), eliminate
      a
      re-borrowing provision of the term loan, increase interest rates on the revolver
      and term loans by 0.5% and revise certain financial covenants.





As
      of
      December 30, 2005, the Company did not meet certain financial covenants
      contained in the credit facility and received a compliance waiver from the
      bank.
      The credit facility was paid in full in March 2006.





In
      December 2005, we entered a new five-year term loan, paying off the previously
      existing term loan with the proceeds there from.





In
      March
      2006, we entered a new revolving credit agreement providing for borrowing up
      to
      $10 million (based on qualified accounts receivable) for a two-year period.
      Additionally, we sold and leased back our Media Center facility which reduced
      mortgage debt by $6.0 million and generated approximately $8.0 million for
      other
      debt reduction and general corporate purposes. The resulting annual lease
      payments will be approximately $1,100,000 as compared to $687,000 of previously
      scheduled mortgage debt service (principal and interest) and approximately
      $600,000 of annual interest cost on other debt repaid with the sale
      proceeds.





6


If
      the
      Company incurs losses in the future, there is a risk that we will default under
      certain financial covenants contained in the new agreements and/or will not
      be
      able to pay off the revolving and term loans when due. If a default condition
      exists in the future, all amounts outstanding under the new agreements will
      be
      due and payable which could materially and adversely affect our
      business.




**We
      may be unable to compete effectively in a highly competitive
      marketplace** .
      Our
      post production, duplication and distribution industry is a highly competitive,
      service-oriented business. In general, we do not have long-term or exclusive
      service agreements with our customers. Business is acquired on a purchase order
      basis and is based primarily on customer satisfaction with reliability,
      timeliness, quality and price.




We
      compete with a variety of post production, duplication and distribution firms,
      some of which have a national presence, and to a lesser extent, t in-house
      post
      production and distribution operations of our major motion picture studio and
      advertising agency customers. Some of these firms, and all of the studios,
      have
      greater financial, distribution and marketing resources and have achieved a
      higher level of brand recognition than the Company. In the future, we may not
      be
      able to compete effectively against these competitors merely on the basis of
      reliability, timeliness, quality and price or otherwise.




We
      may
      also face competition from companies in related markets which could offer
      similar or superior services to those offered by the Company. We believe that
      an
      increasingly competitive environment as evidenced by recent price pressure
      and
      some related loss of work and the possibility that customers may utilize
      in-house capabilities to a greater extent could lead to a loss of market share
      or additional price reductions, which could have a material adverse effect
      on
      our financial condition, results of operations and prospects.




There
      is
      also the risk that third party vendors who directly compete with us will succeed
      in taking away business or curtailing services to us. We rely on such companies
      principally to electronically deliver commercial spots on behalf of our
      advertising clients. In June 2005, one such vendor notified us that its
      electronic distribution channel was no longer available to us except under
      certain circumstances. While curtailment of these services in this instance
      has
      not materially affected our ability to deliver commercial spots, any future
      interruption in the supply of such services could materially and adversely
      affect the Company’s financial condition, results of operations and
      prospects.




**We
      would be adversely affected by the loss of key
      customers** .
      Although we have an active client list of over 2,500 customers, ten motion
      picture studios and advertising agencies and/or their affiliates accounted
      for
      approximately 47%, 38% and 29% of the Company’s revenues in 2005, 2004 and 2003,
      respectively. If one or more of these companies were to stop using our services,
      our business could be adversely affected. Because we derive substantially all
      of
      our revenue from clients in the entertainment and advertising industries, the
      financial condition, results of operations and prospects of the Company could
      also be adversely affected by an adverse change in conditions which impact
      those
      industries.




**Our
      expansion strategy may fail** .
      Our
      growth strategy involves both internal development and expansion through
      acquisitions. We currently have no agreements or commitments to acquire any
      company or business. Even though we have completed ten acquisitions in the
      last
      eight fiscal years, the most recent of which was in November 2005, we cannot
      be
      sure additional acceptable acquisitions will be available or that we will be
      able to reach mutually agreeable terms to purchase acquisition targets, or
      that
      we will be able to profitably manage additional businesses or successfully
      integrate such additional businesses into the Company without substantial costs,
      delays or other problems.





Acquisitions
      may involve a number of special risks including: adverse effects on our reported
      operating results (including the amortization of acquired intangible assets),
      diversion of management’s attention and unanticipated problems or legal
      liabilities. In addition, we may require additional funding to finance future
      acquisitions. We cannot be sure that we will be able to secure acquisition
      financing on acceptable terms or at all. We may also use working capital or
      equity, or raise financing through equity offerings or the incurrence of debt,
      in connection with the funding of any acquisition. Some or all of these risks
      could negatively affect our financial condition, results of operations and
      prospects or could result in dilution to the Company’s shareholders. In
      addition, to the extent that consolidation becomes more prevalent in the
      industry, the prices for attractive acquisition candidates could increase
      substantially. We may not be able to effect any such transactions. Additionally,
      if we are able to complete such transactions they may prove to be
      unprofitable.





The
      geographic expansion of the Company’s customers may result in increased demand
      for services in certain regions where it currently does not have post
      production, duplication and distribution facilities. To meet this demand, we
      may
      subcontract. However, we have not entered into any formal negotiations or
      definitive agreements for this purpose. Furthermore, we cannot assure you that
      we will be able to effect such transactions or that any such transactions will
      prove to be profitable.





7


If
      we
      acquire any entities, we may have to finance a large portion of the anticipated
      purchase price and/or refinance our existing credit agreements. The cost of
      any
      new financing may be higher than our existing credit facilities. Future earnings
      and cash flow may be negatively impacted if any acquired entity does not
      generate sufficient earnings and cash flow to offset the increased costs.





**We
      are operating in a changing environment that may adversely affect our
      business** .
      In
      prior years, we experienced rapid growth, industry consolidation, changing
      technologies and increased regulation, all of which resulted in new and
      increased responsibilities for management personnel and placed, and continues
      to
      place, increased demands on our management, operational and financial systems
      and resources. To accommodate these circumstances, compete effectively and
      manage future growth, we will be required to continue to implement and improve
      our operational, financial and management information systems, and to expand,
      train, motivate and manage our work force. We cannot be sure that the Company’s
      personnel, systems, procedures and controls will be adequate to support our
      future operations. Any failure to do so could have a material adverse effect
      on
      our financial condition, results of operations and prospects.





**We
      may be unable to adapt our business to changing technological
      requirements** .
      Although we intend to utilize the most efficient and cost-effective technologies
      available for telecine, high definition formatting, editing, coloration and
      delivery of audio and video content, including digital satellite transmission,
      as they develop, we cannot be sure that we will be able to adapt to such
      standards in a timely fashion or at all. We believe our future growth will
      depend in part, on our ability to add to these services and to add customers
      in
      a timely and cost-effective manner. We cannot be sure we will be successful
      in
      offering such services to existing customers or in obtaining new customers
      for
      these services. We intend to rely on third party vendors for the development
      of
      these technologies and there is no assurance that such vendors will be able
      to
      develop such technologies in a manner that meets the needs of the Company and
      its customers. Additionally, in recent years, electronic delivery services
      have
      grown while physical duplication and delivery have been declining. We expect
      this trend to continue over a long term (i.e. the next 5 to 10 years). All
      of
      our electronic, fiber optics, satellite and Internet deliveries are made using
      third party vendors, which eliminates our need to invest in such capability.
      However, the use of others to deliver our services poses the risk that costs
      may
      rise in certain situations that cannot be passed on to customers, thereby
      lowering gross margins.





**The
      loss of key personnel would adversely affect our
      business** .
      The
      Company is dependent on the efforts and abilities of certain of its senior
      management, particularly those of Haig S. Bagerdjian, Chairman, President and
      Chief Executive Officer. The loss or interruption of the services of key members
      of management could have a material adverse effect on our financial condition,
      results of operations and prospects if a suitable replacement is not promptly
      obtained. Mr. Bagerdjian beneficially owns approximately 29% of the Company’s
      outstanding stock. Although we have severance agreements with Mr. Bagerdjian
      and
      certain key executives, we cannot be sure that either Mr. Bagerdjian or other
      executives will remain with the Company. In addition, our success depends to
      a
      significant degree upon the continuing contributions of, and on our ability
      to
      attract and retain, qualified management, sales, operations, marketing and
      technical personnel. The competition for qualified personnel is intense and
      the
      loss of any such persons, as well as the failure to recruit additional key
      personnel in a timely manner, could have a material adverse effect on our
      financial condition, results of operations and prospects. There is no assurance
      that we will be able to continue to attract and retain qualified management
      and
      other personnel for the development of our business.





**We
      may be unable to meet the demands of our customers** .
      Our
      business is dependent on our ability to meet the current and future demands
      of
      our customers, which demands include reliability, timeliness, quality and price.
      Any failure to do so, whether or not caused by factors within our control could
      result in losses to such clients. Although we disclaim any liability for such
      losses, there is no assurance that claims would not be asserted or that
      dissatisfied customers would refuse to make further deliveries through the
      Company in the event of a significant occurrence of lost deliveries, either
      of
      which could have a material adverse effect on our financial condition, results
      of operations and prospects. Although we maintain insurance against business
      interruption, such insurance may not be adequate to protect the Company from
      significant loss in these circumstances and there is no assurance that a major
      catastrophe (such as an earthquake or other natural disaster) would not result
      in a prolonged interruption of our business. In addition, our ability to make
      deliveries within the time periods requested by customers depends on a number
      of
      factors, some of which are outside of our control, including equipment failure,
      work stoppages by package delivery vendors or interruption in services by
      telephone or satellite service providers.





**Our
      quarterly operating results have fluctuated significantly in the past and may
      fluctuate in the future** .
      Our
      operating results have varied in the past, and may vary in the future, depending
      on factors such as the volume of advertising in response to seasonal buying
      patterns, the timing of new product and service introductions, the timing of
      revenue recognition upon the completion of longer term projects, increased
      competition, timing of acquisitions, general economic factors and other factors.
      As a result, we believe that period-to-period comparisons of our results of
      operations are not necessarily meaningful and should not be relied upon as
      an
      indication of future performance. For example, our operating results have
      historically been significantly influenced by the volume of business from the
      motion picture industry, which is an industry that is subject to seasonal and
      cyclical downturns, and, occasionally, work stoppages by actors, writers and
      others. In addition, as our business from advertising agencies tends to be
      seasonal, our operating results may be subject to increased seasonality if
      the
      percentage of business from advertising agencies increases. In any period our
      revenues are subject to variation based on changes in the volume and mix of
      services performed during the period. It is possible that in some future quarter
      the Company’s operating results will be below the expectations of equity
      research analysts and investors. In such event, the price of the Company’s
      Common Stock would likely be materially adversely affected.





8


**Our
      controlling shareholders may cause our company to be operated in a manner that
      is not in the best interests of other shareholders** .
      The
      Company’s Chairman, President and Chief Executive Officer, Haig S. Bagerdjian,
      beneficially owned approximately 29% of the outstanding common stock as of
      December 31, 2005. The ex-spouse of R. Luke Stefanko, the Company’s former
      President and Chief Executive Officer, owned approximately 19% of the common
      stock on that date. Midwood Capital Partners, L.P. owned approximately 7% of
      the
      common stock on that date. Together, they owned approximately 55% of our
      outstanding common stock . By virtue of their stock ownership, Ms. Stefanko,
      Midwood and Mr. Bagerdjian individually or together may be able to significantly
      influence the outcome of matters required to be submitted to a vote of
      shareholders, including (i) the election of the board of directors, (ii)
      amendments to the Company’s Restated Articles of Incorporation and (iii)
      approval of mergers and other significant corporate transactions. The foregoing
      may have the effect of discouraging, delaying or preventing certain types of
      transactions involving an actual or potential change of control of the Company,
      including transactions in which the holders of common stock might otherwise
      receive a premium for their shares over current market prices.





**Our
      shareholder rights plan and ability to issue preferred stock may discourage,
      delay or prevent a change in control of our company that would benefit our
      shareholders** .
      Our
      Board of Directors has the authority to issue up to 5,000,000 shares of
      preferred stock without par value (the “Preferred Stock”) and to determine the
      price, rights, preferences, privileges and restrictions thereof, including
      voting rights, without any further vote or action by the Company’s shareholders.
      On November 17, 2004, the Company declared a dividend distribution of one
      Preferred Share Purchase Right on each outstanding share of its common stock.
      The Rights will be attached to the Company’s Common Stock and will trade
      separately and be exercisable only in the event that a person or group acquires
      or announces the intent to acquire 20% or more of Point.360’s Common Stock. Each
      Right will entitle shareholders to buy one one-hundredth of a share of a new
      series of junior participating preferred stock at an exercise price of $10.
      If
      the Company is acquired in a merger or other business combination transaction
      after a person has acquired 20% or more of the Company’s outstanding Common
      Stock, each Right will entitle its holder to purchase, at the Right’s
      then-current exercise price, a number of the acquiring company’s common shares
      having a market value of twice such price. In addition, if a person or group
      acquires 20% or more of Point.360’s outstanding Common Stock, each Right will
      entitle its holder (other than such person or members of such group) to
      purchase, at the Right’s then-current exercise price, a number of the Company’s
      common shares having a market value of twice such price. Following an
      acquisition by a person or group of beneficial ownership of 20% of more of
      the
      Company’s Common Stock and before an acquisition of 50% or more of the Common
      Stock, Point.360’s Board of Directors may exchange the Rights (other than Rights
      owned by such person or group), in whole or in part, at an exchange ratio of
      one
      one-hundredth of a share of the new series of junior participating preferred
      stock per Right. Before a person or group acquires beneficial ownership of
      20%
      or more of the Company’s Common Stock, the Rights are redeemable for $.0001 per
      Right at the option of the Board of Directors. The Rights are intended to enable
      Point.360’s shareholders to realize the long-term value of their investment in
      the Company. They will not prevent a takeover, but should encourage anyone
      seeking to acquire the Company to negotiate with the Board prior to attempting
      a
      takeover.




Although
      we have no current plans to issue any other shares of Preferred Stock, the
      rights of the holders of common stock would be subject to, and may be adversely
      affected by, the rights of the holders of any Preferred Stock that may be issued
      in the future. Issuance of Preferred Stock could have the effect of
      discouraging, delaying, or preventing a change in control of the Company.
      Furthermore, certain provisions of the Company’s Restated Articles of
      Incorporation and By-Laws and of California law also could have the effect
      of
      discouraging, delaying or preventing a change in control of the
      Company.




**ITEM
      1B. UNRESOLVED STAFF COMMENTS**





Not
      applicable




9


**ITEM
      2. PROPERTIES**




The
      Company currently leases 11 facilities which all have production capabilities
      and/or sales activities. The terms of leases for leased facilities expire at
      various dates from 2008 to 2021. The following table sets forth the location
      and
      approximate square footage of the Company's properties as of December 31,
      2005:





**Square****Footage**Hollywood,
                CA
            31,000Hollywood,
                CA
            13,400Hollywood,
                CA
            13,000Burbank,
                CA
            32,000Burbank,
                CA
            45,500Los
                Angeles, CA
            64,600Los
                Angeles, CA
            13,400San
                Francisco, CA
            9,500Chicago,
                IL
            13,200New
                York, NY
            9,000Dallas,
                TX
            11,300




**ITEM
      3. LEGAL PROCEEDINGS**




From **** time
      to
      time, the Company may become a party to various legal actions and complaints
      arising in the ordinary course of business, although it is not currently
      involved in any such material legal proceedings.




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




No
      matters were submitted to the Company’s shareholders for a vote during the
      fourth quarter of the fiscal year covered by this report.




10


**PART
      II**


**ITEM
      5. MARKET FOR THE COMPANY'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
      ISSUER PURCHASES OF EQUITY SECURITIES**




**Market
      Information**




The
      Company's Common Stock is traded on the Nasdaq National Market ("NNM") under
      the
      symbol PTSX. The following table sets forth, for the periods indicated, the
      high
      and low closing price per share for the Common Stock.





**Common
                Stock****Low**
            
            
            **High****Year
                Ended December 31, 2004**First
                Quarter
            
            $
            4.05
            
            $
            4.95Second
                Quarter
            
            
            2.95
            
            
            4.61Third
                Quarter
            
            
            2.29
            
            
            3.72Fourth
                Quarter
            
            
            2.00
            
            
            4.09**Year
                Ended December 31, 2005**First
                Quarter
            
            $
            3.21
            
            $
            3.95Second
                Quarter
            
            
            2.76
            
            
            3.50Third
                Quarter
            
            
            2.21
            
            
            3.21Fourth
                Quarter
            
            
            1.65
            
            
            2.25





On
      February 24, 2006, the closing sale price of the Common Stock as reported on
      the
      NNM was $2.49 per share. As of February 24, 2006, there were approximately
      1,000
      holders of record of the Common Stock.





**Dividends**




The
      Company did not pay dividends on its Common Stock during the years ended
      December 31, 2004 or 2005. The Company’s ability to pay dividends depends
      upon limitations under applicable law and covenants under its bank agreements.
      The Company currently does not intend to pay any dividends on its Common Stock
      in the foreseeable future. See "Management's Discussion and Analysis of
      Financial Condition and Results of Operations -- Liquidity and Capital
      Resources."





**Stock
      Repurchases**





The
      Company did not repurchase any shares of its Common Stock during the year ended
      December 31, 2005.




11


**ITEM
      6. SELECTED FINANCIAL DATA**




The
      following data, insofar as they relate to each of the years 2001 to 2005, have
      been derived from the Company’s annual financial statements. This information
      should be read in conjunction with the Financial Statements and Notes thereto
      and "Management's Discussion and Analysis of Financial Condition and Results
      of
      Operations" included elsewhere herein. All amounts are shown in thousands,
      except per share data.




**Year
                  Ended December 31,****2001**
              
              
              **2002**
              
              
              **2003**
              
              
              **2004**
              
              
              **2005****Statement
                  of Income Data**Revenues
              
              $
              69,628
              
              $
              68,419
              
              $
              64,900
              
              $
              63,344
              
              $
              66,199Cost
                  of goods sold
              
              
              (46,864
              )
              
              (42,172
              )
              
              (39,670
              )
              
              (40,519
              )
              
              (43,167
              )Gross
                  profit
              
              
              22,764
              
              
              26,247
              
              
              25,230
              
              
              22,825
              
              
              23,032Selling,
                  general and administrative expense
              
              
              (20,872
              )
              
              (18,977
              )
              
              (17,479
              )
              
              (18,936
              )
              
              (21,424
              )Write-off
                  of deferred acquisition and financing costs ..
              
              
              -
              
              
              -
              
              
              (1,043
              )
              
              (1,050
              )
              
              -Operating
                  income
              
              
              1,892
              
              
              7,270
              
              
              6,708
              
              
              2,839
              
              
              1,608Interest
                  expense, net
              
              
              (3,070
              )
              
              (2,528
              )
              
              (2,056
              )
              
              (811
              )
              
              (1,524
              )Derivative
                  fair value change (2)
              
              
              (700
              )
              
              82
              
              
              611
              
              
              -
              
              
              -Provision
                  for (benefit from) income tax
              
              
              384
              
              
              (2,007
              )
              
              (2,114
              )
              
              (781
              )
              
              (70
              )Net
                  income (loss)
              
              
              (1,494
              )
              $
              2,817
              
              $
              3,149
              
              $
              1,247
              
              $
              14Earnings
                  (loss) per share:Basic
              
              $
              (0.17
              )
              $
              0.31
              
              $
              0.35
              
              $
              0.14
              
              $
              0.00Diluted
              
              $
              (0.17
              )
              $
              0.30
              
              $
              0.33
              
              $
              0.13
              
              $
              0.00Weighted
                  average common shares outstanding:Basic
              
              
              9,060
              
              
              9,013
              
              
              9,067
              
              
              9,197
              
              
              9,347Diluted
              
              
              9,060
              
              
              9,377
              
              
              9,555
              
              
              9,671
              
              
              9,714
  **Year
                  Ended December 31,****2001**
              
              
              **2002**
              
              
              **2003**
              
              
              **2004**
              
              
              **2005****Other
                  Data**
              
              
              
              
              
              
              
              
              
              
              
              (4
              )EBITDA(1)
              
              $
              8,500
              
              $
              12,690
              
              $
              12,818
              
              $
              8,715
              
              $
              7,659Cash
                  flows provided by operating activities
              
              
              9,455
              
              
              10,381
              
              
              10,480
              
              
              6,814
              
              
              6,407Cash
                  flows used in investing activities
              
              
              (4,069
              )
              
              (3,485
              )
              
              (1,599
              )
              
              (8,426
              )
              
              (4,412
              )Cash
                  flows provided by (used in) financing activities
              
              
              (2,397
              )
              
              (5,282
              )
              
              (7,047
              )
              
              (4,926
              )
              
              (2,068
              )Capital
                  expenditures
              
              
              3,082
              
              
              1,949
              
              
              1,237
              
              
              5,307
              
              
              2,202**Selected
                  Balance Sheet Data**Cash
                  and cash equivalents
              
              $
              3,758
              
              $
              5,372
              
              $
              7,206
              
              $
              668
              
              $
              595Working
                  capital
              
              
              (16,006)(3
              )
              
              8,185
              
              
              3,663
              
              
              (119
              )
              
              1,275Property
                  and equipment, net
              
              
              23,232
              
              
              19,965
              
              
              15,751
              
              
              31,451
              
              
              28,079Total
                  assets
              
              
              70,847
              
              
              70,080
              
              
              64,744
              
              
              76,647
              
              
              75,459Borrowings
                  under revolving credit agreements
              
              
              -
              
              
              -
              
              
              -
              
              
              4,323
              
              
              4,054Current
                  portion of notes payable
              
              
              -
              
              
              -
              
              
              -
              
              
              2,849
              
              
              2,310Long-term
                  debt, net of current portion
              
              
              78
              
              
              18,065
              
              
              6,762
              
              
              14,494
              
              
              13,744Shareholders'
                  equity
              
              
              30,778
              
              
              34,512
              
              
              37,368
              
              
              38,944
              
              
              39,510







(1)
              EBITDA
                  is defined herein as earnings before interest, taxes, depreciation
                  and
                  amortization. EBITDA does not represent cash generated from operating
                  activities in accordance with Generally Accepted Accounting Principles
                  (“GAAP”), is not to be considered as an alternative to net income or any
                  other GAAP measurements as a measure of operating performance and
                  is not
                  necessarily indicative of cash available to fund all cash needs.
                  While not
                  all companies calculate and present EBITDA in the same fashion,
                  it may not
                  be comparable to other similarly titled measures of other companies.
                  However, management believes that EBITDA is a useful measure of
                  cash flow
                  available to the Company to pay interest, repay debt, make acquisitions
                  or
                  invest in new technologies. The Company is currently committed
                  to use a
                  portion of its cash flows to service existing debt, if outstanding,
                  and,
                  furthermore, anticipates making certain capital expenditures as
                  part of
                  its business plan.




12




Computation
        of EBITDA (in thousands)
 2001
              
              
              2002
              
              
              2003
              
              
              2004
              
              
              2005Net
                  income (loss)
              
              $
              (1,494
              )
              $
              2,817
              
              $
              3,149
              
              $
              1,247
              
              $
              14Add
                  back:Interest
              
              
              3,070
              
              
              2,528
              
              
              2,056
              
              
              811
              
              
              1,524Income
                  taxes
              
              
              (384
              )
              
              2,007
              
              
              2,114
              
              
              781
              
              
              70Depreciation
                  & Amortization
              
              
              7,308
              
              
              5,338
              
              
              5,499
              
              
              5,876
              
              
              6,051EBITDA
              
              $
              8,500
              
              $
              12,690
              
              $
              12,818
              
              $
              8,715
              
              $
              7,659
 
 (2)
              In
                  November 2000, the Company entered into an interest rate swap contract
                  to
                  economically hedge its floating debt rate. Under the terms of the
                  contract, the notional amount is $15,000,000, whereby the Company
                  received
                  LIBOR and paid a fixed 6.50% rate of interest for three years.
                  Statement
                  of Financial Accounting Standards No. 133,*Accounting
                  for Derivative Instruments and Hedging Activities*(“FAS 133”), required that the interest rate swap contract be recorded at
                  fair value upon adoption of FAS 133 by recording (i) a cumulative-effect
                  type adjustment at January 1, 2001 equal to the fair value of the
                  interest
                  rate swap contract on that date, (ii) amortizing the cumulative-effect
                  type adjustment over the life of the derivative contract, and (iii)
                  a
                  charge or credit to income in the amount of the difference between
                  the
                  fair value of the interest rate swap contract at the beginning
                  and end of
                  such year. The effect of adopting FAS 133 was to record a cumulative
                  effect type adjustment by charging Accumulated Other Comprehensive
                  Income
                  (a component of shareholders’ equity $247,000 (net of $62,000 tax
                  benefit), crediting Derivative Valuation Liability by $309,000
                  gross
                  cumulative effect adjustment and charging Deferred Income Taxes
                  $62,000.
                  The change in the derivative fair value during the year ($579,000),
                  $186,000 and $701,000 in 2001, 2002 and 2003 respectively) and
                  the
                  amortization of the cumulative effect adjustment ($121,000), ($104,000)
                  and ($90,000) in 2001, 2002 and 2003 respectively) were recorded
                  as a
                  charge to Derivative Fair Value
                  Change.
 
 (3)
              As
                  of December 31, 2001, the Company had outstanding $28,999,000 under
                  a
                  credit facility with a group of banks. The entire amount was classified
                  as
                  a current liability due to then-existing covenant breaches. Excluding
                  the
                  borrowed amount, working capital would have been
                  $12,993,000.
 
 (4)
              On
                  July 1, 2004, the Company acquired International Video Conversions,
                  Inc.
                  See Note 3 of the Notes to Consolidated Financial Statements in
                  this Form
                  10-K.




13




**ITEM
        7.**  **MANAGEMENT'S
        DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
        OPERATIONS**
  *Except
        for the historical information contained herein, certain statements in this
        annual 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,
        for a further discussion of these and other risks and uncertainties applicable
        to the Company's business.*
  **Overview**
  We
        are
        one of the largest providers of video and film asset management services
        to
        owners, producers and distributors of entertainment and advertising content.
        We
        provide the services necessary to edit, master, reformat, archive and ultimately
        distribute our clients’ film and video content, including television
        programming, spot advertising, feature films and movie trailers using electronic
        and physical means. We deliver commercials, movie trailers, electronic press
        kits, infomercials and syndicated programming to hundreds of broadcast outlets
        worldwide. Our interconnected facilities in Los Angeles, New York, Chicago,
        Dallas and San Francisco provide service coverage in each of the major U.S.
        media centers. Clients include major motion picture studios, advertising
        agencies and corporations.
  We
        operate in a highly competitive environment in which customers desire a broad
        range of service at a reasonable price. There are many competitors offering
        some
        or all of the services provided by the Company. 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.
  In
        recent
        years, electronic delivery services have grown while physical duplication
        and
        delivery have been declining. We expect this trend to continue over a long
        term
        (i.e. the next 10 years). All of our electronic, fiber optics, satellite
        and
        Internet deliveries are made using third party vendors, which eliminates
        our
        need to invest in such capability. However, the use of others to deliver
        our
        services poses the risk that costs may rise in certain situations that cannot
        be
        passed on to customers, thereby lowering gross margins. There is also the
        risk
        that third party vendors who directly compete with us will succeed in taking
        away business or refuse to allow us to use their distribution channels. In
        fact,
        in June 2005, one such vendor/competitor notified us that its electronic
        distribution channel would not be available to us except in very limited
        circumstances, or unless we entered certain “preferred vendor” arrangements that
        we believed would not be in the best long-term interests of Point.360. While
        curtailment of these services has not materially affected our ability to
        deliver
        commercial spots, we have not been able to pass on increased alternative
        delivery costs to our customers since June 2005. While we are exploring other
        lower cost alternatives, gross margins related to spot delivery revenues
        will be
        lower until such alternatives become available.
  The
        Company has an opportunity to expand its business by establishing closer
        relationships with our customers through excellent service at a competitive
        price and maintaining adequate third party distribution channels. 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 acquisition of International Video Conversions, Inc. (“IVC”)
        in July 2004) which can increase revenues by adding new customers, or expanding
        services provided 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 nationwide interconnected facilities provide the ability
        to
        better service national 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.
  During
        2004, we completed the acquisition of IVC and settled all disputes related
        to a
        proposed acquisition of three subsidiaries of Alliance Atlantis Communications,
        Inc. (“Alliance”). The financial statement comparisons below highlight the
        effects of these transactions.
 
 The
        following table sets forth the amount and percentage relationship to revenues
        of
        certain items included within the Company's Consolidated Statement of Income
        for
        the years ended December 31, 2003, 2004 and 2005. The commentary below is
        based on these financial statements (in thousands).
  14
 
 **Year
                  Ended December 31****2003**
              
              **2004**
              
              **2005****Amount**
              
              
              **Percent
                  of**
                **Revenues**
              
              
              **Amount**
              
              
              **Percent
                  of**
                **Revenues**
              
              
              **Amount**
              
              
              **Percent
                  of**
                **Revenues**Revenues
              
              $
              64,900
              
              
              100.0
              %
              $
              63,344
              
              
              100.0
              %
              $
              66,199
              
              
              100.0
              %Costs
                  of goods sold
              
              
              (39,670
              )
              
              (61.1
              )
              
              (40,519
              )
              
              (64.0
              )
              
              (43,167
              )
              
              (65.2
              )Gross
                  profit
              
              
              25,230
              
              
              38.9
              
              
              22,825
              
              
              36.0
              
              
              23,032
              
              
              34.8Selling,
                  general and administrative expense
              
              
              (17,479
              )
              
              (27.0
              )
              
              (18,936
              )
              
              (29.9
              )
              
              (21,424
              )
              
              (32.4
              )Write-off
                  of deferred acquisition and financing costs
              
              
              (1,043
              )
              
              (1.5
              )
              
              (1,050
              )
              
              (1.6
              )
              
              -
              
              
              -Operating
                  income
              
              
              6,708
              
              
              10.4
              
              
              2,839
              
              
              4.5
              
              
              1,608
              
              
              2.4Interest
                  expense, net
              
              
              (2,056
              )
              
              (3.2
              )
              
              (811
              )
              
              (1.3
              )
              
              (1,524
              )
              
              (2.3
              )Derivative
                  fair value change
              
              
              611
              
              
              1.0
              
              
              -
              
              
              -
              
              
              -
              
              
              -(Provision
                  for) benefit from income taxes
              
              
              (2,114
              )
              
              (3.3
              )
              
              (781
              )
              
              (1.2
              )
              
              (70
              )
              
              (0.1
              )Net
                  income (loss)
              
              $
              3,149
              
              
              4.9
              %
              $
              1,247
              
              
              2.0
              %
              $
              14
              
              
              0.0
              %
  **Statistical
        Analysis**
  The
        table
        below summarizes results and pro forma results for the years ended December
        31,
        2004 and 2005, without the effects of (1) IVC’s results of operations and (2)
        the write-off of deferred Alliance acquisition, financing and settlement
        costs
        in 2003 and 2004. IVC was purchased on July 1, 2004. The Alliance write-off
        represents the costs of due diligence, legal, financing and the settlement
        of
        all matters related to the proposed acquisition of three subsidiaries of
        Alliance, which matters were finalized in 2004 (in thousands except per share
        amounts):
 **Year
                    Ended****December
                    31, 2004**
                
                |
                
                **December
                    31, 2005****Pro
                    forma**
                
                
                **(2)**
                
                
                **GAAP**
                
                |
                
                
                **Pro
                    forma**
                
                
                **(1)**
                
                
                **GAAP**Revenues
                
                $
                63,344
                
                $
                -
                
                $
                63,344
                
                |
                
                $
                60,409
                
                $
                5,790
                
                $
                66,199Cost
                    of goods sold
                
                
                (40,519
                )
                
                -
                
                
                (40,519
                )
                |
                
                
                (39,260
                )
                
                (3,907
                )
                
                (43,167
                )|Gross
                    profit
                
                
                22,825
                
                
                -
                
                
                22,825
                
                |
                
                
                21,149
                
                
                1,883
                
                
                23,032Selling,
                    general andadministrative
                    expense
                
                
                (18,936
                )
                
                -
                
                
                (18,936
                )
                |
                
                
                (20,118
                )
                
                (1,306
                )
                
                (21,424
                )Write-off
                    of deferredacquisition,
                    financingand
                    settlement costs
                
                
                -
                
                
                (1,050
                )
                
                (1,050
                )
                |
                
                
                -
                
                
                -
                
                
                -|Operating
                    income (loss)
                
                
                3,889
                
                
                (1,050
                )
                
                2,839
                
                |
                
                
                1,031
                
                
                577
                
                
                1,608Interest
                    expense, net
                
                
                (811
                )
                
                -
                
                
                (811
                )
                |
                
                
                (1,256
                )
                
                (268
                )
                
                (1,524
                )Income
                    (loss) beforeincome
                    taxesincome
                    taxes
                
                
                3,078
                
                
                (1,050
                )
                
                2,028
                
                |
                
                
                (225
                )
                
                309
                
                
                84(Provision
                    for) benefitfrom
                    income taxesfrom
                    income taxes
                
                
                (1,185
                )
                
                409
                
                
                (781
                )
                |
                
                
                54
                
                
                (124
                )
                
                (70
                )Net
                    income (loss)
                
                $
                1,893
                
                
                (641
                )
                $
                1,247
                
                |
                
                $
                (171
                )
                $
                185
                
                $
                14|Earnings
                    (loss) per share:
                
                
                
                
                
                
                
                
                
                
                |Basic:
                
                $
                0.21
                
                $
                (0.07
                )
                $
                0.14
                
                |
                
                $
                (0.02
                )
                $
                0.02
                
                $
                0.00Diluted:
                
                $
                0.20
                
                $
                (0.07
                )
                $
                0.13
                
                |
                
                $
                (0.02
                )
                $
                0.02
                
                $
                0.00Weighted
                    average sharesoutstanding
                    - diluted
                
                
                9,671
                
                
                9,671
                
                
                9,671
                
                |
                
                
                9,714
                
                
                9,714
                
                
                9,714
 
  15
  **Year
                    Ended****December
                    31, 2003**
                
                |
                
                **December
                    31, 2004****Pro
                    forma**
                
                
                **(2)**
                
                
                **GAAP**
                
                |
                
                
                **Pro
                    forma**
                
                
                **(3)**
                
                
                **(2)**
                
                
                **GAAP**|Revenues
                
                $
                64,900
                
                $
                -
                
                $
                64,900
                
                |
                
                $
                56,864
                
                $
                6,480
                
                $
                -
                
                $
                63,344Cost
                    of goods sold
                
                
                (39,670
                )
                
                -
                
                
                (39,670
                )
                |
                
                
                (36,782
                )
                
                (3,737
                )
                
                -
                
                
                (40,519
                )|Gross
                    profit
                
                
                25,230
                
                
                -
                
                
                25,230
                
                |
                
                
                20,082
                
                
                2,743
                
                
                -
                
                
                22,825Selling,
                    general andadministrative
                    expense(3)
                
                
                (17,479
                )
                
                -
                
                
                (17,479
                )
                |
                
                
                (17,632
                )
                
                (1,304
                )
                
                -
                
                
                (18,936
                )Write-off
                    of deferredacquisition,
                    financingand
                    settlement costs(3)
                
                
                -
                
                
                (1,043
                )
                
                (1,043
                )
                |
                
                
                -
                
                
                -
                
                
                (1,050
                )
                
                (1,050
                )|Operating
                    income (loss)
                
                
                7,751
                
                
                (1,043
                )
                
                6,708
                
                |
                
                
                2,450
                
                
                1,439
                
                
                (1,050
                )
                
                2,839Interest
                    expense, net
                
                
                (2,056
                )
                
                -
                
                
                (2,056
                )
                |
                
                
                (655
                )
                
                (156
                )
                
                -
                
                
                (811
                )Derivative
                    fair valuechange
                
                
                611
                
                
                -
                
                
                611
                
                |
                
                
                -
                
                
                -
                
                
                -
                
                
                -Income
                    (loss) beforeincome
                    taxes
                
                
                6,306
                
                
                (1,043
                )
                
                5,263
                
                |
                
                
                1,795
                
                
                1,283
                
                
                (1,050
                )
                
                2,028(Provision
                    for) benefitfrom
                    income taxes
                
                
                (2,552
                )
                
                438
                
                
                (2,114
                )
                |
                
                
                (691
                )
                
                (494
                )
                
                404
                
                
                (781
                )Net
                    income (loss)
                
                $
                3,754
                
                $
                (605
                )
                $
                3,149
                
                |
                
                $
                1,104
                
                $
                789
                
                
                (646
                )
                $
                1,247|Earnings
                    (loss) per share:
                
                
                
                
                
                
                
                
                
                
                |Basic:
                
                $
                0.41
                
                $
                (0.06
                )
                $
                0.35
                
                |
                
                $
                0.12
                
                $
                0.09
                
                $
                (0.07
                )
                $
                0.14Diluted:
                
                $
                0.39
                
                $
                (0.06
                )
                $
                0.33
                
                |
                
                $
                0.12
                
                $
                0.08
                
                $
                (0.07
                )
                $
                0.13
  (1)
                Contribution
                    of IVC for the first six months of
                    2005.
 (2)
                Write-off
                    of deferred acquisition, financing and settlement
                    costs.
 (3)
                Contribution
                    of IVC for the last six months of
                    2004.
  While
          the
          above presentation of pro forma income statements and adjustments do not
          represent the results of operations in accordance with generally accepted
          accounting principles (“GAAP”), we believe that this disclosure provides useful
          information for readers of the financial statements in analyzing the causes
          of
          operating differences from period to period. Additional comparative data
          is set
          forth below.
  In
          total,
          revenues in 2005 were 5% greater than in 2004. Without the inclusion of
          IVC
          results for the first six months of 2005, revenues in 2005 would have been
          $60.4
          million, a decrease of 5% from 2004. Pro forma 2004 revenues if IVC had
          been
          purchased at the beginning of the year would have been $69.0
          million.
  The
          addition of IVC not only increased revenues in 2005 (twelve months of operations
          compared to six months in 2004), but added to the cost infrastructure of
          the
          Company in both cost of sales and selling, general and administrative
          (“S,G&A”) areas. With the inclusion of IVC, 2005 gross margins as a
          percentage of sales were about the same as those experienced in 2004. We
          expect
          similar gross margins in 2006 after including the increased lease costs
          (approximately $767,000) resulting from the March 2006 sale/leaseback of
          our
          Media Center facility. We also expect 2006 SG&A costs as a percentage of
          sales to be similar to those experienced in 2005. Interest expense in 2006
          is
          expected to be reduced by approximately $600,000 due to the March 2006
          repayment
          of debt with proceeds from the sale/leaseback.
 **Year
            Ended December 31, 2005 Compared To Year Ended December 31,
            2004.**
  *Revenues* . **** Revenues
            increased $2.9 million to $66.2 million for the year ended December 31,
            2005,
            compared to $63.3 million in 2004. A $5.8 million increase is due to
            the
            inclusion of IVC for the entire fiscal year as opposed to six months
            in 2004
            (IVC was acquired on July 1, 2004). Without IVC sales for the first six
            months
            of 2005, twelve month 2005 sales declined $2.9 million to $60.4 million
            as
            compared to 2004. The decline is due to lower spot advertising revenues
            as
            customers switched to electronic from physical distribution. Revenues
            for
            physical distribution of tapes containing commercial spot advertising
            include
            tape stock and freight. In electronic distribution, sales consist of
            only the
            electronic fee for distributing the advertisement.
  *Gross
            Profit* .
            In
            2005, gross profit decreased by 1.2% of sales. Gross profit on sales
            was 35% in
            2005 compared to 36% in 2004, the decline being due principally to higher
            wages
            and benefits and delivery costs.
  16
 *Selling,
            General And Administrative Expense* .  SG&A
            expense increased $1.4 million, or 7%, to $21.4 million in 2005, compared
            to
            $20.0 million in 2004 due principally to higher selling costs. As a percentage
            of revenues, SG&A was 32% for 2005 and 2004.
  In
            2004,
            the Company wrote off approximately $1.1 million of deferred acquisition
            and
            financing and settlement costs related to the termination of the potential
            acquisition of three subsidiaries of Alliance. This expense has been
            set forth
            separately.
  *Operating
            Income* .
            Operating income decreased $1.2 million to $1.6 million, compared to
            $2.8
            million in 2004.
  *Interest
            Expense* .  **** Interest
            expense for 2005 was $1.5 million compared to $0.8 million in 2004. The
            2005
            amount included a $0.2 million write-off of deferred financing costs
            associated
            with a terminated term loan. The remainder of the increase in 2005 resulted
            in
            generally increasing interest rates on the Company’s variable rate debt and
            increased outstanding borrowings and a mortgage for all of 2005 due to
            the
            purchase of IVC in July 2004 and our Media Center land and building in
            August
            2004, respectively.
  *Income
            Taxes* .
            The
            Company’s effective tax rate was 83% for 2005 and 39% for 2004. The increase
            in
            effective tax rate is the result of the Company’s periodic assessment of the
            relationship of book/tax timing differences to total expected annual
            pre-tax
            results and the elimination of goodwill expense for financial statement
            purposes. The effective tax rate percentage may change from period to
            period
            depending on the difference in the timing of the recognition of revenues
            and
            expenses for book and tax purposes. The high effective rate for 2005
            resulted
            from the relatively low amount of pre-tax income when compared to such
            differences.
  *Net
            Income* . **** The
            net
            income for 2005 was $0.0 million, a decrease of $1.2 million compared to
            net income of $1.2 million for 2004.
  **Year
            Ended December 31, 2004 Compared To Year Ended December 31,
            2003.**
  *Revenues* .
            Revenues for 2004 were $63.3 million, down 2% from $64.9 million in 2003.
            The
            decline in 2004 is due to lower spot advertising distribution for studio
            film
            releases and the early 2003 completion of a large firm re-mastering project
            which contributed to higher 2003 sales. The declines were offset by the
            additional revenues of $6.5 million from the July 1, 2004 acquisition
            of
            IVC.
  *Gross
            Profit* .
            In
            2004, gross margin was 36% of sales compared to 39% in 2003. The Company
            achieved $22.8 million of gross profit in 2004 compared to $25.2 million
            in
            2003. The decline in gross margins was due to lower sales and duplicated
            rent
            and moving expenses associated with the new Media Center facility, offset
            by the
            addition of IVC.
  *Selling,
            General And Administrative Expense* .  SG&A
            expense was 30% of sales in 2004 compared to 27% of sales in 2003. Excluding
            S,G&A expenses of IVC, total S,G&A in 2004 was $17.6 million compared to
            $17.5 million in 2003.
  In
            all
            periods presented, the write-off of deferred acquisition and financing
            and
            settlement costs related to the termination of the potential acquisition
            of
            three subsidiaries of Alliance Atlantis Communications, Inc. (“Alliance”) has
            been set forth separately. The Company wrote-off approximately $1.0 million
            of
            such expenses in each of 2004 and 2005.
  *Operating
            Income* .
            Operating income decreased to $2.8 million in 2004 from $6.7 million
            in 2003.
            Operating income in 2004 included $1.4 million contributed by IVC.
  *Interest
            Expense* .  **** Interest
            expense for 2004 was $0.8 million, a decrease of $1.2 million from 2003
            because
            of lower interest rates due to the expiration of an interest rate hedge
            contract, offset by interest expense on additional debt.
  *Derivative
            Fair Value Change* .
            The
            Company adopted SFAS 133 on January 1, 2001. During the year ended December
            31,
            2003, the Company recorded the difference between the derivative fair
            value of
            the Company’s interest rate hedge contract at the beginning and end of the
            period, or income of $611,000 ($367,000 net of tax provision) and amortization
            of the cumulative-effect adjustment. The contract expired in November
            2003.
  *Income
            Taxes* .
            The
            Company’s effective tax rate was 38.5% for 2004 and 40% for 2003. The decrease
            in effective tax rate is the result of the Company’s periodic assessment of the
            relationship of book/tax timing differences to total expected annual
            pre-tax
            results and the elimination of goodwill expense for financial statement
            purposes. The effective tax rate percentage may change from period to
            period
            depending on the difference in the timing of the recognition of revenues
            and
            expenses for book and tax purposes.
  *Net
            Income* .
            The net
            income for 2004 was $1.2 million, a decrease of $1.9 million compared
            to net
            income of $3.1 million for 2003.
  **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-K.
  In
            May
            2002, the Company and its banks entered into a term loan agreement with
            a
            maturity date of December 31, 2004. In January and February 2004, the
            Company
            made $1 million of scheduled principal payments under the term loan.
            In March
            2004, the Company paid off the remaining $14.9 million prior term loan
            principal
            balance with $6.9 of cash and proceeds from the new $8 million term loan
            pursuant to a new credit agreement. The new agreement provided up to
            $10 million
            of revolving credit availability for two years and a five-year $8 million
            five-year term loan. The agreement was subsequently amended to increase
            the
            revolving credit and term loan availability by $1.9 million and $4.7
            million,
            respectively, concurrent with the acquisition of IVC.
  17
 In
            November 2003, the Company leased a new 64,600 square foot building in
            Los
            Angeles, California, for the purpose of consolidating four vault locations
            then
            occupying approximately 71,000 square feet. A provision of the lease
            provided
            that in May 2005, the Company had an option to purchase the building
            for
            approximately $8,572,000. We purchased the building in August 2004 by
            paying
            $2,065,000 in cash and borrowing the $6,435,000 million balance under
            a mortgage
            term loan payable over 15 years. We also spent approximately $3.1 million
            for
            improvements to the building during 2004.
  On
            December 30, 2005, the Company entered a new $10 million term loan agreement.
            The term loan provides for interest at LIBOR plus 3.15% and is secured
            by the
            Company’s equipment. The term loan will be repaid in 60 equal principal payments
            plus interest. Proceeds of the loan were used to pay off our previously
            existing
            term loan.
  In
            March
            2006, the Company entered into a new revolving credit agreement which
            provides
            up to $10 million of revolving credit. The two-year agreement provides
            for
            interest of LIBOR plus 1.85% for the first six months of the agreement,
            and
            thereafter either (i) prime minus 0% - .50% or (ii) LIBOR plus 1.50%
            - 2.50%,
            depending on the level of the Company’s ratio of outstanding debt to fixed
            charges (as defined). The facility is secured by all of the Company’s assets,
            except for equipment securing a new term loan as described above.
  In
            March
            2006, the Company entered into a sale and leaseback transaction with
            respect to
            its real estate. The real estate sold for $13,946,000 resulting in a
            $1.3
            million after tax gain. Additionally, we received $500,000 from the purchaser
            for improvements. In accordance with SFAS No. 28, *Accounting
            for Sales with Leasebacks* (“SFAS
            28”), the gain will be amortized over the initial 15-year lease term as
            reduced
            rent. Net proceeds at the closing of the sale and the improvement advance
            (approximately $14.0 million) were used to pay off the mortgage and other
            outstanding debt. In accordance with our agreement with the revolving
            credit
            lender, we prepaid $4 million of the new term loan.
  The
            following table summarizes the December 31, 2005 status of our revolving
            line of
            credit and term loans, and the pro forma balances showing the debt reduction
            from the proceeds of new loans and sale of real estate:
 
 **Actual
                      Balance**
                  
                  
                  **Payments
                      in****March 2006**
                  
                  
                  **Pro
                      Forma****Balance**Revolving
                      credit
                  
                  $
                  4,054,000
                  
                  $
                  (3,904,000
                  )
                  $
                  150,000Current
                      portion of mortgage and term loans
                  
                  
                  2,373,000
                  
                  
                  (310,000
                  )
                  
                  2,063,000Long-term
                      portion of mortgage and term loans
                  
                  
                  13,790,000
                  
                  
                  (9,744,000
                  )
                  
                  4,046,000Total
                  
                  $
                  20,217,000
                  
                  $
                  (13,958,000
                  )
                  $
                  6,259,000
  Monthly
            and annual principal and interest payments due under the new term debt
            are
            approximately $167,000 and $2 million, respectively, assuming no change
            in
            interest rates, down from $260,000 and $3,100,000, respectively, from
            last year.
            Simultaneously, monthly and annual cash lease costs have increased by
            $93,000
            and $1,111,000, respectively (approximately $70,000 and $837,000, respectively,
            after considering the reduction in building depreciation expense and
            amortization of the deferred gain associated with the sale).
  We
            expect
            that remaining amounts available under the new revolving credit arrangement,
            the
            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 $2.5 - 3.5 million of capital expenditures for the next twelve
            months.
  The
            acquisition of IVC was completed in July 2004, for which we paid $2.3
            million in
            cash and borrowed the $4.7 million. The IVC purchase agreement also required
            payments of $1 million, $2 million and $2 million in 2005, 2006 and 2007,
            respectively, if certain predetermined earnings levels (as defined) are
            met. In
            April 2005, $1 million was paid. $2 million will be paid on March 31,
            2006.
 
 The
            following table summarizes contractual obligations as of December 31,
            2005 due
            in the future:
 **Payment
                        due by Period****Contractual
                        Obligations**
                    
                    
                    **Total**
                    
                    
                    **Less
                        than 1 Year**
                    
                    
                    **Years**
                      **2
                        and 3**
                    
                    
                    **Years**
                      **4
                        and 5**
                    
                    
                    **Thereafter**Long
                        Term Debt Obligations
                    
                    $
                    16,053,000
                    
                    $
                    2,279,000
                    
                    $
                    4,617,000
                    
                    $
                    4,710,000
                    
                    $
                    4,447,000Capital
                        Lease Obligations
                    
                    
                    79,000
                    
                    
                    63,000
                    
                    
                    16,000
                    
                    
                    -
                    
                    
                    -Operating
                        Lease Obligations
                    
                    
                    18,722,000
                    
                    
                    3,866,000
                    
                    
                    7,504,000
                    
                    
                    3,861,000
                    
                    
                    3,491,000Total
                    
                    $
                    34,854,000
                    
                    $
                    6,208,000
                    
                    $
                    12,137,000
                    
                    $
                    8,571,000
                    
                    $
                    7,938,000
  18
 The
              following table summarizes contractual obligations as of December 31,
              2005 due
              in the future after providing for the effects the sale and leaseback
              transaction
              in March 2006:
 
 **Payment
                        due by Period****Contractual
                        Obligations**
                    
                    
                    **Total**
                    
                    
                    **Less
                        than 1 Year**
                    
                    
                    **Years**
                      **2
                        and 3**
                    
                    
                    **Years**
                      **4
                        and 5**
                    
                    
                    **Thereafter**Long
                        Term Debt Obligations
                    
                    $
                    6,000,000
                    
                    $
                    2,000,000
                    
                    $
                    4,000,000
                    
                    $
                    -
                    
                    $
                    -Capital
                        Lease Obligations
                    
                    
                    79,000
                    
                    
                    63,000
                    
                    
                    16,000
                    
                    
                    -
                    
                    
                    -Operating
                        Lease Obligations
                    
                    
                    36,792,000
                    
                    
                    4,656,000
                    
                    
                    9,726,000
                    
                    
                    6,084,000
                    
                    
                    16,326,000Total
                    
                    $
                    42,871,000
                    
                    $
                    6,719,000
                    
                    $
                    13,742,000
                    
                    $
                    6,084,000
                    
                    $
                    16,326,000
  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 complementary to
              its current
              operations. Consummation of any such acquisition or other expansion
              of the
              business conducted by the Company may be subject to the Company securing
              additional financing, perhaps at a cost higher than our existing term
              loans.
              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 or conditions. Management believes
              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 judgements. 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 effects,
              duplication, distribution, etc. A customer orders one or more of these
              services
              with respect to an element (commercial spot, 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.
 
 *Allowance
              for doubtful accounts* .
              We are
              required to make judgments, based on historical experience and future
              expectations, as to the collectibility 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 allowances; 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 and intangibles 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 a comparison
              of the
              carrying amount of an asset to future net cash flows expected to be
              generated by
              that asset. The cash flow projections are based on historical experience,
              management’s view of growth rates within the industry and the anticipated future
              economic environment.
  Factors
                        we consider important which could trigger an impairment
                        review include the following:l
                      significant
                          underperformance relative to expected historical or projected
                          future
                          operating results;l
                      significant
                          changes in the manner of our use of the acquired assets
                          or the strategy
                          for our overall business;l
                      significant
                          negative industry or economic trends;l
                      significant
                          decline in our stock price for a sustained period; andl
                      our
                          market capitalization relative to net book value.
  19
 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 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 intangible assets, long-lived assets,
              and
              goodwill amounted to approximately $57.6 million as of December
              31, 2005 .
 
 In
              2002,
              Statement of Financial Accounting Standards (“SFAS”) No. 142, “ *Goodwill
              and Other Intangible Assets* ”
(“SFAS
              142”) became effective and as a result, we ceased to amortize approximately
              $26.3 million of goodwill beginning in 2002. In lieu of amortization, we
              were required to perform an initial impairment review of our goodwill
              in 2002
              and an annual impairment review thereafter. The initial test on January
              1, 2002,
              and the Fiscal 2002, 2003, 2004 and 2005 tests performed as of September
              30,
              2002, 2003, 2004 and 2005, respectively, required no goodwill impairment.
              An
              additional test was performed as of December 31, 2005 which required
              no
              impairment. The discounted cash flow method used to evaluate goodwill
              impairment
              included cash flow estimates for 2006 and subsequent years. If actual
              cash flow
              performance does not meet these expectations due to factors cited above,
              any
              resulting potential impairment could adversely affect reported goodwill
              asset
              values and earnings.
 
 *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 liability
              as of
              December 31, 2005 was $5.3 million. The Company did not record a valuation
              allowance against its deferred tax assets as of December 31, 2005.
 
 **RECENT
              ACCOUNTING PRONOUNCEMENTS**
 
 In
              November 2004, the FASB issued SFAS No. 151, *“Inventory
              Costs* ”.
              SFAS
              No. 151 amends the accounting for abnormal amounts of idle facility
              expense,
              freight, handling costs, and wasted material (spoilage) under the guidance
              in
              ARB No. 43, Chapter 4, *"Inventory
              Pricing* ”.
              Paragraph 5 of ARB No. 43, Chapter 4, previously stated that “. . . under some
              circumstances, items such as idle facility expense, excessive spoilage,
              double
              freight, and rehandling costs may be so abnormal as to require treatment
              as
              current period charges. . . . *”* This
              Statement requires that those items be recognized as current-period
              charges
              regardless of whether they meet the criterion of "so abnormal." In
              addition,
              this Statement requires that allocation of fixed production overheads
              to the
              costs of conversion be based on the normal capacity of the production
              facilities. This statement is effective for inventory costs incurred
              during
              fiscal years beginning after June 15, 2005. Management does not expect
              adoption
              of SFAS No. 151 to affect the Company’s financial statements.
 
 In
              December 2004, the FASB issued SFAS No. 152, *“Accounting
              for Real Estate Time-Sharing Transactions* .” The
              FASB
              issued this Statement as a result of the guidance provided in AICPA
              Statement of
              Position (SOP) 04-2, “ *Accounting
              for Real Estate Time-Sharing Transactions* . ”
SOP
              04-2 applies to all real estate time-sharing transactions. Among other
              items,
              the SOP provides guidance on the recording of credit losses and the
              treatment of
              selling costs, but does not change the revenue recognition guidance
              in SFAS No.
              66, “ *Accounting
              for Sales of Real Estate* ”,
              for
              real estate time-sharing transactions. SFAS No. 152 amends Statement
              No. 66 to
              reference the guidance provided in SOP 04-2. SFAS No. 152 also amends
              SFAS No.
              67, “ *Accounting
              for Costs and Initial Rental Operations of Real Estate Projects* ”,
              to
              state that SOP 04-2 provides the relevant guidance on accounting for
              incidental
              operations and costs related to the sale of real estate time-sharing
              transactions. SFAS No. 152 is effective for years beginning after June
              15, 2005,
              with restatements of previously issued financial statements prohibited. This
              statement is not applicable to the Company.
 
 In
              December 2004, the FASB issued SFAS No. 153, “ *Exchanges
              of Nonmonetary Assets* ,”
an
              amendment to Opinion
              No. 29, *“Accounting
              for Nonmonetary Transactions* . ”  Statement
              No. 153 eliminates certain differences in the guidance in Opinion No.
              29 as
              compared to the guidance contained in standards issued by the International
              Accounting Standards Board. The amendment to Opinion No. 29 eliminates
              the fair
              value exception for nonmonetary exchanges of similar productive assets
              and
              replaces it with a general exception for exchanges of nonmonetary assets
              that do
              not have commercial substance. Such an exchange has commercial substance
              if the
              future cash flows of the entity are expected to change significantly
              as a result
              of the exchange. SFAS No. 153 is effective for nonmonetary asset exchanges
              occurring in periods beginning after June 15, 2005. Earlier application
              is
              permitted for nonmonetary asset exchanges occuring in periods beginning
              after
              December 16, 2004. Management
              does not expect adoption of SFAS No. 153 to have a material impact
              on the
              Company’s financial statements.
 
 20
 In
              December 2004, the FASB issued SFAS No. 123(R), “ *Share-Based
              Payment* .”
SFAS
              123(R) amends SFAS No. 123, “ *Accounting
              for Stock-Based Compensation* ”,
              and
              APB Opinion 25, “ *Accounting
              for Stock Issued to Employees* .”
SFAS
              No.123(R) requires that the cost of share-based payment transactions
              (including
              those with employees and non-employees) be recognized in the financial
              statements. SFAS No. 123(R) applies to all share-based payment transactions
              in
              which an entity acquires goods or services by issuing (or offering
              to issue) its
              shares, share options, or other equity instruments (except for those
              held by an
              ESOP) or by incurring liabilities (1) in amounts based (even in part)
              on the
              price of the entity’s shares or other equity instruments, or (2) that require
              (or may require) settlement by the issuance of an entity’s shares or other
              equity instruments. This statement is effective (1) for public companies
              qualifying as SEC small business issuers, as of the first interim period
              or
              fiscal year beginning after December 15, 2005, or (2) for all other
              public
              companies, as of the first fiscal year beginning after June 15, 2005,
              or (3) for
              all nonpublic entities, as of the first fiscal year beginning after
              December 15,
              2005. The implementation of SFAS No. 123(R) will affect the Company’s financial
              statements for stock options granted after December 31, 2005.
 
 In
              May
              2005, the FASB issued SFAS No. 154, “ *Accounting
              Changes and Error Corrections* ”,
              an
              amendment to Accounting Principles Bulletin (APB) Opinion No. 20, “ *Accounting
              Changes* ”,
              and
              SFAS No. 3, “ *Reporting
              Accounting Changes in Interim Financial Statements* .”
Though
              SFAS No. 154 carries forward the guidance in APB No. 20 and SFAS No.
              3 with
              respect to accounting for changes in estimates, changes in reporting
              entity, and
              the correction of errors, SFAS No. 154 establishes new standards on
              accounting
              for changes in accounting principles, whereby all such changes must
              be accounted
              for by retrospective application to the financial statements of prior
              periods
              unless it is impracticable to do so. SFAS No. 154 is effective for
              accounting
              changes and error corrections made in fiscal years beginning after
              December 15,
              2005, with early adoption permitted for changes and corrections made
              in years
              beginning after May 2005. The Company will implement SFAS No. 154 in
              the fiscal
              year beginning January 1, 2006.
 
 In
              February 2006, the FASB issued Statement of Financial Accounting Standards
              No.
              155, “ *Accounting
              for Certain Hybrid Financial Instruments* ”
(“SFAS
              155”), which amends SFAS No. 133, “ *Accounting
              for Derivatives Instruments and Hedging Activities* ”
(SFAS
              133”) and SFAS No. 140, “ *Accounting
              for Transfers and Servicing of Financial Assets and Extinguishment
              of
              Liabilities* ”
(SFAS
              140”). SFAS 155 amends SFAS 133 to narrow the scope exception for interest-only
              and principal-only strips on debt instruments to include only such
              strips
              representing rights to receive a specified portion of the contractual
              interest
              or principle cash flows. SFAS 155 also amends SFAS 140 to allow qualifying
              special-purpose entities to hold a passive derivative financial instrument
              pertaining to beneficial interests that itself is derivative instrument.
              The
              Company is currently evaluating the impact this new Standard, but believes
              that
              it will not have a material impact on the Company’s financial position, results
              of operations or cash flows.
 
 **ITEM
              7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
              RISK**
 
 *Market
              Risk* .
              The
              Company had borrowings of $14.0 million at December 31, 2005 under
              a term loan
              and revolving credit agreements, and $6.1 million outstanding under
              a mortgage.
              With the exception of the mortgage, all debt was subject to a variable
              interest
              rate. The weighted average interest rate paid during 2005 was 6.6%.
              For variable
              rate debt outstanding at December 31, 2005, a .25% increase in interest
              rates
              will increase annual interest expense by approximately $35,000. Subsequent
              to
              December 31, 2005, the Company repaid all amounts outstanding under
              the
              revolving credit agreement and mortgage with the proceeds from the
              sale of real
              estate and a new revolving credit agreement. Amounts outstanding under
              the new
              term loan and revolving credit facility provide for interest at the
              banks’ prime
              rate minus .50% to prime rate or LIBOR plus 1.5% to 2.5% for the revolver,
              and
              LIBOR plus 3.15% for the term loan. The Company’s market risk exposure with
              respect to financial instruments is to changes in prime or LIBOR rates.
 
 On
              June
              15, 1998, the Financial Accounting Standards Board (FASB) issued Statement
              of
              Financial Accounting Standards No. 133, “ *Accounting
              for Derivative Instruments and Hedging Activities* .”
The
              standard, as amended by Statement of Financial Accounting Standards
              No. 137,
“ *Accounting
              for Derivative Instruments and Hedging Activities Deferral of the Effective
              Date
              of FASB Statement No. 133, an amendment of FASB Statement No.
              133* ,”
and
              Statement of Financial Accounting Standards No. 138, *“Accounting
              for Certain Derivative Instruments and Certain Hedging Activities,
              an amendment
              of FASB Statement No. 133”* (referred to hereafter as “FAS 133”), is effective for all fiscal quarters of
              all fiscal years beginning after June 15, 2000 (January 1, 2001 for
              the
              Company). FAS 133 requires that all derivative instruments be recorded
              on the
              balance sheet at their fair value. Changes in the fair value of derivatives
              are
              recorded each period in current earnings or in other comprehensive
              income,
              depending on whether a derivative is designated as part of a hedging
              relationship and, if it is, depending on the type of hedging relationship.
              During 2001, the Company recorded a cumulative effect type adjustment
              of
              $247,000 (net of $62,000 tax benefit) as a charge to Accumulated Other
              Comprehensive Income, a component of Shareholders’ Equity, and an expense of
              $700,000 ($560,000 net of tax benefit) for the derivative fair value
              change of
              an interest rate swap contract and amortization of the cumulative effect
              adjustment. During the year ended December 31, 2003, the Company recorded
              income
              of $611,000 ($367,000 net of tax provision) for the derivative fair
              value change
              and amortization of the cumulative effect type adjustment. The interest
              rate-swap contract terminated in November 2003.
 
 21
 **ITEM
                8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**
 
 **Page**Report
                          of Independent Registered Public Accounting Firm
                      23Financial
                          Statements:Consolidated
                          Balance Sheets -December
                          31, 2004 and 2005
                      24Consolidated
                          Statements of Income -Fiscal
                          Years Ended December 31, 2003, 2004 and 2005
                      25Consolidated
                          Statements of Shareholders’ Equity and Comprehensive Income (Loss)
                          -Fiscal
                          Years Ended December 31, 2003, 2004 and 2005
                      26Consolidated
                          Statements of Cash Flows -Fiscal
                          Years Ended December 31, 2003, 2004 and 2005
                      27Notes
                          to Consolidated Financial Statements
                      28Financial
                          Statement Schedule:Schedule
                          II - Valuation and Qualifying Accounts
                      42Consent
                          of Independent Registered Public Accounting Firm
                      48
  Schedules
                other than those listed above have been omitted since they are either
                not
                required, are not applicable or the required information is shown
                in the
                financial statements or the related notes.
 
 22
 **Report
                of Independent Registered Public Accounting Firm**
 
 
 To
                the
                Board of Directors and
 Shareholders
                of Point.360
 Burbank,
                California
  
 We
                have
                audited the accompanying consolidated balance sheets of Point.360
                and
                subsidiaries as of December 31, 2004 and 2005, and the
                related consolidated statements of income, shareholders' equity and
                comprehensive income (loss), and cash flows for each
                of the three years in the period ended December 31, 2005. These financial
                statements are the responsibility of the Company's management. Our
                responsibility is to express an opinion on these financial statements
                based on
                our audit.
 
 We
                conducted our audits in accordance with auditing standards of the
                Public Company
                Accounting Oversight Board (United States). Those standards require
                that we plan
                and perform the audits to obtain reasonable assurance about whether
                the
                financial statements are free of material misstatement. An audit
                includes
                examining, on a test basis, evidence supporting the amounts and disclosures
                in
                the financial statements. An audit also includes assessing the accounting
                principles used and significant estimates made by management, as
                well as
                evaluating the overall financial statement presentation. We believe
                that our
                audits provided a reasonable basis for our opinion.
 
 In
                our
                opinion, the consolidated financial statements referred to above
                present fairly,
                in all material respects, the financial position of Point.360 and
                subsidiaries
                as of December 31, 2004 and 2005, and the results of their operations
                and their
                cash flows for each of the three years in the period ended December
                31, 2005 in
                conformity with accounting principles generally accepted in the United
                States of
                America.
  
 Singer
                Lewak Greenbaum & Goldstein LLP (signed)
 Los
                Angeles, California
 February
                10, 2006, except for Note 12 as to which
 date
                is
                March 29, 2006
 
 23
 **Point.360**
 **Consolidated
                Balance Sheets**
 **December
                            31,****2004**
                        
                        
                        **2005****Assets**Current
                            assets:Cash
                            and cash equivalents
                        
                        $
                        668,000
                        
                        $
                        595,000Accounts
                            receivable, net of allowances for doubtful accounts of
                            $531,000 and
                            $563,000, respectively
                        
                        
                        12,468,000
                        
                        
                        12,662,000Inventories
                        
                        
                        932,000
                        
                        
                        796,000Prepaid
                            expenses and other current assets
                        
                        
                        1,788,000
                        
                        
                        2,432,000Deferred
                            income taxes
                        
                        
                        1,310,000
                        
                        
                        828,000Total
                            current assets
                        
                        
                        17,166,000
                        
                        
                        17,313,000Property
                            and equipment, net (Note 4)
                        
                        
                        31,451,000
                        
                        
                        28,079,000Other
                            assets, net
                        
                        
                        742,000
                        
                        
                        593,000Goodwill
                            and other intangibles, net (Note 3)
                        
                        
                        27,288,000
                        
                        
                        29,474,000$
                        76,647,000
                        
                        $
                        75,459,000**Liabilities
                            and Shareholders’ Equity**Current
                            liabilities:Accounts
                            payable
                        
                        $
                        4,898,000
                        
                        $
                        3,986,000Accrued
                            wages and benefits
                        
                        
                        1,751,000
                        
                        
                        1,711,000Accrued
                            earn-out payments
                        
                        
                        1,000,000
                        
                        
                        2,000,000Other
                            accrued expenses
                        
                        
                        1,249,000
                        
                        
                        683,000Income
                            tax payable
                        
                        
                        1,148,000
                        
                        
                        1,231,000Borrowings
                            under revolving credit agreement (Notes 6 and 12)
                        
                        
                        4,323,000
                        
                        
                        4,054,000Current
                            portion of borrowings under notes payable
                        
                        
                        2,849,000
                        
                        
                        2,310,000Current
                            portion of capital lease obligations (Note 6)
                        
                        
                        67,000
                        
                        
                        63,000Total
                            current liabilities
                        
                        
                        17,285,000
                        
                        
                        16,038,000Deferred
                            income taxes
                        
                        
                        5,788,000
                        
                        
                        6,121,000Notes
                            payable, less current portion (Note 6)
                        
                        
                        14,494,000
                        
                        
                        13,744,000Capital
                            lease and other obligations, less current portion (Note
                            6)
                        
                        
                        136,000
                        
                        
                        46,000Total
                            long-term liabilities
                        
                        
                        20,418,000
                        
                        
                        19,911,000Total
                            liabilities
                        
                        
                        37,703,000
                        
                        
                        35,949,000Commitments
                            and contingencies (Note 8)
                        
                        
                        -
                        
                        
                        -Shareholders’
                            equityPreferred
                            stock - no par value; 5,000,000 shares authorized; none
                            outstanding
                          Common
                            stock - no par value; 50,000,000 shares authorized; 9,236,132
                            and
                            9,368,857 shares issued and outstanding, respectively
                        
                        
                        17,903,000
                        
                        
                        17,971,000Additional
                            paid-in capital
                        
                        
                        675,000
                        
                        
                        1,159,000Retained
                            earnings
                        
                        
                        20,366,000
                        
                        
                        20,380,000Total
                            shareholders’ equity
                        
                        
                        38,944,000
                        
                        
                        39,510,000$
                        76,647,000
                        
                        $
                        75,459,000
 
 The
                  accompanying notes are an integral part of these consolidated financial
                  statements.
  24
 **Point.360**
 **Consolidated
                  Statements of Income**
 **Year
                              Ended December 31,****2003**
                          
                          
                          **2004**
                          
                          
                          **2005**Revenues
                          
                          $
                          64,900,000
                          
                          $
                          63,344,000
                          
                          $
                          66,199,000Cost
                              of goods sold
                          
                          
                          (39,670,000
                          )
                          
                          (40,519,000
                          )
                          
                          (43,167,000
                          )Gross
                              profit
                          
                          
                          25,230,000
                          
                          
                          22,825,000
                          
                          
                          23,032,000Selling,
                              general and administrative expense
                          
                          
                          (17,479,000
                          )
                          
                          (18,936,000
                          )
                          
                          (21,424,000
                          )Write-off
                              of deferred acquisition and financing costs (Note 3)
                          
                          
                          (1,043,000
                          )
                          
                          (1,050,000
                          )
                          
                          -Operating
                              income
                          
                          
                          6,708,000
                          
                          
                          2,839,000
                          
                          
                          1,608,000Interest
                              expense (net)
                          
                          
                          (2,056,000
                          )
                          
                          (811,000
                          )
                          
                          (1,524,000
                          )Derivative
                              fair value change
                          
                          
                          611,000
                          
                          
                          -
                          
                          
                          -Income
                              before income taxes
                          
                          
                          5,263,000
                          
                          
                          2,028,000
                          
                          
                          84,000Provision
                              for income taxes
                          
                          
                          (2,114,000
                          )
                          
                          (781,000
                          )
                          
                          (70,000
                          )Net
                              income
                          
                          $
                          3,149,000
                          
                          $
                          1,247,000
                          
                          $
                          14,000Earnings
                              per share:Basic:Net
                              income
                          
                          $
                          0.35
                          
                          $
                          0.14
                          
                          $
                          0.00Weighted
                              average number of shares
                          
                          
                          9,067,446
                          
                          
                          9,196,620
                          
                          
                          9,346,533Diluted:Net
                              income
                          
                          $
                          0.33
                          
                          $
                          0.13
                          
                          $
                          0.00Weighted
                              average number of shares including the dilutive effect
                              of stock
                              options
                          
                          
                          9,554,847
                          
                          
                          9,671,395
                          
                          
                          9,713,811
  The
                    accompanying notes are an integral part of these consolidated
                    financial
                    statements.
 
 25
  **Point.360**
 **Consolidated
                    Statements of Shareholders’ Equity, and Comprehensive Income (Loss)**
 **(in
                    thousands except for share amounts)**
 **Additional**
                            **Paid-in**
                          
                          
                          **Retained**
                          
                          
                          **Accumulated
                              Other**
                            **Comprehensive**
                          
                          
                          **Share-holders****Shares**
                          
                          
                          **Amount**
                          
                          
                          **Capital**
                          
                          
                          **Earnings**
                          
                          
                          **Income
                              (Loss)**
                          
                          
                          **Equity**Balance
                              on December 31, 2002
                          
                          
                          9,014,232
                          
                          $
                          17,359
                          
                          $
                          1,272
                          
                          $
                          15,970
                          
                          $
                          (90
                          )
                          $
                          34,511Net
                              income
                          
                          
                          -
                          
                          
                          -
                          
                          
                          -
                          
                          
                          3,149
                          
                          
                          -
                          
                          
                          3,149Shares
                              issued in connection with exercise of stock options
                          
                          
                          120,327
                          
                          
                          266
                          
                          
                          -
                          
                          
                          -
                          
                          
                          -
                          
                          
                          266Tax
                              effect of stock options exercised
                          
                          
                          -
                          
                          
                          -
                          
                          
                          59
                          
                          
                          -
                          
                          
                          -
                          
                          
                          59Termination
                              of stock purchase warrants
                          
                          
                          -
                          
                          
                          -
                          
                          
                          (617
                          )
                          
                          -
                          
                          
                          -
                          
                          
                          (617
                          )Termination
                              of stock options
                          
                          
                          -
                          
                          
                          -
                          
                          
                          (90
                          )
                          
                          -
                          
                          
                          -
                          
                          
                          (90
                          )Change
                              in other comprehensive income
                          
                          
                          -
                          
                          
                          -
                          
                          
                          -
                          
                          
                          -
                          
                          
                          90
                          
                          
                          90Balance
                              on December 31, 2003
                          
                          
                          9,134,559
                          
                          
                          17,625
                          
                          
                          624
                          
                          
                          19,119
                          
                          
                          -
                          
                          
                          37,368Net
                              income
                          
                          
                          -
                          
                          
                          -
                          
                          
                          -
                          
                          
                          1,247
                          
                          
                          -
                          
                          
                          1,247Shares
                              issued in connection with exercise of stock options
                          
                          
                          101,573
                          
                          
                          278
                          
                          
                          -
                          
                          
                          -
                          
                          
                          -
                          
                          
                          278Tax
                              effect of options exercised
                          
                          
                          -
                          
                          
                          -
                          
                          
                          51
                          
                          
                          -
                          
                          
                          -
                          
                          
                          51Balance
                              on December 31, 2004
                          
                          
                          9,236,132
                          
                          
                          17,903
                          
                          
                          675
                          
                          
                          20,366
                          
                          
                          -
                          
                          
                          38,944Net
                              income
                          
                          
                          -
                          
                          
                          -
                          
                          
                          -
                          
                          
                          14
                          
                          
                          -
                          
                          
                          14Shares
                              issued in connection with the purchase of equipment
                              (Note
                              3)
                          
                          
                          105,000
                          
                          
                          -
                          
                          
                          484
                          
                          
                          -
                          
                          
                          -
                          
                          
                          484Shares
                              issued in connection with exercise of stock options
                          
                          
                          27,725
                          
                          
                          68
                          
                          
                          -
                          
                          
                          -
                          
                          
                          -
                          
                          
                          68Balance
                              on December 31, 2005
                          
                          
                          9,368,857
                          
                          
                          17,971
                          
                          
                          1,159
                          
                          
                          20,380
                          
                          
                          -
                          
                          
                          39,510
 
 Comprehensive
                              income is as follows:**2003**Net
                              income
                          
                          $
                          3,149Amortization
                              of cumulative effect
                            Adjustment
                              of adoption of FAS 133, net of tax
                          
                          
                          90Comprehensive
                              income
                          
                          $
                          3,239
 
 The
                    accompanying notes are an integral part of these consolidated
                    financial
                    statements.
 
 26
 **Point.360**
 **Consolidated
                    Statements of Cash Flows**
 **Year
                                Ended December 31,****2003**
                            
                            
                            **2004**
                            
                            
                            **2005**Cash
                                flows from operating activities:Net
                                income
                            
                            $
                            3,149,000
                            
                            $
                            1,247,000
                            
                            $
                            14,000Adjustments
                                to reconcile net income to net cash provided by operating
                              activities:Depreciation
                                and amortization
                            
                            
                            5,499,000
                            
                            
                            5,876,000
                            
                            
                            6,051,000Provision
                                for (recovery of) doubtful accounts
                            
                            
                            121,000
                            
                            
                            (48,000
                            )
                            
                            32,000Deferred
                                income taxes
                            
                            
                            (210,000
                            )
                            
                            (324,000
                            )
                            
                            815,000Loss
                                on disposal of property and equipment.
                            
                            
                            72,000
                            
                            
                            -
                            
                            
                            -Derivative
                                fair value change.
                            
                            
                            (611,000
                            )
                            
                            -
                            
                            
                            -Other
                                noncash items
                            
                            
                            -
                            
                            
                            (242,000
                            )
                            
                            -Write-off
                                of acquisition costs
                            
                            
                            1,002,000
                            
                            
                            -
                            
                            
                            -Changes
                                in operating assets and liabilities (net of acquisitions):(Increase)
                                decrease in accounts receivable
                            
                            
                            2,607,000
                            
                            
                            (1,146,000
                            )
                            
                            (226,000
                            )(Increase)
                                decrease in inventories
                            
                            
                            109,000
                            
                            
                            (18,000
                            )
                            
                            136,000(Increase)
                                in prepaid expenses and other current assets
                            
                            
                            (138,000
                            )
                            
                            (732,000
                            )
                            
                            (645,000
                            )(Increase)
                                decrease in other assets
                            
                            
                            (826,000
                            )
                            
                            606,000
                            
                            
                            149,000(Decrease)
                                increase in accounts payable
                            
                            
                            (514,000
                            )
                            
                            996,000
                            
                            
                            (912,000
                            )Increase
                                (decrease) in accrued expenses
                            
                            
                            (533,000
                            )
                            
                            (340,000
                            )
                            
                            394,000Increase
                                in income taxes payable (receivable), net.
                            
                            
                            753,000
                            
                            
                            939,000
                            
                            
                            83,000Net
                                cash and cash equivalents provided by operating activities
                            
                            
                            10,480,000
                            
                            
                            6,814,000
                            
                            
                            5,891,000Cash
                                flows from investing activities:Increase
                                in restricted cash.
                            
                            
                            800,000
                            
                            
                            -
                            
                            
                            -Payment
                                for acquisition costs subsequently written off
                            
                            
                            (369,000
                            )
                            
                            -
                            
                            
                            -Capital
                                expenditures
                            
                            
                            (1,237,000
                            )
                            
                            (5,307,000
                            )
                            
                            (2,355,000
                            )Proceeds
                                from sale of equipment
                            
                            
                            15,000
                            
                            
                            40,000
                            
                            
                            -Net
                                cash paid for acquisitions
                            
                            
                            (8,000
                            )
                            
                            (1,094,000
                            )
                            
                            (2,025,000
                            )Net
                                cash paid for acquisition of building
                            
                            
                            -
                            
                            
                            (2,065,000
                            )
                            
                            -Net
                                cash and cash equivalents used in investing activities
                            
                            
                            (1,599,000
                            )
                            
                            (8,426,000
                            )
                            
                            (4,380,000
                            )Cash
                                flows from financing activities:Change
                                in revolving credit agreement
                            
                            
                            -
                            
                            
                            4,323,000
                            
                            
                            (269,000
                            )Proceeds
                                from bank note for new loan
                            
                            
                            -
                            
                            
                            8,000,000
                            
                            
                            266,000Change
                                in note payable
                            
                            
                            -
                            
                            
                            182,000
                            
                            
                            -Proceeds
                                from exercise of stock options
                            
                            
                            266,000
                            
                            
                            329,000
                            
                            
                            68,000Repayment
                                of notes payable
                            
                            
                            (7,134,000
                            )
                            
                            (17,657,000
                            )
                            
                            (1,555,000
                            )Contract
                                settlement
                            
                            
                            (90,000
                            )
                            
                            -
                            
                            
                            -Repayment
                                of capital lease obligations
                            
                            
                            (89,000
                            )
                            
                            (103,000
                            )
                            
                            (94,000
                            )Net
                                cash and cash equivalents used in financing activities
                            
                            
                            (7,047,000
                            )
                            
                            (4,926,000
                            )
                            
                            (1,584,000
                            )Net
                                increase in cash and cash equivalents
                            
                            
                            1,834,000
                            
                            
                            (6,538,000
                            )
                            
                            (73,000
                            )Cash
                                and cash equivalents at beginning of year
                            
                            
                            5,372,000
                            
                            
                            7,206,000
                            
                            
                            668,000Cash
                                and cash equivalents at end of year
                            
                            $
                            7,206,000
                            
                            $
                            668,000
                            
                            $
                            595,000
 
 The
                      accompanying notes are an integral part of these consolidated
                      financial
                      statements.
  27
  **Point.360**
 **Notes
                      to Consolidated Financial Statements**
 
 **1.**  **THE
                      COMPANY:**
 
 Point.360
                      (“Point.360” or the “Company”) provides video and film asset management services
                      to owners, producers and distributors of entertainment and
                      advertising content.
                      The Company provides the services necessary to edit, master,
                      reformat, archive
                      and distribute its clients’ video content, including television programming,
                      spot advertising and movie trailers. The Company provides worldwide
                      electronic
                      distribution, using fiber optics and satellites. The Company
                      delivers
                      commercials, movie trailers, electronic press kits, infomercials
                      and syndicated
                      programming, by both physical and electronic means, to thousands
                      of broadcast
                      outlets worldwide. The Company operates in one reportable segment.
 
 **2.**  **SUMMARY
                      OF SIGNIFICANT ACCOUNTING POLICIES:**
 
 *Basis
                      of Consolidation*
 
 The
                      consolidated financial statements include the accounts of the
                      Company and three
                      subsidiaries, International Video Conversions, Inc. (“IVC”), a California
                      corporation, and two non-operating wholly owned subsidiaries,
                      VDI Multimedia,
                      Inc. and Multimedia Services, Inc., which subsidiaries were
                      shell companies
                      dissolved in 2003. All significant intercompany accounts and
                      transactions have
                      been eliminated in consolidation.
 
 *Use
                      of Estimates in the Preparation of Financial Statements*
 
 The
                      preparation of financial statements in conformity with accounting
                      principles
                      generally accepted in the United States requires management
                      to make estimates
                      and assumptions that affect the reported amounts of assets
                      and liabilities and
                      disclosure of contingent assets and liabilities at the date
                      of the financial
                      statements and the reported amounts of revenues and expenses
                      during the
                      reporting period. Actual results could differ from those estimates.
 
 *Cash
                      and Cash Equivalents*
 
 Cash
                      equivalents represent highly liquid short-term investments
                      with original
                      maturities of less than three months.
 
 *Revenues
                      and Receivables*
 
 The
                      Company records revenues when the services have been completed.
                      Although sales
                      and receivables are concentrated in the entertainment and advertising
                      industries, credit risk due to financial insolvency is limited
                      because of the
                      financial stability of the customer base (i.e., large studios
                      and advertising
                      agencies).
 
 *Concentration
                      of Credit Risk*
 
 Financial
                      instruments which potentially subject the Company to concentrations
                      of credit
                      risk consist principally of cash and cash equivalents, and
                      accounts receivable. The
                      Company maintains its cash and cash equivalents with high credit
                      quality
                      financial institutions; at times, such balances with any one
                      financial
                      institution may exceed FDIC insured limits.
 
 Credit
                      risk with respect to trade receivables is concentrated due
                      to the large number
                      of orders with major entertainment studios and advertising
                      agencies in any
                      particular reporting period. Our ten largest studio and advertising
                      agency
                      customers represented 52% of accounts receivable at both December
                      31, 2004 and
                      December 31, 2005. The Company reviews credit evaluations of
                      its customers but
                      does not require collateral or other security to support customer
                      receivables.
 
 The ten
                      largest studio and advertising agency customers **** accounted
                      for 37%, 38% and 47% of net sales for the years ended December
                      31, 2003, 2004
                      and 2005, respectively.
 
 *Inventories*
 
 Inventories
                      comprise raw materials, principally tape stock, and are stated
                      at the lower of
                      cost or market. Cost is determined using the average cost method.
 
 28
 *Property
                      and Equipment*
 
 Property
                      and equipment are stated at cost. Expenditures for additions
                      and major
                      improvements are capitalized. Depreciation is computed using
                      the straight-line
                      method over the estimated useful lives of the related assets.
                      Amortization of
                      leasehold improvements is computed using the straight-line
                      method over the
                      lesser of the estimated useful lives of the improvements or
                      the remaining lease
                      term. The estimated useful life of property and equipment is
                      7 to 39 years and
                      leasehold improvements are amortized over the remaining lease
                      term.
 
 *Goodwill
                      and Other Intangibles*
 
 Prior
                      to
                      the January 1, 2002 implementation of Statement of Financial
                      Accounting
                      Standards No. 142, “ *Goodwill
                      and Other Intangible Assets* ”
(“SFAS
                      142”), goodwill was amortized on a straight-line basis over 5-20
                      years. Since
                      that date, goodwill has been subject to periodic impairment
                      tests in accordance
                      with SFAS 142. Other intangibles consist primarily of covenants
                      not to compete
                      and are amortized on a straight-line basis over 3-5 years.
 
 The
                      Company identifies and records impairment losses on long-lived
                      assets, including
                      goodwill that is not identified with an impaired asset, when
                      events and
                      circumstances indicate that such assets might be impaired.
                      Events and
                      circumstances that may indicate that an asset is impaired include
                      significant
                      decreases in the market value of an asset, a change in the
                      operating model or
                      strategy and competitive forces.
 
 The
                      company evaluates its goodwill on an annual basis. If events
                      and circumstances
                      indicate that the carrying amount of an asset may not be recoverable
                      and the
                      expected undiscounted future cash flow attributable to the
                      asset is less than
                      the carrying amount of the asset, an impairment loss equal
                      to the excess of the
                      asset’s carrying value over its fair value is recorded. Fair value
                      is determined
                      based on the present value of estimated expected future cash
                      flows using a
                      discount rate commensurate with the risk involved, quoted market
                      prices or
                      appraised values, depending on the nature of the assets. To
                      date, no such
                      impairment has been recorded.
 
 *Income
                      Taxes*
 
 The
                      Company accounts for income taxes in accordance with Statement
                      of Financial
                      Accounting Standards No. 109, “ *Accounting*  *for
                      Income Taxes”* (“SFAS
                      109”). SFAS 109 requires the recognition of deferred tax assets
                      and liabilities
                      for the expected future tax consequences of temporary differences
                      between the
                      carrying amounts for financial reporting purposes and the tax
                      basis of assets
                      and liabilities. A valuation allowance is recorded for that
                      portion of deferred
                      tax assets for which it is more likely than not that the assets
                      will not be
                      realized.
 
 *Advertising
                      Costs*
 
 Advertising
                      costs are not significant to the Company’s operations and are expensed as
                      incurred.
 
 *Fair
                      Value of Financial Instruments*
 
 To
                      meet
                      the reporting requirements of Statement of Financial Accounting
                      Standards No.
                      107, “ *Disclosures
                      About Fair Value of Financial Instruments* ”
(“SFAS
                      107”), the Company calculates the fair value of financial instruments
                      and
                      includes this additional information in the notes to financial
                      statements when
                      the fair value is different than the book value of those financial
                      instruments.
                      When the fair value is equal to the book value, no additional
                      disclosure is
                      made. The Company uses quoted market prices whenever available
                      to calculate
                      these fair values.
 
 The
                      accrual method of accounting was used for the interest rate
                      swap agreement
                      entered into by the Company which converted the interest rate
                      on $15 million of
                      the Company’s variable-rate debt to a fixed rate (see Note 6). Under the
                      accrual
                      method, each net payment or receipt due or owed under the derivative
                      was
                      recognized in income in the period to which the payment or
                      receipt relates.
                      Amounts to be paid/received under these agreements are recognized
                      as an
                      adjustment to interest expense. The related amounts payable
                      to counter parties
                      was included in other accrued liabilities. The swap agreement
                      expired in
                      November 2003.
 
 *Accounting
                      for Stock-Based Compensation*
 
 As
                      permitted by Statement of Financial Accounting Standards No.
                      123, “ *Accounting
                      for Stock-Based Compensation”* (“SFAS
                      123”), the Company measures compensation costs in accordance with
                      Accounting
                      Principles Board Opinion No. 25, *Accounting
                      for Stock Issued to Employees* ,
                      but
                      provides pro forma disclosures of net income and earnings per
                      share using the
                      fair value method defined by FAS 123. Under APB No. 25, compensation
                      expense is
                      recognized over the vesting period based on the difference,
                      if any, on the date
                      of grant between the deemed fair value for accounting purposes
                      of the Company’s
                      stock and the exercise price on the date of grant. The Company
                      accounts for
                      stock issued to non-employees in accordance with the provisions
                      of SFAS No. 123
                      and Emerging Issues Task Force (“EITF”) 96-18, *Accounting
                      for Equity Instruments That Are Issued to Other Than Employees
                      for Acquiring, or
                      in Conjunction with Selling, Goods and Services* .
 
 29
 
 Had
                      the
                      Company determined compensation cost based on the fair value
                      for its stock
                      options at grant date, as set forth under SFAS 123, the Company’s net income and
                      earnings per share would have been reduced to the pro forma
                      amounts indicated
                      below:
 **2003**
                          
                          
                          **2004**
                          
                          
                          **2005**Net
                              income (loss):As
                              reported
                          
                          $
                          3,149,000
                          
                          $
                          1,247,000
                          
                          $
                          14,000Deduct:
                              Total stock-based employee compensation expense determined
                            under
                              fair value based method for all awards, net of related
                              tax
                              effects
                          
                          
                          (310,000
                          )
                          
                          (255,000
                          )
                          
                          (738,000
                          )Pro
                              forma
                          
                          
                          2,839,000
                          
                          
                          992,000
                          
                          
                          (724,000
                          )Earnings
                              (loss) per share:As
                              reported:Basic
                          
                          
                          0.35
                          
                          
                          0.14
                          
                          
                          0.00Diluted
                          
                          
                          0.33
                          
                          
                          0.13
                          
                          
                          0.00Pro
                              forma:Basic
                          
                          
                          0.31
                          
                          
                          0.11
                          
                          
                          (0.07
                          )Diluted
                          
                          
                          0.30
                          
                          
                          0.10
                          
                          
                          (0.07
                          )
  The
                    fair
                    value for these options was estimated at the grant date using
                    the Black-Scholes
                    option-pricing model with the following weighted-average assumptions
                    used for
                    grants in 2003, 2004 and 2005, respectively: expected volatility
                    of 60%, 44% and
                    38% and risk-free interest rates of 1.05%, 1.33% and 3.26%. A
                    dividend yield of
                    0% and expected life of five years was assumed for 2003, 2004
                    and 2005 grants.
                    The weighted average fair value of options granted at the fair
                    market price on
                    the grant date in 2003, 2004 and 2005 were $3.00, $1.03 and $1.05,
                    respectively.
                    All options granted in 2003, 2004 and 2005 were at fair market
                    price.
  *Earnings
                    Per Share*
  The
                    Company follows Statement of Financial Accounting Standards No.
                    128,
“ *Earnings
                    per Share”* (“SFAS
                    128”), and related interpretations for reporting Earnings per Share.
                    SFAS 128
                    requires dual presentation of Basic Earnings per Share (“Basic EPS”) and Diluted
                    Earnings per Share (“Diluted EPS”). Basic EPS excludes dilution and is computed
                    by dividing net income (loss) by the weighted average number
                    of common shares
                    outstanding during the reported period. Diluted EPS reflects
                    the potential
                    dilution that could occur if stock options were exercised using
                    the treasury
                    stock method.
 
 In
                    accordance with SFAS 128, basic earnings (loss) per share is
                    calculated based on
                    the weighted average number of shares of common stock outstanding
                    during the
                    reporting period. Diluted earnings per share is calculated giving
                    effect to all
                    potentially dilutive common shares, assuming such shares were
                    outstanding during
                    the reporting period.
 
 A
                    reconciliation of the denominator of the basic EPS computation
                    to the
                    denominator of the diluted EPS computation is as follows:
 
 **2003**
                          
                          
                          **2004**
                          
                          
                          **2005**Weighted
                              average number of common shares outstanding used in
                              computation of basic
                              EPS
                          
                          
                          9,067,446
                          
                          
                          9,196,620
                          
                          
                          9,346,533Dilutive
                              effect of outstanding stock options
                          
                          
                          487,401
                          
                          
                          474,775
                          
                          
                          367,278Weighted
                              average number of common and potential common shares
                              outstanding used in
                              computation of diluted EPS
                          
                          
                          9,554,847
                          
                          
                          9,671,395
                          
                          
                          9,713,811Outstanding
                              stock options excluded in the computation of diluted
                              EPS
                          
                          
                          1,573,277
                          
                          
                          1,878,172
                          
                          
                          1,342,357
 *Comprehensive
                    Income*
  In
                    1998,
                    the Company adopted Statement of SFAS No. 130, “ *Reporting
                    Comprehensive Income”* (“SFAS
                    130”). This Statement establishes standards for the reporting and
                    display of
                    comprehensive income and its components in a full set of general-purpose
                    financial statements. Comprehensive income, as defined, includes
                    all changes in
                    equity during a period from non-owner sources.
 
 30
 *Supplemental
                    Cash Flow Information*
  Selected
                    cash payments and noncash activities were as follows:
 **2003**
                            
                            
                            **2004**
                            
                            
                            **2005**Cash
                                payments for income taxes (net of refunds)
                            
                            $
                            2,626,000
                            
                            $
                            441,000
                            
                            $
                            131,000Cash
                                payments for interest
                            
                            
                            1,852,000
                            
                            
                            708,000
                            
                            
                            1,345,000Noncash
                                investing and financing activities:Termination
                                of warrants
                            
                            
                            619,000
                            
                            
                            -
                            
                            
                            -Capitalized
                                lease obligations incurred
                            
                            
                            -
                            
                            
                            -
                            
                            
                            -Tax
                                benefits related to stock options
                            
                            
                            59,000
                            
                            
                            51,000
                            
                            
                            -Accrual
                                for earn-out payments
                            
                            
                            -
                            
                            
                            1,000,000
                            
                            
                            2,000,000Termination
                                of stock purchase warrants incurred as part of proposed
                                acquisition
                            
                            
                            617,000
                            
                            
                            -
                            
                            
                            -Obligation
                                to purchase tenant improvements
                            
                            
                            800,000
                            
                            
                            -
                            
                            
                            -Right
                                to purchase tenant improvements
                            
                            
                            (800,000
                            )
                            
                            -
                            
                            
                            -Leasehold
                                improvements transferred from prepaid expenses
                            
                            
                            100,000
                            
                            
                            -
                            
                            
                            -Detail
                                of acquisitions:Goodwill
                                (1)
                            
                            
                            -
                            
                            
                            242,000
                            
                            
                            2,186,000
 
 (1)
                            Includes
                                additional purchase price payments made or accrued
                                to former owners in
                                periods subsequent to various acquisitions of $1,000,000
                                and $2,000,000 in
                                2004 and 2005, respectively.
 
 *Recent
                      Accounting Pronouncements*
 
 In
                      November 2004, the FASB issued SFAS No. 151, *“Inventory
                      Costs* ”.
                      SFAS
                      No. 151 amends the accounting for abnormal amounts of idle
                      facility expense,
                      freight, handling costs, and wasted material (spoilage) under
                      the guidance in
                      ARB No. 43, Chapter 4, *"Inventory
                      Pricing* ”.
                      Paragraph 5 of ARB No. 43, Chapter 4, previously stated that
“. . . under some
                      circumstances, items such as idle facility expense, excessive
                      spoilage, double
                      freight, and rehandling costs may be so abnormal as to require
                      treatment as
                      current period charges. . . . *”* This
                      Statement requires that those items be recognized as current-period
                      charges
                      regardless of whether they meet the criterion of "so abnormal."
                      In addition,
                      this Statement requires that allocation of fixed production
                      overheads to the
                      costs of conversion be based on the normal capacity of the
                      production
                      facilities. This statement is effective for inventory costs
                      incurred during
                      fiscal years beginning after June 15, 2005. Management does
                      not expect adoption
                      of SFAS No. 151 to affect the Company’s financial statements.
 
 In
                      December 2004, the FASB issued SFAS No. 152, *“Accounting
                      for Real Estate Time-Sharing Transactions* ”. The
                      FASB
                      issued this Statement as a result of the guidance provided
                      in AICPA Statement of
                      Position (SOP) 04-2, “ *Accounting
                      for Real Estate Time-Sharing Transactions* ”.
                      SOP
                      04-2 applies to all real estate time-sharing transactions.
                      Among other items,
                      the SOP provides guidance on the recording of credit losses
                      and the treatment of
                      selling costs, but does not change the revenue recognition
                      guidance in SFAS No.
                      66,” *Accounting
                      for Sales of Real Estate* ”,
                      for
                      real estate time-sharing transactions. SFAS No. 152 amends
                      Statement No. 66 to
                      reference the guidance provided in SOP 04-2. SFAS No. 152 also
                      amends SFAS No.
                      67, “ *Accounting
                      for Costs and Initial Rental Operations of Real Estate Projects* ”,
                      to
                      state that SOP 04-2 provides the relevant guidance on accounting
                      for incidental
                      operations and costs related to the sale of real estate time-sharing
                      transactions. SFAS No. 152 is effective for years beginning
                      after June 15, 2005,
                      with restatements of previously issued financial statements
                      prohibited. This
                      statement is not applicable to the Company.
 
 In
                      December 2004, the FASB issued SFAS No. 153, “ *Exchanges
                      of Nonmonetary Assets* ,”
an
                      amendment to Opinion
                      No. 29, *“Accounting
                      for Nonmonetary Transactions* ” . Statement
                      No. 153 eliminates certain differences in the guidance in Opinion
                      No. 29 as
                      compared to the guidance contained in standards issued by the
                      International
                      Accounting Standards Board. The amendment to Opinion No. 29
                      eliminates the fair
                      value exception for nonmonetary exchanges of similar productive
                      assets and
                      replaces it with a general exception for exchanges of nonmonetary
                      assets that do
                      not have commercial substance. Such an exchange has commercial
                      substance if the
                      future cash flows of the entity are expected to change significantly
                      as a result
                      of the exchange. SFAS No. 153 is effective for nonmonetary
                      asset exchanges
                      occurring in periods beginning after June 15, 2005. Earlier
                      application is
                      permitted for nonmonetary asset exchanges occuring in periods
                      beginning after
                      December 16, 2004. Management
                      does not expect adoption of SFAS No. 153 to have a material
                      impact on the
                      Company’s financial statements.
 
 31
 In
                      December 2004, the FASB issued SFAS No. 123(R), “ *Share-Based
                      Payment.* ”
SFAS
                      123(R) amends SFAS No. 123, “ *Accounting
                      for Stock-Based Compensation* ”,
                      and
                      APB Opinion 25, “ *Accounting
                      for Stock Issued to Employees* .”
SFAS
                      No.123(R) requires that the cost of share-based payment transactions
                      (including
                      those with employees and non-employees) be recognized in the
                      financial
                      statements. SFAS No. 123(R) applies to all share-based payment
                      transactions in
                      which an entity acquires goods or services by issuing (or offering
                      to issue) its
                      shares, share options, or other equity instruments (except
                      for those held by an
                      ESOP) or by incurring liabilities (1) in amounts based (even
                      in part) on the
                      price of the entity’s shares or other equity instruments, or (2) that require
                      (or may require) settlement by the issuance of an entity’s shares or other
                      equity instruments. This statement is effective (1) for public
                      companies
                      qualifying as SEC small business issuers, as of the first interim
                      period or
                      fiscal year beginning after December 15, 2005, or (2) for all
                      other public
                      companies, as of the first fiscal year beginning after June
                      15, 2005, or (3) for
                      all nonpublic entities, as of the first fiscal year beginning
                      after December 15,
                      2005. The implementation of SFAS No. 123(R) will affect the
                      Company’s financial
                      statements for stock options granted after December 31, 2005.
 
 In
                      May
                      2005, the FASB issued SFAS No. 154, “ *Accounting
                      Changes and Error Corrections* ”,
                      an
                      amendment to Accounting Principles Bulletin (APB) Opinion No.
                      20, “ *Accounting
                      Changes* ”,
                      and
                      SFAS No. 3, “ *Reporting
                      Accounting Changes in Interim Financial Statements* .”
                      Although SFAS No. 154 carries forward the guidance in APB No.
                      20 and SFAS No. 3
                      with respect to accounting for changes in estimates, changes
                      in reporting
                      entity, and the correction of errors, SFAS No. 154 establishes
                      new standards on
                      accounting for changes in accounting principles, whereby all
                      such changes must
                      be accounted for by retrospective application to the financial
                      statements of
                      prior periods unless it is impracticable to do so. SFAS No.
                      154 is effective for
                      accounting changes and error corrections made in fiscal years
                      beginning after
                      December 15, 2005, with early adoption permitted for changes
                      and corrections
                      made in years beginning after May 2005. The Company will implement
                      SFAS No. 154
                      in the fiscal year beginning January 1, 2006.
  In
                      February 2006, the FASB issued Statement of Financial Accounting
                      Standards No.
                      155, “ *Accounting
                      for Certain Hybrid Financial Instruments* ”
(“SFAS
                      155”), which amends SFAS No. 133, “ *Accounting
                      for Derivatives Instruments and Hedging Activities* ”
(SFAS
                      133”) and SFAS No. 140, “ *Accounting
                      for Transfers and Servicing of Financial Assets and Extinguishment
                      of
                      Liabilities* ”
(SFAS
                      140”). SFAS 155 amends SFAS 133 to narrow the scope exception for
                      interest-only
                      and principal-only strips on debt instruments to include only
                      such strips
                      representing rights to receive a specified portion of the contractual
                      interest
                      or principle cash flows. SFAS 155 also amends SFAS 140 to allow
                      qualifying
                      special-purpose entities to hold a passive derivative financial
                      instrument
                      pertaining to beneficial interests that itself is derivative
                      instrument. The
                      Company is currently evaluating the impact this new Standard,
                      but believes that
                      it will not have a material impact on the Company’s financial position, results
                      of operations or cash flows.
  **3.**  **ACQUISITIONS**
 
 During
                      1997 to 2005, the Company acquired ten businesses. These acquisitions
                      were
                      accounted for as purchases, with the excess of the purchase
                      price over the fair
                      value of the net assets acquired allocated to goodwill. The
                      contingent portion
                      of the purchase prices, to the extent earned, was recorded
                      as an increase to
                      goodwill. As of December 31, 2005, possible additional earn-out
                      payments are as
                      described below. The consolidated financial statements reflect
                      the operations of
                      the acquired companies since their respective acquisition dates.
  Goodwill
                      and other intangibles, net as of December 31, 2004 and 2005,
                      consist of the
                      following:
  **Actual****2004**
                            
                            
                            **2005**Goodwill
                            
                            $
                            32,864,000
                            
                            $
                            35,050,000Covenant
                                not to compete
                            
                            
                            1,000,000
                            
                            
                            1,000,00033,864,000
                            
                            
                            36,050,000Less
                                accumulated amortization
                            
                            
                            (6,576,000
                            )
                            
                            (6,576,000
                            )$
                            27,288,000
                            
                            $
                            29,474,000
 
 The
                      Company ceased amortizing goodwill on January 1, 2002 with
                      the adoption of SFAS
                      142. Amortization of the covenant not to compete was $35,000
                      in 2003 at which
                      time the covenant was fully amortized.
 
 In
                      July
                      2002, the Company acquired an option to purchase three subsidiaries
                      (the
“Subsidiaries”) of Alliance Atlantis Communications Inc. (“Alliance”) engaged in
                      businesses directly related to those of the Company. In consideration
                      for the
                      option, the Company issued to Alliance a warrant to acquire
                      500,000 shares of
                      the Company’s common stock at $2.00 per share. The warrant was to expire
                      five
                      years from the closing date of the transaction, or July 3,
                      2005 if the Company
                      did not purchase the Subsidiaries. In connection therewith,
                      the Company
                      capitalized the fair value of the warrant ($619,000 determined
                      by using the
                      Black-Scholes valuation model) as an other asset on the balance
                      sheet.
  In
                      December 2002, the option was extended to March 10, 2003. In
                      connection with the
                      extension, the Company made a $300,000 deposit toward the purchase
                      price of the
                      Subsidiaries, which deposit was nonrefundable except in very
                      limited
                      circumstances. The deposit was capitalized as an other asset.
                      Additionally, the
                      Company capitalized approximately $700,000 of due diligence
                      and other expenses
                      associated with the proposed acquisition during the six months
                      ended June 30,
                      2003.
 
 32
 The
                      Company did not exercise its option to purchase the Subsidiaries
                      by the March
                      10, 2003 termination date; however, Alliance agreed to continue
                      negotiations
                      with the Company to complete the transaction.
 
 In
                      connection with the possible acquisition of the Subsidiaries,
                      the Company
                      entered discussions with several possible lenders to provide
                      financing for the
                      purchase of the Subsidiaries and to pay off the Company’s then existing term
                      loan with a group of banks. A provision in the Company’s term loan agreement
                      prohibited acquisitions unless approved by the banks, which
                      permission had been
                      denied.
 
 In
                      June
                      2003, discussions with Alliance and the new lenders were terminated.
                      As a
                      result, the Company wrote off the above mentioned deposit,
                      due diligence costs
                      and approximately $400,000 of legal and other costs associated
                      with the proposed
                      new financing. The $619,000 value of the warrant was reversed
                      against Additional
                      Paid-in Capital because, in management’s opinion, Alliance had breached certain
                      provisions of the option agreement resulting in a termination
                      event according to
                      the provisions of the warrant. In July 2003, Alliance filed
                      a complaint in the
                      United States District Court, Central District of California,
                      seeking a judicial
                      determination that Alliance has full right of legal ownership
                      to the warrant as
                      well as the $300,000 deposit. If the Company was not successful
                      in this defense,
                      the warrant value would have to be expensed.
 
 On
                      July
                      18, 2003, Alliance filed a complaint against the Company in
                      the Superior Court
                      of Justice, Ontario, Canada, alleging that the Company breached
                      a non-disclosure
                      agreement between Alliance and the Company by issuing a press
                      release with
                      respect to termination of negotiations to purchase the Subsidiaries
                      without
                      obtaining the required prior written consent of Alliance. Alliance
                      maintained
                      that the press release impaired its ability to extract value
                      from the
                      Subsidiaries and negatively affected its ability to sell the
                      Subsidiaries to a
                      third party. The complaint sought breach of contract and punitive
                      damages of
                      approximately $4.4 million, expenses and a permanent order
                      enjoining further
                      such statements by the Company.
 
 On
                      August
                      11, 2003, the Company filed a counterclaim in the United States
                      District Court,
                      Central District of California against Alliance for, among
                      other things,
                      misrepresentation and breach of contract seeking cancellation
                      of the warrant and
                      general damages of at least $1.2 million.
 
 Pursuant
                      to a Settlement and Mutual Release Agreement executed in November
                      2004, Alliance
                      and the Company agreed to settle all claims. Pursuant to the
                      agreement, the
                      Company paid Alliance $575,000 in cash in November 2004.
 
 In
                      order
                      to expand our relationships with our studio customers and gain
                      new customers, on
                      July 1, 2004, the Company acquired all of the outstanding stock
                      of IVC for $7
                      million in cash. The purchase agreement requires possible additional
                      payments of
                      $1 million, $2 million and $2 million in 2005, 2006 and 2007,
                      respectively, if
                      earnings before interest, taxes, depreciation and amortization
                      during the 30
                      months after the acquisition reach certain predetermined levels
                      (the first two
                      increments of $1 million increment and $2 million were earned
                      and are reflected
                      as accrued liabilities on the balance sheet as of December
                      31, 2004 and 2005,
                      respectively). As part of the transaction, the Company entered
                      into employment
                      and/or non competition agreements with four senior officers
                      of IVC which fix
                      responsibilities, salaries and other benefits and set forth
                      limitations on the
                      individuals’ ability to compete with the Company for the term of the earn-out
                      period (30 months). IVC is a high definition and standard definition
                      digital
                      mastering and data conversion entity serving the motion picture/television
                      production industry. To pay for the acquisition, the Company
                      used $2.3 million
                      of cash on hand and borrowed $4.7 million under the term loan
                      portion of the
                      Company’s bank facility.
 
 The
                      total
                      purchase consideration ($9 million either paid or accrued as
                      of December 31,
                      2005) has been allocated to the assets and liabilities acquired
                      based on their
                      respective estimated fair values as summarized below.
 Cash
                                  and cash equivalents
                              
                              $
                              1,205,000Inventories
                              
                              
                              120,000Other
                                  current assets
                              
                              
                              1,000Accounts
                                  receivable
                              
                              
                              2,036,000Goodwill
                              
                              
                              2,242,000Property,
                                  plant and equipment
                              
                              
                              6,009,000Total
                                  assets acquired
                              
                              
                              11,613,000Accounts
                                  payable
                              
                              
                              (442,000
                              )Accrued
                              
                              
                              (417,000
                              )Income
                                  tax payable
                              
                              
                              (72,000
                              )Deferred
                                  tax liabilities
                              
                              
                              (1,682,000
                              )Current
                                  and other liabilities assumed
                              
                              
                              (2,613,000
                              )Net
                                  assets acquired over liabilities, and purchase
                                  price
                              
                              $
                              9,000,000
 
 33
 The
                        following table presents unaudited pro forma results of the
                        combined operations
                        for the years ended December 31, 2003 and 2004, respectively,
                        as if the
                        acquisition had occurred as of the beginning of such periods
                        rather than as of
                        the acquisition date. The pro forma information presented
                        below is for
                        illustrative purposes only and is not indicative of results
                        that would have been
                        achieved or results which may be achieved in the future:
 
 **2003**
                              
                              
                              **2004**Revenue
                              
                              $
                              76,315,000
                              
                              $
                              69,032,000Operating
                                  Income
                              
                              
                              28,816,000
                              
                              
                              3,303,000Net
                                  income (loss)
                              
                              
                              2,804,000
                              
                              
                              1,456,000Basic
                                  earnings per share
                              
                              
                              0.31
                              
                              
                              0.16Diluted
                                  earnings per share
                              
                              
                              0.29
                              
                              
                              0.15
  In
                        2005,
                        the Company issued 105,000 shares in connection with a purchase
                        of assets. The
                        shares were recorded at fair value on the issue date. In
                        connection with the
                        transition, $189,000 was recorded as goodwill.
  During
                        2005, the amount of goodwill and other intangibles, net,
                        increased from
                        $27,288,000 to $29,474,000 due to the $2,000,000 earn-out
                        payment accrued for
                        the IVC acquisition and $186,000 of excess of fair value
                        of stock issued over
                        the fair value of purchased assets, as noted above. The periodic
                        impairment test
                        of goodwill performed in accordance with SFAS 142 as of December
                        31, 2005
                        required no goodwill impairment.
 
 **4.**  **PROPERTY
                        AND EQUIPMENT:**
 
 In
                        November 2003, the Company leased a new 64,600 square foot
                        building in Los
                        Angeles, California, for the purpose of consolidating four
                        vault locations then
                        occupying approximately 71,000 square feet. As part of the
                        transaction, the
                        Company paid $600,000 for an option to purchase the facility
                        for $8,571,500.
                        Additionally, the landlord, General Electric Capital Business
                        Asset Funding
                        Corporation (“General Electric”), committed to finance approximately $6,500,000
                        of the purchase price at a fixed interest rate of 7.75% over
                        15 years. The
                        Company was not obligated to purchase the building or, if
                        the option was
                        exercised, borrow any portion of the purchase price from
                        General Electric. The
                        cost of the option was included in other assets on the balance
                        sheet as of
                        December 31, 2003, to be capitalized as a cost of the building
                        or written off
                        when the Company exercised the purchase option or does not
                        exercise the option,
                        respectively.
 
 Pursuant
                        to the lease, General Electric also advanced the Company
                        $800,000 to pay for
                        improvements to the building. As of December 31, 2003, the
                        $800,000 was
                        reflected as an obligation to purchase property and equipment
                        as a long-term
                        asset with an offsetting liability on the balance sheet.
                        In 2004, the Company
                        reduced the right and the obligation to purchase property
                        and equipment by
                        $800,000 expended for improvements to the building.
 
 In
                        August
                        2004, the Company purchased the facility for $8.6 million
                        ($2.2 in cash and a
                        $6.4 million mortgage).
 
 Property
                        and equipment consist of the following:
 
 **December
                                  31,****2004**
                              
                              
                              **2005**Land
                              
                              $
                              5,600,000
                              
                              $
                              4,500,000Building
                              
                              
                              5,288,000
                              
                              
                              6,230,000Machinery
                                  and equipment
                              
                              
                              48,731,000
                              
                              
                              35,537,000Leasehold
                                  improvements
                              
                              
                              8,076,000
                              
                              
                              8,051,000Computer
                                  equipment.
                              
                              
                              4,818,000
                              
                              
                              4,693,000Equipment
                                  under capital lease
                              
                              
                              291,000
                              
                              
                              297,00072,804,000
                              
                              
                              59,308,000Less
                                  accumulated depreciation and amortization
                              
                              
                              (41,352,000
                              )
                              
                              (31,229,000
                              )$
                              31,452,000
                              
                              $
                              28,079,000
  Depreciation
                        expense totaled $5,464,000, $5,876,000 and $6,051,000 for
                        the years ended
                        December 31, 2003, 2004 and 2005, respectively. Accumulated
                        amortization on
                        capital leases amounted to $166,000 and $211,000, as of December
                        31, 2004 and
                        2005, respectively.
  34
 In
                        March
                        2006, the Company sold and leased back the building and related
                        improvements.
                        See Note 12.
  **5.**  **401(K)
                        PLAN**
 
 The
                        Company has a 401(K) plan, which covers substantially all
                        employees. Each
                        participant is permitted to make voluntary contributions
                        not to exceed the
                        lesser of: 20% of his or her respective compensation or the
                        applicable statutory
                        limitation, and is immediately 100% vested. The Company matches
                        one-fourth of
                        the first 4% contributed by the employee. Company contributions
                        to the plan were
                        $92,000, $92,000 and $127,000 in 2003, 2004 and 2005, respectively.
  **6.**  **LONG
                        TERM DEBT AND NOTES PAYABLE:**
 
 *Term
                        Loans and Revolving Credit*
  In
                        May
                        2002, the Company and its banks entered into a term loan
                        agreement amending a
                        previous credit arrangement and having a maturity date of
                        December 31, 2004.
                        Pursuant to the agreement, the Company made a $2 million
                        principal payment and
                        made additional principal payments of $3.5 million and $7.0
                        million in 2002 and
                        2003, respectively. The agreement provided for interest at
                        the banks’ reference
                        rate plus 1.25% and required the Company to maintain certain
                        financial covenant
                        ratios. The term loan was secured by substantially all of
                        the Company’s assets.
                        Certain legal and other costs associated with the new term
                        loan, including fees
                        of $50,000 and $250,000 paid in May 2002 and June 2003, respectively,
                        were
                        capitalized to be amortized over the remaining life of the
                        loan.
  On
                        March
                        12, 2004, the Company entered into a new credit agreement
                        which provided up to
                        $10 million of revolving credit availability for two years
                        and a five-year $8
                        million term loan. The agreement provided for interest at
                        the banks’ prime rate
                        or LIBOR plus 2.25% for the revolver, prime rate (7.25% as
                        of December 31, 2005)
                        plus 0.25% or LIBOR (4.5% as of December 31, 2005) plus 2.50%
                        for the term loan,
                        and required the Company to maintain certain financial covenant
                        ratios. The
                        facilities are secured by all of the Company’s assets. The term loan required
                        principal payments of $1.6 million annually. The $15,866,000
                        outstanding term
                        loan as of December 31, 2003 was repaid by $1,000,000 of
                        scheduled principal
                        payments made in January and February 2004 and, on March
                        12, 2004, by new term
                        loan borrowings of $8,000,000 and cash payment of $6,866,000.
  In
                        July
                        and August 2004, the term loan and revolving portions of
                        the Company’s bank
                        facility were increased by $4.7 million and $1.9 million,
                        respectively.
  As
                        of
                        June 30, 2005, the credit agreement was changed with respect
                        to the following:
                        (i) the due date of the revolving portion of loans outstanding
                        was changed from
                        March 12, 2006 to January 31, 2006; (ii) the re-borrowing
                        commitment under the
                        term loan was eliminated; (iii) the interest rate for both
                        the LIBOR and prime
                        rate options was increased by 0.5%; and (iv) certain financial
                        covenants were
                        changed.
  On
                        December 30, 2005, the Company entered into a new $10 million
                        term loan
                        agreement. The term loan provides for interest at LIBOR plus
                        3.15% and is
                        secured by the Company’s equipment. The new term loan will be repaid in 60 equal
                        monthly principal payments plus interest. Proceeds of the
                        new term loan were
                        used to repay the previously existing term loan.
  In
                        January 2006, the due date of the existing revolving credit
                        facility was
                        extended to coincide with the completion of a sale and leaseback
                        transaction. As
                        of December 30, 2005, the Company did not meet certain financial
                        covenants
                        contained in the credit facility and received a compliance
                        waiver from the bank.
                        The credit facility was paid in full in March 2006. See Note
                        12.
  In
                        August
                        2004, the Company entered into a Standing Loan Agreement
                        and Swap Commitment
                        with a bank (the “Mortgage”) in order to purchase land and a building (see
                        below). Pursuant to the Mortgage, the Company borrowed $6,435,000
                        payable in
                        monthly installments of principal and interest on a fully
                        amortized basis over
                        15 years. The mortgage debt was secured by the land and building.
                        In March 2006,
                        the Mortgage was paid in full pursuant to a sale and leaseback
                        transaction with
                        respect to the real estate (see Note 12).
  *Interest
                        Rate Swaps*
  In
                        November 2000, the Company entered into an interest rate
                        swap contract to
                        economically hedge its floating debt rate. Under the terms
                        of the contract, the
                        notional amount was $15,000,000, whereby the Company received
                        LIBOR and paid a
                        fixed 6.5% rate of interest for three years. Statement of
                        Financial Accounting
                        Standards No. 133, “ *Accounting
                        for Derivative Instruments and Hedging Activities”* (“SFAS
                        133”) required that the interest rate swap contract be recorded
                        at fair value
                        upon adoption of SFAS 133 and quarterly by recording (i)
                        a cumulative-effect
                        type adjustment at January 1, 2001 equal to the fair value
                        of the interest rate
                        swap contract on that date, (ii) amortizing the cumulative-effect
                        type
                        adjustment quarterly over the life of the derivative contract,
                        and (iii) a
                        charge or credit to income in the amount of the difference
                        between the fair
                        value of the interest rate swap contract at the beginning
                        and end of such
                        quarter. The interest rate swap contract terminated in November
                        2003. The
                        following adjustments were recorded to reflect changes during
                        the year ended
                        December 31, 2003:
  35
  **Increase
                                  (Decrease) Income****Derivative
                                  Fair**
                                **Value
                                  Change**
                              
                              
                              **(Provision
                                  for ) Benefit****from
                                  Income Taxes**
                              
                              
                              **Net
                                  Derivative****Fair
                                  Value Change**Amortization
                                  of cumulative-effect type adjustment
                              
                              $
                              (90,000
                              )
                              $
                              6,000
                              
                              $
                              (54,000
                              )Difference
                                  in the derivative fair value between the beginning
                                  and end of the
                                  year
                              
                              
                              701,000
                              
                              
                              (280,000
                              )
                              
                              421,000$
                              611,000
                              
                              $
                              (244,000
                              )
                              $
                              367,000
  In
                        August
                        2004, the Company entered into a one-year interest rate swap
                        contract to
                        economically hedge Mortgage debt. Under the terms of the
                        swap agreement, the
                        amount hedged was $6,435,000 at a fixed 4.35% interest rate
                        for the first year.
                        Prior to the end of the first year, in August 2005, the Company
                        was obligated to
“fix” the interest rate with respect to the remaining 14 years
                        of the Mortgage
                        debt term based on a fixed rate quoted by the bank or LIBOR
                        plus 1.85% for that
                        period. In December 2004, the rate was fixed at 6.83% for
                        the remaining term of
                        the mortgage through new hedge agreement.
  The
                        objective of the hedge was to eliminate the variability of
                        cash flows in the
                        interest payments for the variable-rate Mortgage debt, the
                        sole source of which
                        is due to changes in the LIBOR benchmark interest rate. Changes
                        in the cash
                        flows of the interest rate swap are expected to exactly offset
                        the changes in
                        cash flows (i.e. changes in interest rate payments) attributable
                        to fluctuations
                        in the LIBOR on the mortgage debt.
  Both
                        at
                        hedge inception and on an ongoing basis, the market values
                        of the hedge
                        instrument and the hypothetical transaction were expected
                        to be highly
                        correlated. Also, cash receipts under the hedge instrument
                        were to offset
                        changes in LIBOR on the hedged item.
  The
                        hypothetical derivative was a $6,334,000 notional amount,
                        receive-variable and
                        pay-fixed interest rate swap, with reset dates and a variable
                        rate index that
                        match those of the Mortgage, and which had a zero fair market
                        value at inception
                        of the hedge relationship. Hedge effectiveness was assessed
                        on a quarterly
                        basis.
  The
                        hedge
                        was terminated in March 2006 in connection with a sale and
                        leaseback transaction
                        with respect to the real estate and pay-off of the mortgage.
 
 *Mortgage
                        and Equipment Financing and Capital Leases*
  The
                        Company has financed the purchase of certain equipment and
                        real property through
                        the issuance of bank notes payable, a mortgage and under
                        capital leasing
                        arrangements. The notes bear interest at rates ranging from
                        3% to LIBOR plus
                        3.15% (7.62% as of December 31, 2005). Such obligations are
                        payable in monthly
                        installments through May 2019.
  Annual
                        maturities for debt, under bank notes payable, mortgage and
                        capital lease
                        obligations as of December 31, 2005, are as follows:
 2006
                                
                                $
                                2,325,0002007
                                
                                
                                2,330,0002008
                                
                                
                                2,319,0002009
                                
                                
                                2,343,0002010
                                
                                
                                2,367,000Thereafter
                                
                                
                                4,448,000$
                                16,132,000
 
 In
                          March
                          2006, the Company entered into a sale and leaseback transaction
                          with respect to
                          the real property (see Note 12), pursuant to which the
                          mortgage was paid in
                          full. Remaining notes and capital leasing arrangements
                          bear interest at rates
                          ranging from 3% to LIBOR plus 3.15% (7.62% as of December
                          31, 2005). Annual
                          maturities for debt as of December 31, 2005, excluding
                          mortgage and other debt
                          paid down as a result of the sale and leaseback transaction,
                          are as
                          follows:
 
 2006
                                
                                $
                                2,047,0002007
                                
                                
                                2,032,0002008
                                
                                
                                2,000,0002009
                                
                                
                                -2010
                                
                                
                                -Thereafter
                                
                                
                                -$
                                6,079,000
  36
 **7.**  **INCOME
                          TAXES:**
  The
                          Company’s provision for (benefit from) income taxes for the three
                          years ended
                          December 31, 2005 consists of the following:
 **Year
                                      Ended December 31,****2003**
                                  
                                  
                                  **2004**
                                  
                                  
                                  **2005**Current
                                      tax (benefit) expense:Federal
                                  
                                  $
                                  1,820,000
                                  
                                  $
                                  642,000
                                  
                                  $
                                  329,000State
                                  
                                  
                                  504,000
                                  
                                  
                                  142,000
                                  
                                  
                                  6,000Total
                                      current
                                  
                                  
                                  2,324,000
                                  
                                  
                                  784,000
                                  
                                  
                                  335,000Deferred
                                      tax expense:Federal
                                  
                                  
                                  (178,000
                                  )
                                  
                                  (13,000
                                  )
                                  
                                  (253,000
                                  )State
                                  
                                  
                                  (32,000
                                  )
                                  
                                  10,000
                                  
                                  
                                  (12,000
                                  )Total
                                      deferred
                                  
                                  
                                  (210,000
                                  )
                                  
                                  (3,000
                                  )
                                  
                                  (265,000
                                  )Total
                                      provision for (benefit from) for income taxes
                                  
                                  $
                                  2,114,000
                                  
                                  $
                                  781,000
                                  
                                  $
                                  70,000
 
 The
                            composition of the deferred tax assets (liabilities)
                            at December 31, 2004 and
                            December 31, 2005 are listed below:
 
 **2004**
                                  
                                  
                                  **2005**Accrued
                                      liabilities
                                  
                                  $
                                  587,000
                                  
                                  $
                                  393,000Allowance
                                      for doubtful accounts
                                  
                                  
                                  228,000
                                  
                                  
                                  241,000Other
                                  
                                  
                                  495,000
                                  
                                  
                                  194,000Total
                                      current deferred tax assets
                                  
                                  
                                  1,310,000
                                  
                                  
                                  828,000Property
                                      and equipment
                                  
                                  
                                  (3,844,000
                                  )
                                  
                                  (3,869,000
                                  )Goodwill
                                      and other intangibles
                                  
                                  
                                  (2,097,000
                                  )
                                  
                                  (2,763,000
                                  )Other
                                  
                                  
                                  153,000
                                  
                                  
                                  511,000Total
                                      non-current deferred tax liabilities
                                  
                                  
                                  (5,788,000
                                  )
                                  
                                  (6,121,000
                                  )Net
                                      deferred tax liability
                                  
                                  $
                                  (4,478,000
                                  )
                                  $
                                  (5,293,000
                                  )
 
 The
                            provision for (benefit from) income taxes differs from
                            the amount of income tax
                            determined by applying the applicable U.S. Statutory
                            income taxes rates to
                            income before taxes as a result of the following differences:
 
 **2003**
                                  
                                  
                                  **2004**
                                  
                                  
                                  **2005**Federal
                                      tax computed at statutory rate
                                  
                                  
                                  34
                                  %
                                  
                                  34
                                  %
                                  
                                  34
                                  %State
                                      taxes, net of federal benefit and net operating
                                      loss
                                      limitation
                                  
                                  
                                  5
                                  %
                                  
                                  2
                                  %
                                  
                                  6
                                  %Other
                                      (meals and entertainment)
                                  
                                  
                                  1
                                  %
                                  
                                  3
                                  %
                                  
                                  43
                                  %40
                                  %
                                  
                                  39
                                  %
                                  
                                  83
                                  %
 
 37




**8.**  **COMMITMENTS
          AND CONTINGENCIES:**
  *Operating
        Leases*
 
 The
        Company leases office and production facilities in California, Illinois,
        Texas
        and New York under various operating leases. Approximate minimum rental payments
        under these non-cancelable operating leases as of December 31, 2005 are as
        follows:
 
 2006
              
              $
              3,713,0002007
              
              
              3,804,0002008
              
              
              3,513,0002009
              
              
              2,263,0002010
              
              
              1,480,000Thereafter
              
              
              3,470,000
 
 Total
        rental expense was approximately $3,436,000, $4,299,000 and $3,838,000 for
        the
        three years in the period ended December 31, 2005, respectively.
 
 In
        March
        2006, the Company entered into a sale and leaseback transaction with respect
        to
        real property (see Note 12), pursuant to which the Company leased the facility.
        Approximate minimum rental payments assuming the lease existed as of December
        31, 2005 are as follows:
 
 2006
              
              $
              4,502,0002007
              
              
              4,915,0002008
              
              
              4,624,0002009
              
              
              3,374,0002010
              
              
              2,591,000Thereafter
              
              
              16,307,000
 
 On
        September 30, 2003 the Company entered into severance agreements with its
        Chief
        Executive Officer and Chief Financial Officer which continue in effect through
        December 31, 2006, and are renewed automatically on an annual basis after
        that
        unless notice is received terminating the agreement by September 30 of the
        preceding year. The severance agreements contain a “Golden Parachute”
provision.
 
 From
        time
        to time, the Company may become involved in litigation arising out of operations
        in the normal course of business. As of December 31, 2005, the Company was
        not a
        party to any pending legal proceedings the adverse outcome of which could
        reasonably be expected to have a material adverse effect on operating results
        or
        financial position.
 
 **9.**  **STOCK
        RIGHTS PLAN:**
 
 In
        November 2004, the Company implemented a stock rights program. Pursuant to
        the
        program, stockholders of record November 17, 2004 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 in the future.
        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
        November 16, 2014 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.
  **10.**  **STOCK
        OPTION PLANS:**
  *Stock
        Option Plans*
 
 In
        May
        1996, the Board of Directors, approved the 1996 Stock Incentive Plan (the
“1996
        Plan”). The 1996 Plan provided for the award of options to purchase up to
        900,000 shares of common stock, as well as stock appreciation rights,
        performance share awards and restricted stock awards. In July 1999, the
        Company’s shareholders approved an amendment to the 1996 Plan increasing the
        number of shares reserved for grant to 2,000,000 and providing for automatic
        increases of 300,000 shares on each August 1 thereafter to a maximum of
        4,000,000 shares. As of December 31, 2005, there were 1,754,597 options
        outstanding under the 1996 Plan and no options were available for
        grant.
 
 38
 In
        December 2000, the Company’s Board of Directors adopted the 2000 Nonqualified
        Stock Option Plan (the “2000 Plan”). As amended, the 2000 Plan provided for the
        award of options to purchase up to 1,500,000 shares of common stock. Options
        may
        be granted under the 2000 Plan solely to attract people who have not previously
        been employed by the Company as a substantial inducement to join the Company.
        As
        of December 31, 2005, there were 771,200 options outstanding under the plan
        and
        no options were available for grant.
  In
        February 2005, the Board of Directors, approved the 2005 Equity Incentive
        Plan
        (the “2005 Plan”). The 2005 Plan provides for the award of options to purchase
        up to 2,000,000 shares of common stock, as well as stock appreciation rights
        and
        restricted stock awards. Upon approval of the 2005 Plan by the Company’s
        shareholders in May 2005, the 1996 Plan and the 2000 Plan were terminated,
        except that outstanding options under those plans were not terminated. As
        of
        December 31, 2005, there were 140,000 options outstanding under the 2005
        Plan
        and 1,860,000 options were available for grant.
  Under
        all
        plans, 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 date it was granted. The stock options
        generally vest over one to five years.
 
 In
        accounting for its plans, the Company, in accordance with the provisions
        of SFAS
        123, “ *Accounting
        for Stock-Based Compensation* ,”
        applies Accounting Principles Board Opinion No. 25, “ *Accounting
        for Stock Issued to Employees* .”
As
        a
        result of this election, the Company does not recognize compensation expense
        for
        its stock option plans since the exercise price of the options granted equals
        the fair value of the stock on the date of grant.
 
 Transactions
        involving stock options are summarized as follows:
 **Number**
                  **of
                    Shares**
                
                
                **Weighted
                    Average**
                  **Exercise
                    Price**Balance
                    at December 31, 2002
                
                
                2,798,569
                
                $
                3.06Granted
                    during 2003
                
                
                423,000
                
                $
                3.00Exercised
                    during 2003
                
                
                (120,327
                )
                
                2.21Cancelled
                    during 2003
                
                
                (1,050,654
                )
                
                3.41Balance
                    at December 31, 2003
                
                
                2,050,678
                
                $
                2.91Granted
                    during 2004
                
                
                608,100
                
                
                2.58Exercised
                    during 2004
                
                
                (101,573
                )
                
                2.76Cancelled
                    during 2004
                
                
                (204,258
                )
                
                3.14Balance
                    at December 31, 2004
                
                
                2,352,947
                
                $
                2.82Granted
                    during 2005
                
                
                606,400
                
                
                2.63Exercised
                    during 2005
                
                
                (27,725
                )
                
                1.97Cancelled
                    during 2005
                
                
                (265,825
                )
                
                3.01Balance
                    at December 31, 2005
                
                
                2,665,797
                
                $
                2.79
 
 Additional
          information with respect to the outstanding options as of December 31,
          2005 is
          as follows (shares in thousands):
 
 
 **Options
                    Outstanding**
                
                **Options
                    Exercisable****Option
                    Exercise****Price
                    Range**
                
                **Number
                    of Shares**
                **Weighted
                    Average**
                  **Remaining****Contractual
                    Life**
                **Weighted
                    Average**
                  **Exercise
                    Price**
                
                **Number
                    of****Shares**
                **Weighted**
                  **Average****Exercise
                    Price**$1.20
                    - $5.38
                
                2,658,976
                3.4
                    years
                $
                    2.77
                
                2,658,976
                $
                    2.77$7.00
                    - $10.00
                
                6,821
                1.2
                    years
                $
                    7.00
                
                6,821
                $
                    7.00
  39
 **11.**  **SUPPLEMENTAL
          DATA (unaudited)**
 
 The
          following tables set forth quarterly supplementary data for each of the
          years in
          the two-year period ended December 31, 2005 (in thousands except per share
          data).
 **2004****Quarter
                      Ended**
                  
                  
                  **Year
                      Ended****March
                      31**
                  
                  
                  **June
                      30**
                  
                  
                  **Sept
                      30**
                  
                  
                  **Dec
                      31**
                  
                  
                  **Dec
                      31**Revenues
                  
                  $
                  15,468
                  
                  $
                  13,913
                  
                  $
                  16,465
                  
                  $
                  17,498
                  
                  $
                  63,344Gross
                      profit
                  
                  $
                  5,649
                  
                  $
                  4,803
                  
                  $
                  5,736
                  
                  $
                  6,636
                  
                  $
                  22,825Net
                      income (loss)
                  
                  $
                  493
                  
                  $
                  73
                  
                  $
                  (81
                  )
                  $
                  761
                  
                  $
                  1,247Income
                      (loss) per share:Basic
                  
                  $
                  0.06
                  
                  $
                  0.01
                  
                  $
                  (0.01
                  )
                  $
                  0.08
                  
                  $
                  0.14Diluted
                  
                  $
                  0.05
                  
                  $
                  0.01
                  
                  $
                  (0.01
                  )
                  $
                  0.08
                  
                  $
                  0.13**2005****Quarter
                      Ended**
                  
                  
                  **Year
                      Ended****March
                      31**
                  
                  
                  **June
                      30**
                  
                  
                  **Sept
                      30**
                  
                  
                  **Dec
                      31**
                  
                  
                  **Dec
                      31**Revenues
                  
                  $
                  17,183
                  
                  $
                  15,890
                  
                  $
                  16,748
                  
                  $
                  16,378
                  
                  $
                  66,199Gross
                      profit
                  
                  $
                  5,781
                  
                  $
                  5,262
                  
                  $
                  5,965
                  
                  $
                  6,024
                  
                  $
                  23,032Net
                      income (loss)
                  
                  $
                  69
                  
                  $
                  (268
                  )
                  $
                  214
                  
                  $
                  (1
                  )
                  $
                  14Income
                      (loss) per share:Basic
                  
                  $
                  0.01
                  
                  $
                  (0.03
                  )
                  $
                  0.02
                  
                  $
                  (0.00
                  )
                  $
                  0.00Diluted
                  
                  $
                  0.01
                  
                  $
                  (0.03
                  )
                  $
                  0.02
                  
                  $
                  (0.00
                  )
                  $
                  0.00
  **12.**  **SUBSEQUENT
            EVENTS**
 
 In
            March
            2006, the Company entered into a new revolving credit agreement which
            provides
            up to $10 million of revolving credit. The two-year agreement provides
            for
            interest of LIBOR plus 1.85% for the first six months of the agreement,
            and
            thereafter at either (i) prime minus 0% - 1.00% or (ii) LIBOR plus 1.50%
            - 2.5%,
            depending on the level of the Company’s ratio of outstanding debt to fixed
            charges (as defined). The facility is secured by all of the Company’s assets,
            except for equipment securing the new term loan as described in Note
            6. The
            revolving credit agreement requires the Company to comply with various
            financial
            and business covenants. There are cross default provisions contained
            in the two
            in both the new revolving and term loan agreements.
  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 SFAS No. 28, *Accounting
            for Sales with Leasebacks* ,
            the
            gain will be amortized over the initial 15-year lease term as reduced
            rent. Net
            proceeds at the closing of the sale and the improvement advance (approximately
            $14.0 million) were used to pay off the mortgage and other outstanding
            debt.
  The
            following table presents unaudited pro forma results the year ended December
            31,
            2005, as if the sale and leaseback transaction had occurred as of the
            beginning
            of the year. The pro forma information presented below is for illustrative
            purposes only and is not indicative of results that would have been achieved
            or
            results which may be achieved in the future (in thousands):
  **As
                      Reported**
                  
                  
                  **Adjustments**
                  
                  
                  **Pro
                      Forma**Revenue
                  
                  $
                  66,199
                  
                  
                  
                  
                  $
                  66,199Cost
                      of sales
                  
                  
                  (43,167
                  )
                  
                  (837
                  )
                      (1)
                  
                  (44,004
                  )Gross
                      profit
                  
                  
                  23,032
                  
                  
                  
                  
                  
                  22,195Selling,
                      general and administrative expense
                  
                  
                  (21,424
                  )
                  
                  
                  
                  
                  (21,424
                  )Operating
                      income
                  
                  
                  1,608
                  
                  
                  
                  
                  
                  771Interest
                      expense
                  
                  
                  (1,524
                  )
                  
                  881
                  (2)
                  
                  (643
                  )Income
                      before income taxes
                  
                  
                  84
                  
                  
                  
                  
                  
                  128Provision
                      for income taxes
                  
                  
                  (70
                  )
                  
                  (17
                  )
                      (3)
                  
                  (87
                  )Net
                      income
                  
                  $
                  14
                  
                  
                  
                  
                  $
                  41Diluted
                      net income per share
                  
                  $
                  0.00
                  
                  
                  
                  
                  $
                  0.00
 
 (1)
                  First
                      year rent expense net of amortization of the deferred gain
                      on the sale,
                      partially offset by the elimination of depreciation expense
                      associated
                      with the building.
 (2)
                  Pro
                      forma interest saved on the amount of mortgage, term and revolving
                      credit
                      debt paid off with net sales
                      proceeds.
 (3)
                  Tax
                      effect at 40%.
  40
 The
            following table present an unaudited pro forma summary balance sheet
            as of
            December 31, 2005 as if the sale and leaseback had occurred on that date
            (in
            thousands):
 
 **As
                      Reported**
                  
                  
                  **Adjustments**
                  
                  
                  **Pro
                      Forma**Current
                      assets
                  
                  $
                  17,313
                  
                  
                  
                  
                  $
                  17,313Property
                      and equipment, net
                  
                  
                  28,079
                  
                  
                  (11,261
                  )
                      (1)
                  
                  16,818Goodwill
                      and other assets
                  
                  
                  30,067
                  
                  
                  
                  
                  
                  30,067Total
                      assets
                  
                  $
                  75,459
                  
                  
                  
                  
                  $
                  64,198Accounts
                      payable and accrued expenses
                  
                  $
                  8,380
                  
                  
                  
                  
                  $
                  8,380Deferred
                      income taxes
                  
                  
                  1,231
                  
                  
                  879
                  (2)
                  
                  2,110Short-term
                      debt
                  
                  
                  2,373
                  
                  
                  (310
                  )
                      (4)
                  
                  2,063Borrowings
                      under revolving credit
                  
                  
                  4,054
                  
                  
                  (3,904
                  )
                      (4)
                  
                  150Current
                      liabilities
                  
                  
                  16,038
                  
                  
                  
                  
                  
                  12,703Deferred
                      gain on sale
                  
                  
                  -
                  
                  
                  1,318
                  (3)
                  
                  1,318Deferred
                      income taxes and other
                  
                  
                  6,121
                  
                  
                  500
                  (5)
                  
                  6,621Long-term
                      notes payable
                  
                  
                  13,790
                  
                  
                  (9,744
                  )
                      (4)
                  
                  4,046Shareholders’
                      equity
                  
                  
                  39,510
                  
                  
                  
                  
                  
                  39,510Total
                      liabilities and shareholders’ equity
                  
                  $
                  75,459
                  
                  
                  
                  
                  $
                  64,198
 
 (1)
                  Net
                      book value of assets sold.
 (2)
                  Tax
                      on gain on sale at 40%.
 (3)
                  Deferred
                      gain on sale to be amortized over life of
                      lease.
 (4)
                  Pay-down
                      of debt with net proceeds.
 (5)
                  Non-refundable
                      advance from purchaser for
                      improvements.
  
 41
 **Report
            of Independent Registered Public Accounting Firm**
 
 
 To
            the
            Board of Directors
 and
            Shareholders of Point.360
 Burbank,
            California
 
 
 Our
            audit
            of the consolidated financial statements referred to in our report dated
            February 10, 2006, except for note 12 for which the date is March 29,
            2006
            (included elsewhere in this Annual Report on Form 10-K) also included
            the
            financial statement schedule of Point.360 ,
            listed
            in Item 8 of this Form 10-K. This schedule is the responsibility of Point.360 's
            management. Our responsibility is to express an opinion based on our
            audit of
            the consolidated financial statements.
 
 In
            our
            opinion, the financial statement schedule, when considered in relation
            to the
            basic consolidated financial statements taken as a whole, presents fairly
            in all
            material respects the information set forth therein.
  Singer
            Lewak Greenbaum & Goldstein, LLP (signed)
 Los
            Angeles, CA
 February
            10, 2006
 
 _______________________________________
 
 **Point.360**
 **Schedule
              II- Valuation and Qualifying Accounts**
 
 
 **Allowance
                        for Doubtful Accounts**
                    
                    
                    **Balance
                        at**
                      **Beginning
                        of**
                      **Year**
                    
                    
                    **Charged
                        to**
                      **Costs
                        and**
                      **Expenses**
                    
                    
                    **Other**
                    
                    
                    **Deductions/**
                      **Write-Offs**
                    
                    
                    **Balance
                        at**
                      **End
                        of**
                      **Year**Year
                        ended December 31, 2003
                    
                    $
                    801,000
                    
                    $
                    121,000
                    
                    $
                    --
                    
                    $
                    (187,000
                    )
                    $
                    735,000Year
                        ended December 31, 2004
                    
                    $
                    735,000
                    
                    $
                    48,000
                    
                    $
                    (153,000
                    )
                    $
                    (99,000
                    )
                    $
                    531,000Year
                        ended December 31, 2005
                    
                    $
                    531,000
                    
                    $
                    113,000
                    
                    $
                    --
                    
                    $
                    (81,000
                    )
                    $
                    563,000




42




**ITEM
        9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
        DISCLOSURE**
 
 Information
        regarding the Company’s change in independent accountants was previously
        reported in its Form 8-K reports dated June 12, 2002 and July 26, 2002.
  **ITEM
        9A.** **CONTROLS
        AND PROCEDURES**
  Pursuant
        to Rule 13a-15(b) under the Securities and Exchange Act of 1934 (the “Exchange
        Act”), the Company’s management, with the participation of the Chief Executive
        Officer and Chief Financial Officer, evaluated the effectiveness of the
        Company’s disclosure controls and procedures, as of the end of the period
        covered by this report. Based on that evaluation, the Chief Executive Officer
        and Chief Financial Officer concluded that the Company’s disclosure controls and
        procedures are effective in ensuring that information required to be disclosed
        in reports that the Company files or submits under the Exchange Act is recorded,
        processed, summarized and reported within the time periods specified in the
        SEC’s rules and forms. No change in the Company’s internal control over
        financial reporting occurred during the Company’s most recent fiscal quarter
        that materially affected, or is reasonably likely to materially affect the
        Company’s internal control over financial reporting.
  **ITEM
        9B.** **OTHER
        INFORMATION**
  None.
 
 **PART
        III**
 
 **ITEM
        10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT**
 
 On
        July
        3, 2003, the Company adopted a Code of Ethics (the “Code”) applicable to the
        Company’s Chief Executive Officer, Chief Financial Officer and all other
        employees. Among other provisions, the Code sets forth standards for honest
        and
        ethical conduct, full and fair disclosure in public filings and shareholder
        communications, compliance with laws, rules and regulations, reporting of
        code
        violations and accountability for adherence to the Code. The text of the
        Code
        has been posted on the Company’s website ( www.point360.com).
        A copy of the Code can be obtained free-of-charge upon written request
        to:
 
 Corporate
        Secretary
 Point.360
 2777
        North Ontario Street
 Burbank,
        CA 91504
 
 If
        the
        Company makes any amendment to, or grant any waivers of, a provision of the
        Code
        that applies to our principal executive officer or principal financial officer
        and that requires disclosure under applicable SEC rules, we intend to disclose
        such amendment or waiver and the reasons for the amendment or waiver on our
        website.
 
 Other
        information called for by Item 10 of Form 10-K is set forth under the heading
        “Election of Directors” in the Company’s Proxy Statement for its annual meeting
        of shareholders to be held on May 3, 2006 (the “Proxy Statement”), which is
        incorporated herein by reference.
  **ITEM
        11. EXECUTIVE COMPENSATION**
 
 Information
        called for by Item 11 of Form 10-K is set forth under the heading “Executive
        Compensation” in the Proxy Statement, which is incorporated herein by
        reference.
  **ITEM
        12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
        STOCKHOLDER MATTERS**
  Information
        called for by Item 12 of Form 10-K is set forth under the headings “Security
        Ownership of Certain Beneficial Owners and Management” and “Equity Compensation
        Plan Information” in the Proxy Statement, which is incorporated herein by
        reference.
  **ITEM
        13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**
 
 Information
        called for by Item 13 of Form 10-K is set forth under the heading “Certain
        Relationships and Related Transactions” in the Proxy Statement, which is
        incorporated herein by reference.
  43
 **ITEM
        14. PRINCIPAL ACCOUNTING FEES AND SERVICES**
 
 Information
        called for by Item 14 of Form 10-K is set forth under the heading “Independent
        Public Accountants” in the Proxy Statement, which is incorporated herein by
        reference.
  **PART
        IV**
 
 **ITEM
        15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM
        8-K**
 (a)
                Documents
                    Filed as Part of this Report:
 
 (1,2)
                Financial
                    Statements and Schedules.The
                    following financial documents of Point.360 are filed as part
                    of this
                    report under Item 8:Consolidated
                    Balance Sheets - December 31, 2004 and 2005Consolidated
                    Statements of Income - Fiscal Years Ended December 31, 2003,
                    2004 and
                    2005Consolidated
                    Statements of Shareholders’ Equity - Fiscal Years Ended December 31, 2003,
                    2004 and 2005Consolidated
                    Statements of Cash Flows - Fiscal Years Ended December 31, 2003,
                    2004 and
                    2005Notes
                    to Consolidated Financial Statements


(3)
              **Exhibit**
                **Number**
              **Description**3.1
              Restated
                  Articles of Incorporation of the Company.(2)3.2
              By-laws
                  of the Company.(2)10.1
              Agreement
                  and Plan of Merger, dated as of December 24, 1999, among VDI MultiMedia,
                  VDI MultiMedia, Inc. and VMM Merger Corp.(1)10.2
              1996
                  Stock Incentive Plan of the Company.(2)10.3
              2000
                  Stock Incentive Plan of the Company.(7)10.4
              Asset
                  Purchase Agreement, dated as of December 28, 1996 by and among VDI
                  Media, Woodholly Productions, Yvonne Parker, Rodger Parker, Jim
                  Watt and
                  Kim Watt.(3)10.5
              Asset
                  Purchase Agreement, dated as of June 12, 1998 by and between VDI
                  Media and
                  All Post, Inc.(4)10.6
              Asset
                  Purchase Agreement, dated as of November 9, 1998 by and among VDI
                  Media,
                  Dubs Incorporated, Vincent Lyons and Barbara Lyons.(5)10.7
              Asset
                  Purchase Agreement dated November 3, 2000 by and among the Company,
                  Creative Digital, Inc. and
                  Larry Hester.(7)10.8
              Third
                  Amendment and Restated Credit Agreement dated May 2, 2002, among
                  the
                  Company, Union Bank of California, N.A., United California Bank,
                  and U.S.
                  Bank National Association.(8)10.9
              Option
                  Agreement dated July 3, 2002 between the Company and Alliance Atlantis
                  Communications Inc.(9)10.10
              First
                  Amendment to Credit Agreement dated October 2, 2002, among the
                  Company,
                  Union Bank of California, Bank of the West and U.S. National Bank
                  Association.(11)10.11
              Resignation
                  and General Release Agreement dated October 2, 2002 between R.
                  Luke
                  Stefanko and the Company.(10)10.12
              Consulting
                  Agreement dated October 2, 2002 between R. Luke Stefanko and the
                  Company.(10)10.13
              Non-competition
                  Agreement dated October 2, 2002 between R. Luke Stefanko and the
                  Company.(10)10.14
              Amended
                  and Restated Option Agreement dated December 30, 2002 between the
                  Company
                  and Alliance Atlantis Communications Inc.(12)
  44
  10.15
              Severance
                  Agreement dated September 30, 2003 between the Company and Haig
                  S.
                  Bagerdjian.(13)10.16
              Severance
                  Agreement dated September 30, 2003 between the Company and Alan
                  R. Steel.(13)10.17
              Lease
                  Agreement dated November 26, 2003 between the Company and General
                  Electric
                  Capital Business Asset Funding Corporation.10.18
              Credit
                  Agreement dated March 12, 2004 among the Company, Union Bank of
                  California, N.A. and U.S. National Bank Association.(14)10.19
              Stock
                  Purchase Agreement dated June 23, 2004 among the Company, International
                  Video Conversions, Inc. (“IVC”) and the Stockholders of IVC.(15)10.20
              First
                  Amendment to Credit Agreement dated July 1, 2004 among the Company,
                  Union
                  Bank of California, N.A. and U.S. National Bank Association.(15)10.21
              Second
                  Amendment to Credit Agreement dated August 13, 2004 among the Company,
                  Union Bank of California, N.A. and U.S. National Bank Association.(16)10.22
              Standing
                  Loan Agreement and Swap Commitment dated August 18, 2004 between
                  the
                  Company and Bank of America, N.A.(17)10.23
              Settlement
                  and Mutual Release Agreement executed November 9, 2004 between
                  the Company
                  and Alliance Atlantis Communications, Inc.(18)10.24
              Amended
                  and Restated Rights Agreement, dated as of November 17, 2004, between
                  the
                  Company and American Stock Transfer and Trust Company.(19)10.25
              2005
                  Equity Incentive Plan of Point.360.(20)10.26
              Promissory
                  Note between General Electric Capital Corporation and the Company
                  dated
                  December 30, 2005.(21)10.27
              Master
                  Security Agreement between General Electric Capital Corporation
                  and the
                  Company dated December 30, 2005.(21)10.28
              Standard
                  Loan Agreement dated March 29, 2006 between the Company and Bank
                  of
                  America, N.A.(22)10.29
              Agreement
                  of Purchase and Sale dated December 30, 2005 between the Company
                  and
                  United Trust Fund Limited Partnership.(22)10.30
              Lease
                  Agreement between UTFLA LLC and the Company dated March 28,
                  2006.(22)23.1
              Consent
                  of Independent Accountants.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.




45


_____________________________________


(1)
              Filed
                  with the Securities and Exchange Commission (“SEC”) on January 11, 2000 as
                  an exhibit to the Company’s Form 8-K and incorporated herein by
                  reference.
 (2)
              Filed
                  with the SEC as an exhibit to the Company’s Registration Statement on Form
                  S-1 filed with the SEC on May 17, 1996 or as an exhibit to Amendment
                  No. 1
                  to the Form S-1 filed with the SEC on December 31, 1996 and incorporated
                  herein by reference.
 (3)
              Filed
                  with the SEC on June 29, 1998 as an exhibit to the Company’s Form 8-K and
                  incorporated herein by reference
 (4)
              Filed
                  with SEC on December 2, 1998 as an exhibit to the Company’s Form 8-K and
                  incorporated herein by reference.
 (5)
              Filed
                  with the SEC on April 11, 2001 as an exhibit to the Company’s Form 10-K
                  and incorporated herein by
                  reference.
 (6)
              Filed
                  with the SEC on August 14, 2001 as an exhibit to the Company’s Form 10-Q
                  and incorporated herein by
                  reference.
 (7)
              Filed
                  with the SEC on September 7, 2001 as an exhibit to the Company’s Form S-8
                  and incorporated herein by
                  reference.
 (8)
              Filed
                  with the Commission on May 14, 2002 as an exhibit to Form 10-Q
                  for the
                  period ended March 31, 2002.
 (9)
              Filed
                  as an exhibit to Form 8-K with the Commission on July 15,
                  2002.
 (10)
              Filed
                  as an exhibit to Form 8-K with the Commission on October 7,
                  2002.
 (11)
              Filed
                  with the Commission on November 14, 2002 as an exhibit to Form
                  10-Q for
                  the period ended September 30,
                  2002.
 (12)
              Filed
                  as exhibit to Form 8-K with the Commission on January 8,
                  2003.
 (13)
              Filed
                  as an exhibit to Form 10-Q with the Commission on November 12,
                  2003.
 (14)
              Filed
                  as an exhibit to Form 8-K with the Commission on March 16,
                  2004.
 (15)
              Filed
                  as an exhibit to Form 8-K with the Commission on July 1,
                  2004.
 (16)
              Filed
                  as an exhibit to Form 8-K with the Commission on August 20,
                  2004.
 (17)
              Filed
                  as an exhibit to Form 8-K with the Commission on August 26,
                  2004.
 (18)
              Filed
                  as an exhibit to Form 10-Q with the Commission on November 12,
                  2004.
 (19)
              Filed
                  as an exhibit to Form 8-K with the Commission on December 29,
                  2004.
 (20)
              Filed
                  as an exhibit to Form S-8 with the Commission on May 25,
                  2005.
 (21)
              Filed
                  as an exhibit to Form 8-K with the Commission on January 3,
                  2006.
 (22)
              Filed
                  as an exhibit to Form 8-K with the Commission on March 30,
                  2006.
 
 46
 **SIGNATURES**
 
 Pursuant
          to the requirements of Section 13 or 15(d) 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.
 
 Dated:
          March 24, 2006
  Point.360By:
                /s/
                    Haig S. Bagerdjian
                  Haig S. Bagerdjian
                  Chairman
                    of the Board of Directors,
                  President
                    and Chief Executive Officer
 
 Pursuant
          to the requirements of Section 13 or 15(d) of the Securities Exchange Act
          of 1934, this report has been signed by the following persons on behalf
          of the
          Registrant and in the capacities and on the dates indicated.
 
 /s/
                    Haig S. Bagerdjian
                  
                  Haig
                    S. Bagerdjian
                Chairman
                    of the Board of Directors,
                  President
                    and Chief Executive Officer
                March
                    24, 2006/s/
                    Alan R. Steel
                  
                  Alan
                    R. Steel
                Executive
                    Vice President,
                  Finance
                    and Administration, Chief Financial Officer
                  (Principal
                    Accounting and Financial Officer)
                March
                    24, 2006/s/
                    Robert A. Baker
                  
                  Robert
                    A. Baker
                Director
                March
                    10, 2006/s/
                    Greggory J. Hutchins
                  
                  Greggory
                    J. Hutchins
                Director
                March
                    11, 2006/s/
                    Sam P. Bell
                  
                  Sam
                    P. Bell
                Director
                March
                    20, 2006/s/
                    G. Samuel Oki
                  
                  G.
                    Samuel Oki
                Director
                March
                    12, 2006
 
 47