**UNITED
STATES SECURITIES AND EXCHANGE COMMISSION**
 **Washington,
D.C. 20549**
 
 **___________**
 
 **FORM
10-K**
 
 **n ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE**
 **SECURITIES
EXCHANGE ACT OF 1934**
 
 **For
the fiscal year ended December 31, 2004**
 
 **OR**
 
 **o TRANSITION REPORT PURSUANT TO SECTION 13 OR
15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**
 
 **For
the transition period from** **** **to** ****
 
 **Commission
File Number 0-21917**
 **___________**
 
 **POINT.360**
 (Exact
name of registrant as specified in its charter)
 
 **California**
      (State
      or other jurisdiction ofincorporation
      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 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 N  o o
  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. o
  Indicate
by checkmark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Act).
 Yes o  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, 2004) was approximately $17,432,000.
As of February 28, 2005, there were 9,344,132 shares of Common Stock
outstanding.
  
 DOCUMENTS
INCORPORATED BY REFERENCE
 
 Definitive
Proxy Statement relating to the Company’s Annual Meeting of Shareholders to be
held on May 4, 2005 is incorporated by reference in Part III of this report.
 
 
 
   **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 nine 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:
  1
 *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.
  2
 *Archival
Services.* The
Company currently stores approximately 1.5 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. The Company currently derives a small percentage
of its 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 (five 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.
  As the
Company continues to develop and acquire facilities in new markets, its network
enables it to maximize the usage of its network-wide capacity by instantaneously
transmitting video content to facilities with available capacity. 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
significantly 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 center at its
Burbank, California, facility.
  *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.
  3
 **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 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, 2004,
ten major motion picture studios and advertising agencies accounted for
approximately 38% of the Company's revenues. No customer accounted for greater
than 10% of the Company’s revenues for the year ended December 31,
2004.
  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.
  4
 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 subsidiary of the Williams Companies), 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 475 full-time employees as of December 31, 2004. 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
2. PROPERTIES**
  The
Company currently owns one and leases 10 of its facilities. Ten of these
locations have production capabilities and/or sales activities, and the one
owned facility is a media storage center. The terms of leases for leased
facilities expire at various dates from 2005 to 2012. The following table sets
forth the location and approximate square footage of the Company's properties as
of December 31, 2004:
 
 **Owned**
    
    **Square****Footage**Los
      Angeles, CA.
    
    
    64,600**Leased**Hollywood,
      CA.
    
    
    31,000Hollywood,
      CA.
    
    
    13,400Hollywood,
      CA.
    
    
    13,000Burbank,
      CA.
    
    
    32,000Burbank,
      CA.
    
    
    45,500Los
      Angeles, CA.
    
    
    13,400San
      Francisco, CA.
    
    
    9,500Chicago,
      IL.
    
    
    13,200New
      York, NY.
    
    
    9,000Dallas,
      TX.
    
    
    11,300
  In
November 2003, the Company leased 64,600 square feet of free-standing warehouse
space in Los Angeles to be used primarily as a vault facility to store
customers’ intellectual property (i.e. “elements”). During 2004, the Company
vacated approximately 71,000 square feet of existing vault space in four
locations as the respective leases expired, consolidating the vaulting functions
into the new space. In 2004, the Company also moved its headquarters from 9,500
square feet of leased space into the 45,500 square foot Burbank
facility.
  **ITEM
3. LEGAL PROCEEDINGS**
 
 On July
7, 2003, Alliance Atlantis Communications, Inc. (“Alliance”) filed a complaint
against the Company in the United States District Court, Central District of
California. The complaint sought a declaration of the court that Alliance has
full right of legal ownership of (i) a warrant issued by the Company in July
2003 in consideration of an option to purchase three subsidiaries of Alliance
and (ii) the $300,000 paid to Alliance in December 2002 to extend the option.
The complaint alleged that the Company made false and misleading statements in
its press release announcing the termination of negotiations with Alliance,
asking for undetermined damages.
 
 On July
18, 2003, Alliance filed a complaint against the Company in the Superior Court
of Justice, Ontario, Canada. The complaint alleged 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.
 
 5
 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. In November 2004, the Company and
Alliance signed a Settlement and Mutual Release Agreement, and the Company paid
Alliance $575,000 to settle all matters between the parties.
  In
addition to the above, 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.
  **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, 2003**First
      Quarter
    
    $
    1.75
    
    $
    2.38Second
      Quarter
    
    
    1.92
    
    
    2.70Third
      Quarter
    
    
    2.26
    
    
    4.15Fourth
      Quarter
    
    
    3.71
    
    
    5.08**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
 
 On
February 25, 2005, the closing sale price of the Common Stock as reported on the
NNM was $3.56 per share. As of February 25, 2005, 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, 2003 or 2004. 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 quarter
ended December 31, 2004.
 6
   ITEM 6. SELECTED FINANCIAL
DATA
 
 The
following data, insofar as they relate to each of the years 2000 to 2004, 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,****2000**
    
    **2001**
    
    **2002**
    
    **2003**
    
    **2004****Statement
      of Income Data**Revenues
    
    $
    74,841
    
    $
    69,628
    
    $
    68,419
    
    $
    64,900
    
    $
    63,344Cost
      of goods sold
    
    
    (45,894
    )
    
    (46,864
    )
    
    (42,172
    )
    
    (39,670
    )
    
    (40,519
    )Gross
      profit
    
    
    28,947
    
    
    22,764
    
    
    26,247
    
    
    25,230
    
    
    22,825Selling,
      general and administrative expense
    
    
    (21,994
    )
    
    (20,872
    )
    
    (18,977
    )
    
    (17,479
    )
    
    (18,936
    )Write-off
      of deferred acquisition and financing costs ..
    
    
    -
    
    
    -
    
    
    -
    
    
    (1,043
    )
    
    (1,050
    )Operating
      income
    
    
    6,953
    
    
    1,892
    
    
    7,270
    
    
    6,708
    
    
    2,839Interest
      expense, net
    
    
    (2,889
    )
    
    (3,070
    )
    
    (2,528
    )
    
    (2,056
    )
    
    (811
    )Derivative
      fair value change (4)
    
    
    -
    
    
    (700
    )
    
    82
    
    
    611
    
    
    -Provision
      for (benefit from) income tax
    
    
    (1,814
    )
    
    384
    
    
    (2,007
    )
    
    (2,114
    )
    
    (781
    )Income
      (loss) before extraordinary item, adoption of SAB 101(2)
    
    $
    2,250
    
    $
    (1,494
    )
    
    2,817
    
    
    3,149
    
    
    1,247Extraordinary
      item (net of tax benefit of $168) (1)
    
    
    (232
    )
    
    -
    
    
    -
    
    
    -
    
    
    -Cumulative
      effect of adopting SAB 101 (2)
    
    
    (322
    )
    
    -
    
    
    -
    
    
    -
    
    
    -Net
      income (loss)
    
    $
    1,696
    
    $
    (1,494
    )
    $
    2,817
    
    $
    3,149
    
    $
    1,247Earnings
      (loss) per share:Basic:Income
      (loss) per share before extraordinary item,adoption
      of SAB 101 (2)
    
    $
    0.24
    
    $
    (0.17
    )
    $
    0.31
    
    $
    0.35
    
    $
    0.14Extraordinary
      item (1)
    
    
    (0.03
    )
    
    -
    
    
    -
    
    
    -
    
    
    -Cumulative
      effect of adopting SAB 101 (2)
    
    
    (0.03
    )
    
    -
    
    
    -
    
    
    -
    
    
    -Net
      income (loss)
    
    $
    0.18
    
    $
    (0.17
    )
    $
    0.31
    
    $
    0.35
    
    $
    0.14Diluted:Income
      (loss) per share before extraordinary itemand
      adoption of SAB 101
    
    $
    0.24
    
    $
    (0.17
    )
    $
    0.30
    
    $
    0.33
    
    $
    0.13Extraordinary
      item (1)
    
    
    (0.03
    )
    
    -
    
    
    -
    
    
    -
    
    
    -Cumulative
      effect of adopting SAB 101 (2)
    
    
    (0.03
    )
    
    -
    
    
    -
    
    
    -
    
    
    -Net
      income (loss)
    
    $
    0.18
    
    $
    (0.17
    )
    $
    0.30
    
    $
    0.33
    
    $
    0.13Weighted
      average common shares outstandingBasic
    
    
    9,216
    
    
    9,060
    
    
    9,013
    
    
    9,067
    
    
    9,197Diluted
    
    
    9,491
    
    
    9,060
    
    
    9,377
    
    
    9,555
    
    
    9,671
 
 **Year
      Ended December 31,****2000**
    
    **2001**
    
    **2002**
    
    **2003**
    
    **2004****Other
      Data**
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5
    )EBITDA(3)
    
    $
    12,172
    
    $
    8,500
    
    $
    12,690
    
    $
    12,818
    
    $
    8,715Cash
      flows provided by operating activities
    
    
    10,963
    
    
    9,455
    
    
    10,381
    
    
    10,480
    
    
    6,814Cash
      flows used in investing activities
    
    
    (9,488
    )
    
    (4,069
    )
    
    (3,485
    )
    
    (1,599
    )
    
    (8,426
    )Cash
      flows provided by (used in) financing activities
    
    
    (1,556
    )
    
    (2,397
    )
    
    (5,282
    )
    
    (7,047
    )
    
    (4,926
    )Capital
      expenditures
    
    
    9,717
    
    
    3,082
    
    
    1,949
    
    
    1,237
    
    
    5,307**Selected
      Balance Sheet Data**Cash
      and cash equivalents
    
    $
    769
    
    $
    3,758
    
    $
    5,372
    
    $
    7,206
    
    $
    668Working
      capital
    
    
    12,701
    
    
    (16,006)(6
    )
    
    8,185
    
    
    3,663
    
    
    (119
    )Property
      and equipment, net
    
    
    25,236
    
    
    23,232
    
    
    19,965
    
    
    15,751
    
    
    31,451Total
      assets
    
    
    77,375
    
    
    70,847
    
    
    70,080
    
    
    64,744
    
    
    76,647Borrowings
      under revolving credit agreements
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    4,323Current
      portion of notes payable
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    2,849Long-term
      debt, net of current portion
    
    
    31,054
    
    
    78
    
    
    18,065
    
    
    6,762
    
    
    14,494Shareholders'
      equity
    
    
    32,919
    
    
    30,778
    
    
    34,512
    
    
    37,368
    
    
    38,944
 
 7
 ____________________
 
 (1)
    Amount
      represents the write off of deferred financing costs, net of tax benefit,
      related to a bank credit agreement which was terminated in Fiscal
      2000.
 
 (2)
    Effective
      January 1, 2000, the Company adopted Staff Accounting Bulletin No. 101
      (“SAB 101”),*Revenue
      Recognition in Financial Statements*.
      The amount represents the cumulative effect, net of tax, on January 1,
      2000 retained earnings as if SAB 101 had been adopted prior to Fiscal
      2000.
 
 (3)
    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.
 
 Computation
of EBITDA (in thousands)
 2000
    
    2001
    
    2002
    
    2003
    
    2004Net
      income (loss)
    
    $
    1,696
    
    $
    (1,494
    )
    $
    2,817
    
    $
    3,149
    
    $
    1,247Add
      back:Interest
    
    
    2,889
    
    
    3,070
    
    
    2,528
    
    
    2,056
    
    
    811Income
      taxes
    
    
    1,814
    
    
    (384
    )
    
    2,007
    
    
    2,114
    
    
    781Depreciation
      & Amortization
    
    
    5,773
    
    
    7,308
    
    
    5,338
    
    
    5,499
    
    
    5,876EBITDA
    
    $
    12,172
    
    $
    8,500
    
    $
    12,690
    
    $
    12,818
    
    $
    8,715
 
 (4)
    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 receives
      LIBOR and pays 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”), requires 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.
 
 (5)
    Amounts
      shown under Selected Balance Sheet Data as of December 31, 2004 reflect a
      new credit agreement and the acquisition of International Video
      Conversions, Inc. See Notes 3 and 6 of Notes to Consolidated Financial
      Statements elsewhere in this Form 10-K.
 
 (6)
    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.
 8
 **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 discussions in the Company's
documents filed with the Securities and Exchange Commission and Cautionary
Statements and Risk Factors in this Item 7, for a further discussion of these
and other risks and uncertainties applicable to the Company's business.*
 
 **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;
and
 l
    our
      market capitalization relative to net book value.
 9
  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 $58.7 million as of December
31, 2004 .
  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. We had recorded approximately
$2.0 million of amortization on these amounts during the year ended
December 31, 2001. 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 and 2004 tests performed as of September 30, 2002, 2003 and 2004,
respectively, required no goodwill impairment. The discounted cash flow method
used to evaluate goodwill impairment included cash flow estimates for 2005 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, 2004 was $4.4 million. The Company did not record a valuation
allowance against its deferred tax assets as of December 31, 2004.
  **Results
of Operations**
  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 will restrict our access to their distribution
capabilities.
  The
Company has an opportunity to expand its business by establishing closer
relationships with our customers through excellent service at a competitive
price. 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.
  10
 
 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 International Video Conversions, Inc.
(“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, 2002, 2003 and 2004. The commentary below is
based on these financial statements (in thousands).
 
 **Year
      ended December 31****2002**
    
    **2003**
    
    **2004****Amount**
    
    **Percent
      of**
      **Revenues**
    
    **Amount**
    
    **Percent
      of**
      **Revenues**
    
    **Amount**
    
    **Percent
      of**
      **Revenues**Revenues
    
    $
    68,419
    
    
    100.0
    %
    $
    64,900
    
    
    100.0
    %
    $
    63,344
    
    
    100.0
    %Costs
      of goods sold
    
    
    (42,172
    )
    
    (
      61.6
    )
    
    (39,670
    )
    
    (61.1
    )
    
    (40,519
    )
    
    (64.0
    )Gross
      profit
    
    
    26,247
    
    
    38.4
    
    
    25,230
    
    
    38.9
    
    
    22,825
    
    
    36.0Selling,
      general and administrative expense
    
    
    (18,977
    )
    
    (27.7
    )
    
    (17,479
    )
    
    (27.0
    )
    
    (18,936
    )
    
    (29.9
    )Write-off
      of deferred acquisition and financing costs
    
    
    -
    
    
    -
    
    
    (1,043
    )
    
    (1.5
    )
    
    (1,050
    )
    
    (1.6
    )Operating
      income
    
    
    7,270
    
    
    10.7
    
    
    6,708
    
    
    10.4
    
    
    2,839
    
    
    4.5Interest
      expense, net
    
    
    (2,528
    )
    
    (3.7
    )
    
    (2,056
    )
    
    (3.2
    )
    
    (811
    )
    
    (1.3
    )Derivative
      fair value change
    
    
    82
    
    
    0.1
    
    
    611
    
    
    1.0
    
    
    -
    
    
    -(Provision
      for) benefit from income taxes
    
    
    (2,007
    )
    
    (2.9
    )
    
    (2,114
    )
    
    (3.3
    )
    
    (781
    )
    
    (1.2
    )Net
      income (loss)
    
    $
    2,817
    
    
    4.2
    %
    $
    3,149
    
    
    4.9
    %
    $
    1,247
    
    
    2.0
    %
  **Statistical
Analysis**
  The table
below summarizes results for the year ended December 31, 2002, and pro forma
results for the years ended December 31, 2003 and 2004, 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, 2003**
    
    **December
      31, 2004****Pro
      forma**
    
    **(2)**
    
    **GAAP**
    
    **Pro
      forma**
    
    **(1)**
    
    **(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 and administrative expense (3)
    
    
    (17,479
    )
    
    -
    
    
    (17,479
    )
    
    (17,632
    )
    
    (1,304
    )
    
    -
    
    
    (18,936
    )Write-off
      of deferred acquisition, financing and 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
    )
    $
    1,247Earnings
      (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
 11
  **Year
      Ended****December
      31, 2002**
    
    **December
      31, 2003****Pro
      forma**
    
    **(2)**
    
    **GAAP**
    
    **Pro
      forma**
    
    **(2)**
    
    **GAAP**Revenues
    
    $
    68,419
    
    $
    -
    
    $
    68,419
    
    $
    64,900
    
    $
    -
    
    $
    64,900Cost
      of goods sold
    
    
    (42,172
    )
    
    -
    
    
    (42,172
    )
    
    (39,670
    )
    
    -
    
    
    (39,670
    )Gross
      profit
    
    
    26,247
    
    
    -
    
    
    26,247
    
    
    25,230
    
    
    -
    
    
    25,230Selling,
      general and administrative expense (3)
    
    
    (18,977
    )
    
    -
    
    
    (18,977
    )
    
    (17,479
    )
    
    -
    
    
    (17,479
    )Write-off
      of deferred acquisition, financing and settlement costs
      (3)
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    (1,043
    )
    
    (1,043
    )Operating
      income (loss)
    
    
    7,270
    
    
    -
    
    
    7,270
    
    
    7,751
    
    
    (1,043
    )
    
    6,708Interest
      expense, net
    
    
    (2,528
    )
    
    -
    
    
    (2,528
    )
    
    (2,056
    )
    
    -
    
    
    (2,056
    )Derivative
      fair valuechange
    
    
    82
    
    
    -
    
    
    82
    
    
    611
    
    
    -
    
    
    611Income
      (loss) beforeincome
      taxes
    
    
    4,824
    
    
    -
    
    
    4,824
    
    
    6,306
    
    
    (1,043
    )
    
    5,263(Provision
      for) benefitfrom
      income taxes
    
    
    (2,007
    )
    
    -
    
    
    (2,007
    )
    
    (2,552
    )
    
    438
    
    
    (2,114
    )Net
      income (loss)
    
    $
    2,817
    
    $
    -
    
    $
    2,817
    
    $
    3,754
    
    $
    (605
    )
    $
    3,149Earnings
      (loss) per share:Basic:
    
    $
    0.31
    
    $
    -
    
    $
    0.31
    
    $
    0.41
    
    $
    (0.06
    )
    $
    0.35Diluted:
    
    $
    0.30
    
    $
    -
    
    $
    0.30
    
    $
    0.39
    
    $
    (0.06
    )
    $
    0.33
  (1)
    Contribution
      of IVC.
 (2)
    Write-off
      of deferred acquisition, financing and settlement
costs.
 (3)
    Previously
      reported amounts have been adjusted to segregate Alliance-related expenses
      from Selling, General and Administrative expense for consistency of
      presentation among periods.
  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 2004 were 2% below 2003 levels. Without the inclusion of IVC, a
company purchased on July 1, 2004, revenues in 2004 would have been $56.9
million, a decrease of 12% from 2003. 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 will not only increase revenues in 2005 (twelve months of
operations compared to six months in 2004), but will add to the cost infracture
of the Company in both cost of sales and selling, general and administrative
(“S,G&A”) areas. With the inclusion of IVC and the elimination of the 2004
duplicated rent and move costs associated with the consolidation of four media
asset storage facilities, we expect 2005 gross margins as a percentage of sales
to be slightly higher than experienced in 2004. We expect S,G&A in 2005 to
be higher as a percentage of sales than in 2004 (excluding the special charge)
due to the addition of management and sales personnel and costs associated to
Sarbanes-Oxley process documentation and assessment and the addition of stock
option compensation expense due to the required July 1, 2005 implementation of
Statement of Financial Accounting Standards No. 123R, *Accounting
for Stock-Ba sed Compensation* (see
Note 1 of Note to Consolidated Financial Statements elsewhere in this Form 10-K
for a discussion of pro forma amounts of such compensation for 2002, 2003 and
2004). Interest expense is expected to be higher in 2005 because of additional
debt incurred for the acquisition of IVC and capital expenditures made in 2004
for the Media Center storage facility.
  Please
refer to Cautionary Statements and Risk Factors below with respect to these
forward-looking statements.
  **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.
  12
 *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.
  **Year
Ended December 31, 2003 Compared To Year Ended December 31,
2002.**
  *Revenues* . **** Revenues
decreased by $3.5 million to $64.9 million for the year ended December 31, 2003,
compared to $68.4 million for 2002. Revenues declined due to delays in new
feature film introductions being promoted in 2003 by several studio clients
thereby affecting the volume of advertising spots. Additionally, one specific
post-production project was completed in 2002 and early 2003, which volume was
not entirely replaced by new business.
  *Gross
Profit* . In
2003, gross margin increased by 0.5% of sales. Gross margin on sales was 38.9%
in 2003 compared to 38.4% in the prior year due principally to lower wages and
benefits.
  *Selling,
General And Administrative Expense* .  SG&A
expense decreased $1.5 million, or 7.7% to $17.5 million for the 2003 period,
compared to $18.9 million for 2002. As a percentage of revenues, SG&A
decreased to 27.0% for 2003, compared to 27.7% for 2002.
  In 2003,
the Company wrote off approximately $1.0 million of previously deferred expenses
related to a proposed acquisition and financing package. Amounts expensed
related to $300,000 paid to extend the option to purchase three subsidiaries of
Canadian entity, $360,000 of legal, accounting and other due diligence costs
related to the proposed acquisition, and approximately $342,000 of legal and
other costs associated with the proposed financing.
  *Operating
Income* .
Operating income decreased $0.6 million to $6.7 million for 2003, compared to a
$7.3 million for 2002.
  *Interest
Expense* .  **** Interest
expense for 2003 was $2.1 million, a decrease of $0.5 million from 2002
because of lower debt levels due to principal payments made during the
year.
  *Derivative
Fair Value Change* . The
Company adopted SFAS 133 on January 1, 2001. During the years ended December 31,
2003 and 2002, 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 periods, or income of $611,000 ($367,000 net of tax provision) and $82,000
($48,000 net of tax provision) in 2003 and 2002, respectively, and amortization
of the cumulative-effect adjustment.
  *Income
Taxes* . The
Company’s effective tax rate was 40% for 2003 and 42% for 2002. 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 2003 was $3.1 million, an increase of $0.3 million compared to
net income of $2.8 million for 2002.
 13
 **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.
  Cash
flows for the period ended September 30, 2004 were affected by approximately
$3.2 million of capital expenditures related to the vault consolidation project.
A portion of the vault expenditures were covered by cash previously advanced by
the building landlord and reflected as accrued expenses on the December 31, 2003
balance sheet (about $0.8 million). All advanced amounts have been either paid
out or reclassified as accounts payable as of September 30, 2004. Other
principal changes in cash flows related to financing activities and are
described below.
  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. For the first two years of the term loan, the Company can
re-borrow all principal payments on $8 million of the term loan to finance up to
80% of capital equipment purchases. The agreement provides for interest at the
banks’ prime rate or LIBOR plus 2.25% for the revolver, prime rate plus 0.25% or
LIBOR plus 2.50% for the term loan, and requires the Company to maintain certain
financial covenant ratios. The term loan requires principal payments of
approximately $2.5 million annually.
  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 in four locations. After the initial
build-out of the new facility and termination of the existing leases during
2004, the resulting annual lease and operating expense levels are expected to be
favorable to the Company. 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.
  The
acquisition of International Video Conversions, Inc. (“IVC”) was completed in
July 2004. We paid $2.3 million in cash and borrowed the $4.7 million. The IVC
purchase agreement will also require 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
November 2004, we paid $575,000 to Alliance in full settlement of all disputes
related to the previously proposed acquisition and financing of three Alliance
subsidiaries.
  The
following table summarizes the December 31, 2004 status of our revolving line of
credit and term loans:
 
 **Balance
      at December 31, 2004**Revolving
      credit
    
    $
    4,323,000Current
      portion of term loans
    
    
    2,849,000Long-term
      portion of term loans
    
    
    14,494,000Total
    
    $
    21,666,000
  Monthly
and annual principal and interest payments due under the term-loan debt are
approximately $260,000 and $3,100,000, respectively, assuming no change in
interest rates. Monthly and annual principal and interest payments due under the
mortgage debt are approximately $57,000 and $700,000, respectively. We expect
that remaining amounts available under the revolving credit and term-loan
re-borrowing arrangements (approximately $5.4 million as of December 31, 2004)
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
following table summarizes contractual obligations as of December 31, 2004 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
    
    $
    20,488,384
    
    $
    2,799,960
    
    $
    5,657,001
    
    $
    5,349,608
    
    $
    6,681,815Capital
      Lease Obligations
    
    
    142,923
    
    
    64,375
    
    
    78,548
    
    
    -
    
    
    -Operating
      Lease Obligations
    
    
    16,884,866
    
    
    3,490,425
    
    
    6,779,855
    
    
    4,303,917
    
    
    2,310,668Total
    
    $
    37,516,173
    
    $
    6,354,760
    
    $
    12,515,405
    
    $
    9,653,525
    
    $
    8,992,484
  14
 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.
  The
Company, from time to time, considers 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 loan. 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.
 
 **Recent
Accounting Pronouncements**
  In May
2003, the Financial Accounting Standards Board issued Statement of Financial
Accounting Standard (“SFAS”) No. 150, “ *Accounting
for Certain Financial Instruments with Characteristics of both Liabilities and
Equity* .” SFAS
No. 150 establishes standards for how an issuer classifies and measures in its
statement of financial position certain financial instruments with
characteristics of both liabilities and equity. In accordance with the standard,
financial instruments that embody obligations for the issuer are required to be
classified as liabilities. SFAS No. 150 will be effective for financial
instruments entered into or modified after May 31, 2003 and otherwise will be
effective at the beginning of the first interim period beginning after June 15,
2003. SFAS No. 150 does not have a material impact on the Company’s financial
statements.
 
 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 re-handling 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.
 
 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 interim period or fiscal year beginning after June
15, 2005, or (3) for all nonpublic entities, as of the first fiscal year
beginning after December 15, 2005. Management is currently assessing the effect
of SFAS No. 123(R) on the Company’s financial statement.
 
 15
 **CAUTIONARY
STATEMENTS AND RISK FACTORS**
  In our
capacity as Company management, we may from time to time make written or oral
forward-looking statements with respect to our long-term objectives or
expectations which may be included in our filings with the Securities and
Exchange Commission (the “SEC”), reports to stockholders and information
provided 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.
 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 growth.
 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.
  These
risk factors are discussed further below.
  **Recent
History of Losses** . The
Company reported losses for each of the five fiscal quarters ended December 31,
2001 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 the three fiscal years ended December 31, 2004, there can
be no assurance as to future profitability on a quarterly or annual basis.
 
 **Prior
Breach and Changes in Credit Agreements** **.** 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 are $1.6
million each for five years. Any principal outstanding under the revolver will
be due in March 2006.
 
 In July
and August 2004, the credit agreement was amended in connection with the
acquisition of another company (see Note 10) 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 vault storage facilities. While we believe operating cash flows
are sufficient to service increased total debt levels, reduced future sales
levels, if they occur, could possibly result in a breach of the financial
covenants contained in the credit agreements.
 
 16
 In
November 2004, we began discussion 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 recent
quarters. We cannot be sure that we will be successful in achieving such changes
and, if we are not successful, there is a risk that we will be in default of
certain financial covenants in future quarters. If a default condition exists in
the future, all amounts outstanding under the credit agreement will be due and
payable which could materially and adversely affect our business.
  **Competition.** 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, the 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.
  **Customer
and Industry Concentration.** Although
we have an active client list of over 2,500 customers, ten motion picture
studios and advertising agencies accounted for approximately 38% of the
Company’s revenues during the year ended December 31, 2004. 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.
  **Expansion
Strategy.** 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 nine acquisitions in the last
seven fiscal years, the most recent of which was in July 2004, 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.
 
 Certain
of the businesses previously acquired by the Company reported net losses for
their most recent fiscal years prior to being acquired, and our future financial
performance will be in part dependent on our ability to implement operational
improvements in, or exploit potential synergies with, these acquired
businesses.
 
 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.
 
 In July
2002, the Company issued a warrant to purchase 500,000 shares of the Company’s
common stock to Alliance Atlantis Communications, Inc. (“Alliance”) in
consideration of an option to purchase three post-production facilities (the
“Subsidiaries”) owned by Alliance. In connection therewith, the Company
capitalized the fair value of the warrant ($619,000, determined by using the
Black-Scholes valuation model). In December 2002, the option was extended by
mutual agreement and we deposited $300,000 toward the ultimate purchase price,
which was negotiated downward. Additionally, the Company capitalized
approximately $360,000 of due diligence costs associated with the proposed
acquisition and approximately $342,000 of costs associated with a related new
financing arrangement.
 
 17
 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 costs associated with the proposed new financing. The $619,000 value of the
warrant was charged to 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 seeking a judicial determination that
Alliance has full right of legal ownership to the warrant as well as the
$300,000 deposit.
 
 On July
18, 2003, Alliance filed a complaint against the Company in the Superior Court
of Justice, Ontario, Canada. The complaint alleged 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. In November 2004, the Company and
Alliance signed a Settlement and Mutual Release Agreement, and the Company paid
Alliance $575,000 to settle all matters between the parties.
 
 If we
acquire any entities, we may have to finance a large portion of the anticipated
purchase price and/or refinance our existing credit agreement. The cost of any
new financing may be higher than our existing credit facility. 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.
 
 **Management
of Growth.** In prior
years, we experienced rapid growth that 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 this growth, 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.
 
 **Dependence
on Technological Developments.** Although
we intend to utilize the most efficient and cost-effective technologies
available for telecine, high definition formatting, editing, coloration and
delivery of 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,
including the Company’s significant investment in high definition technology in
2000 and 2001. 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. Any material interruption in the supply of such services could
materially and adversely affect the Company’s financial condition, results of
operations and prospects.
 
 **Dependence
on Key Personnel.** 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 26% 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.
 
 **Ability
to Maintain and Improve Service Quality.** 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.
 
 18
 **Fluctuating
Results, Seasonality.** 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 as 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. Fluctuations in
sales due to seasonality may become more pronounced if the growth rate of the
Company’s sales slows.
 
 **Control
by Principal Shareholder; Potential Issuance of Preferred Stock; Anti-Takeover
Provisions.** The
Company’s Chairman, President and Chief Executive Officer, Haig S. Bagerdjian,
beneficially owned approximately 26% of the outstanding common stock as of
December 31, 2004. The ex-spouse of R. Luke Stefanko, the Company’s former
President and Chief Executive Officer, owned approximately 20% of the common
stock on that date. Together, they owned approximately 46%. By virtue of their
stock ownership, Ms. Stefanko 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 Board
of Directors also 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 Compay 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.
 19
  **ITEM
7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK**
  *Market
Risk* . The
Company had borrowings of $15.4 million at December 31, 2004 under a term loan
and revolving credit agreement, and $6.3 million outstanding under a Mortgage.
Amounts outstanding under the term loan and revolving credit facility and the
mortgage debt provide for interest at the banks’ prime rate or LIBOR plus 2.25%
for the revolver, prime plus 0.25% or LIBOR plus 2.50% for the term loan and
LIBOR plus a variable amount for the mortgage debt. 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.
 
 In August
2004, the Company entered into a one-year interest rate swap contract to
economically hedge the 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 is 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 banks or LIBOR plus 1.85% for that
period.
 20
   **ITEM
8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**
  **Page**Report
      of Independent Registered Public Accounting Firm
    
    
    22Financial
      Statements:Consolidated
      Balance Sheets -December
      31, 2003 and 2004
    
    
    23Consolidated
      Statements of Income -Fiscal
      Years Ended December 31, 2002, 2003 and 2004
    
    
    24Consolidated
      Statements of Shareholders’ Equity and Comprehensive (Loss) Income
      -Fiscal
      Years Ended December 31, 2002, 2003 and 2004
    
    
    25Consolidated
      Statements of Cash Flows -Fiscal
      Years Ended December 31, 2002, 2003 and 2004
    
    
    26Notes
      to Consolidated Financial Statements
    
    
    27Financial
      Statement Schedule:Schedule
      II - Valuation and Qualifying Accounts
    
    
    39Consent
      of Independent Registered Public Accounting Firm
    
    
    45
  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.
 21
 **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, 2003 and 2004, and the
related consolidated statements of income, shareholders' equity, and cash
flows for each
of the three years in the period ended December 31, 2004. 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 audit 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, 2003 and 2004, and the results of their operations and their
cash flows for each of the three years in the period ended December 31, 2004 in
conformity with accounting principles generally accepted in the United States of
America.
 
 Singer
Lewak Greenbaum & Goldstein LLP (signed)
 Los
Angeles, California
 February
15, 2005
 22
  **Point.360**
 **Consolidated
Balance Sheets**
 
 ******December
      31,********2003**
    
    ******2004****Assets**Current
      assets:Cash
      and cash equivalents
    
    $
    7,206,000
    
    $
    668,000Accounts
      receivable, net of allowances for doubtful accounts of $735,000 and
      $531,000,respectively
    
    
    9,490,000
    
    
    12,468,000Inventories
    
    
    794,000
    
    
    932,000Prepaid
      expenses and other current assets
    
    
    895,000
    
    
    1,788,000Deferred
      income taxes
    
    
    1,414,000
    
    
    1,310,000Total
      current assets
    
    
    19,799,000
    
    
    17,166,000Property
      and equipment, net (Note 4)
    
    
    15,751,000
    
    
    31,451,000Other
      assets, net (Note 8)
    
    
    1,348,000
    
    
    742,000Goodwill
      and other intangibles, net (Note 3)
    
    
    27,046,000
    
    
    27,288,000Rights
      to purchase property and equipment (Note 8)
    
    
    800,000
    
    
    -$
    64,744,000
    
    $
    76,647,000**Liabilities
      and Shareholders’ Equity**Current
      liabilities:Accounts
      payable
    
    $
    3,460,000
    
    $
    4,898,000Accrued
      wages and benefits
    
    
    1,773,000
    
    
    1,751,000Accrued
      earn-out payments
    
    
    -
    
    
    1,000,000Other
      accrued expenses
    
    
    1,350,000
    
    
    1,249,000Income
      tax payable
    
    
    296,000
    
    
    1,148,000Borrowings
      under revolving credit agreement (Notes 6 and 12)
    
    
    9,199,000
    
    
    4,323,000Current
      portion of borrowings under notes payable
    
    
    -
    
    
    2,849,000Current
      portion of capital lease obligations (Note 6)
    
    
    58,000
    
    
    67,000Total
      current liabilities
    
    
    16,136,000
    
    
    17,285,000Deferred
      income taxes
    
    
    3,678,000
    
    
    5,788,000Notes
      payable, less current portion (Note 6)
    
    
    6,667,000
    
    
    14,494,000Capital
      lease and other obligations, less current portion (Note 6)
    
    
    95,000
    
    
    136,000Obligation
      to purchase property and equipment (Note 8)
    
    
    800,000
    
    
    -Total
      long-term liabilities
    
    
    11,240,000
    
    
    20,418,000Total
      liabilities
    
    
    27,376,000
    
    
    37,703,000Commitments
      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; 9,134,559 and
      9,236,132shares
      issued and outstanding, respectively
    
    
    17,625,000
    
    
    17,903,000Additional
      paid-in capital
    
    
    624,000
    
    
    675,000Accumulated
      other comprehensive income
    
    
    -
    
    
    -Retained
      earnings
    
    
    19,119,000
    
    
    20,366,000Total
      shareholders’ equity
    
    
    37,368,000
    
    
    38,944,000$
    64,744,000
    
    $
    76,647,000
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
 
 23
  **Point.360**
 **Consolidated
Statements of Income**
 
 **Year
      Ended December 31,****2002**
    
    **2003**
    
    **2004**Revenues
    
    $
    68,419,000
    
    $
    64,900,000
    
    $
    63,344,000Cost
      of goods sold
    
    
    (42,172,000
    )
    
    (39,670,000
    )
    
    (40,519,000
    )Gross
      profit
    
    
    26,247,000
    
    
    25,230,000
    
    
    22,825,000Selling,
      general and administrative expense
    
    
    (18,977,000
    )
    
    (17,479,000
    )
    
    (18,936,000
    )Write-off
      of deferred acquisition and financing costs (Note 3)
    
    
    -
    
    
    (1,043,000
    )
    
    (1,050,000
    )Operating
      income
    
    
    7,270,000
    
    
    6,708,000
    
    
    2,839,000Interest
      expense (net)
    
    
    (2,528,000
    )
    
    (2,056,000
    )
    
    (811,000
    )Derivative
      fair value change
    
    
    82,000
    
    
    611,000
    
    
    -Income before
      income taxes
    
    
    4,824,000
    
    
    5,263,000
    
    
    2,028,000Provision
      for income taxes
    
    
    (2,007,000
    )
    
    (2,114,000
    )
    
    (781,000
    )Net
      income
    
    $
    2,817,000
    
    $
    3,149,000
    
    $
    1,247,000Earnings
      per share:Basic:Net
      income
    
    $
    0.31
    
    $
    0.35
    
    $
    0.14Weighted
      average number of shares
    
    
    9,013,224
    
    
    9,067,446
    
    
    9,196,620Diluted:Net
      income
    
    $
    0.30
    
    $
    0.33
    
    $
    0.13Weighted
      average number of shares including the dilutive effect ofstock
      options (Note 2)
    
    
    9,376,707
    
    
    9,554,847
    
    
    9,671,395
  The
accompanying notes are an integral part of these consolidated financial
statements.
 
 24
  **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
      at December 31, 2001
    
    
    8,992,806
    
    $
    17,336
    
    $
    439
    
    $
    13,153
    
    $
    (150
    )
    $
    30,778Net
      income
    
    
    -
    
    
    -
    
    
    -
    
    
    2,817
    
    
    -
    
    
    2,817Shares
      issued in connection withexercise
      of stock option
    
    
    10,000
    
    
    20
    
    
    -
    
    
    -
    
    
    -
    
    
    20Issuance
      of stock options toconsultants
    
    
    -
    
    
    -
    
    
    214
    
    
    -
    
    
    -
    
    
    214Issuance
      of stock purchase warrants
    
    
    -
    
    
    -
    
    
    619
    
    
    -
    
    
    -
    
    
    619Shares
      issued in settlement of a debt
    
    
    18,518
    
    
    20
    
    
    -
    
    
    -
    
    
    -
    
    
    20Adjustment
      of shares issued foran
      acquisition
    
    
    (7,092
    )
    
    (17
    )
    
    -
    
    
    -
    
    
    -
    
    
    (17
    )Change
      in Other ComprehensiveIncome
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    60
    
    
    60Balance
      on December 31, 2002
    
    
    9,014,232
    
    
    17,359
    
    
    1,272
    
    
    15,970
    
    
    (90
    )
    
    34,511Net
      income
    
    
    
    
    
    
    
    
    
    
    
    3,149
    
    
    
    
    
    3,149Shares
      issued in connection withexercise
      of stock options
    
    
    120,327
    
    
    266
    
    
    
    
    
    
    
    
    
    
    
    266Tax
      effect of stock options exercised
    
    
    
    
    
    
    
    
    59
    
    
    
    
    
    
    
    
    59Termination
      of stock purchasewarrants
    
    
    -
    
    
    -
    
    
    (617
    )
    
    
    
    
    
    
    
    (617
    )Termination
      of stock options
    
    
    -
    
    
    -
    
    
    (90
    )
    
    -
    
    
    -
    
    
    (90
    )Change
      in other comprehensiveIncome
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    90
    
    
    90Balance
      on December 31, 2003
    
    
    9,134,559
    
    
    17,625
    
    
    624
    
    
    19,119
    
    
    -
    
    
    37,368Net
      income
    
    
    -
    
    
    -
    
    
    -
    
    
    1,247
    
    
    -
    
    
    1,247Shares
      issued in connection withexercise
      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
    
    $
    -
    
    $
    38,944
  Comprehensive income
      is as follows:**2002**
    
    **2003**Net income
    
    $
    2,817
    
    $
    3,149Amortization
      of cumulative effectAdjustment
      of adoption of FAS 133,net
      of tax
    
    
    60
    
    
    90Comprehensive income
    
    $
    2,877
    
    $
    3,239
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
 
 25
  
 **Point.360**
 **Consolidated
Statements of Cash Flows**
 
 
 **Year
      Ended December 31,****2002**
    
    **2003**
    
    **2004**Cash
      flows from operating activities:Net
      income
    
    $
    2,817,000
    
    $
    3,149,000
    
    $
    1,247,000Adjustments
      to reconcile net income to net cashprovided
      by operating activities:Depreciation
      and amortization
    
    
    5,338,000
    
    
    5,499,000
    
    
    5,876,000Provision
      for doubtful accounts
    
    
    301,000
    
    
    121,000
    
    
    (48,000
    )Deferred
      income taxes
    
    
    723,000
    
    
    (210,000
    )
    
    (324,000
    )Loss
      on disposal of property and equipment
    
    
    -
    
    
    72,000
    
    
    -Derivative
      fair value change
    
    
    (82,000
    )
    
    (611,000
    )
    
    -Other
      noncash items
    
    
    41,000
    
    
    -
    
    
    (242,000
    )Write-off
      of note receivable
    
    
    148,000
    
    
    -
    
    
    -Write-off
      of acquisition costs
    
    
    -
    
    
    1,002,000
    
    
    -Changes
      in operating assets and liabilities:(Increase)
      decrease in accounts receivable
    
    
    (400,000
    )
    
    2,607,000
    
    
    (1,146,000
    )(Increase)
      decrease in inventories
    
    
    (83,000
    )
    
    109,000
    
    
    (18,000
    )(Increase)
      in prepaid expenses and other current assets
    
    
    (303,000
    )
    
    (138,000
    )
    
    (732,000
    )(Increase)
      decrease in other assets
    
    
    (10,000
    )
    
    (826,000
    )
    
    606,000(Decrease)
      increase in accounts payable
    
    
    (559,000
    )
    
    (514,000
    )
    
    996,000Increase
      (decrease) in accrued expenses
    
    
    1,449,000
    
    
    (533,000
    )
    
    (340,000
    )Increase
      in income taxes payable (receivable), net
    
    
    1,001,000
    
    
    753,000
    
    
    939,000Net
      cash and cash equivalents provided by operating activities
    
    
    10,381,000
    
    
    10,480,000
    
    
    6,814,000Cash
      flows from investing activities:Increase
      in restricted cash
    
    
    -
    
    
    800,000
    
    
    -Payment
      for acquisition costs subsequently written off
    
    
    -
    
    
    (369,000
    )
    
    -Capital
      expenditures
    
    
    (1,949,000
    )
    
    (1,237,000
    )
    
    (5,307,000
    )Proceeds
      from sale of equipment
    
    
    27,000
    
    
    15,000
    
    
    40,000Net
      cash paid for acquisitions (IVC)
    
    
    (1,563,000
    )
    
    (8,000
    )
    
    (1,094,000
    )Net
      cash paid for acquisition of building
    
    
    -
    
    
    -
    
    
    (2,065,000
    )Net
      cash and cash equivalents used in investing activities
    
    
    (3,485,000
    )
    
    (1,599,000
    )
    
    (8,426,000
    )Cash
      flows from financing activities:Change
      in revolving credit agreement
    
    
    -
    
    
    -
    
    
    4,323,000Proceeds
      from bank note for new loan
    
    
    -
    
    
    -
    
    
    8,000,000Change
      in note payable
    
    
    -
    
    
    -
    
    
    182,000Issuance
      of notes receivable
    
    
    780,000
    
    
    -
    
    
    -Proceeds
      from exercise of stock options
    
    
    12,000
    
    
    266,000
    
    
    329,000Repayment
      of notes payable
    
    
    (5,999,000
    )
    
    (7,134,000
    )
    
    (17,657,000
    )Contract
      settlement
    
    
    -
    
    
    (90,000
    )
    
    -Repayment
      of capital lease obligations
    
    
    (75,000
    )
    
    (89,000
    )
    
    (103,000
    )Net
      cash and cash equivalents used in financing activities
    
    
    (5,282,000
    )
    
    (7,047,000
    )
    
    (4,926,000
    )Net
      increase in cash and cash equivalents
    
    
    1,614,000
    
    
    1,834,000
    
    
    (6,538,000
    )Cash
      and cash equivalents at beginning of year
    
    
    3,758,000
    
    
    5,372,000
    
    
    7,206,000Cash
      and cash equivalents at end of year
    
    $
    5,372,000
    
    $
    7,206,000
    
    $
    668,,000
 
 
 The
accompanying notes are an integral part of these consolidated financial
statements.
 
 26
  **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, including its 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 39% of accounts receivable at December 31, 2003 and 52% of
accounts receivable at December 31, 2004. 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 38% of net sales for both of the years ended December 31, 2003 and 2004,
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.
  *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 seven years,
leasehold improvements are ten years and building improvements are 39
years.
  27
 *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.
  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 estimated fair value of the
interest rate swap agreement was a net payable of $701,000 at December 31, 2002.
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* .
 
 28
 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:
 
 **2002**
    
    **2003**
    
    **2004**Net
      income (loss):As
      reported
    
    $
    2,817,000
    
    $
    3,149,000
    
    $
    1,247,000Deduct:
      Total stock-based employee compensationexpense
      determined under fair value based methodfor
      all awards, net of related tax effects
    
    
    (516,000
    )
    
    (310,000
    )
    
    (255,000
    )Pro
      forma
    
    
    2,301,000
    
    
    2,839,000
    
    
    992,000Earnings
      (loss) per share:As
      reported:Basic
    
    
    0.31
    
    
    0.35
    
    
    0.14Diluted
    
    
    0.30
    
    
    0.33
    
    
    0.13Pro
      forma:Basic
    
    
    0.26
    
    
    0.31
    
    
    0.11Diluted
    
    
    0.25
    
    
    0.30
    
    
    0.10
  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 2002, 2003 and 2004, respectively: expected volatility of 94%, 60% and
44%and risk-free interest rates of 4.00%, 1.05% and 1.33%. A dividend yield of
0% and expected life of five years was assumed for 2002, 2003 and 2004 grants.
The weighted average fair value of options granted at the fair market price on
the grant date in 2002, 2003 and 2004 were $1.76, $3.00 and $1.03, respectively.
All options granted in 2002, 2003 and 2004 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:
 *****
    
    **2002**
    
    **2003**
    
    **2004**Weighted
      average number of common shares outstandingused
      in computation of basic EPS
    
    
    9,013,224
    
    
    9,067,446
    
    
    9,196,620Dilutive
      effect of outstanding stock options
    
    
    363,483
    
    
    487,401
    
    
    474,775Weighted
      average number of common and potentialcommon
      shares outstanding used in computation of diluted EPS
    
    
    9,376,707
    
    
    9,554,847
    
    
    9,671,395Outstanding
      stock options excluded in thecomputation
      of diluted EPS
    
    
    2,435,086
    
    
    1,573,277
    
    
    1,878,172*
 *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.
  29
 *Supplemental
Cash Flow Information*
  Selected
cash payments and noncash activities were as follows:
 **2002**
    
    **2003**
    
    **2004**Cash
      payments for income taxes
    
    $
    1,364,000
    
    $
    2,626,000
    
    $
    441,000Cash
      payments for interest
    
    
    2,453,000
    
    
    1,852,000
    
    
    708,000Noncash
      investing and financing activities:Termination
      of warrants
    
    
    -
    
    
    619,000
    
    
    -Capitalized
      lease obligations incurred
    
    
    69,000
    
    
    -
    
    
    -Tax
      benefits related to stock options
    
    
    7,000
    
    
    59,000
    
    
    51,000Adjustment
      of acquisition holdback shares
    
    
    (17,000
    )
    
    -
    
    
    -Accrual
      for earn-out payments
    
    
    -
    
    
    -
    
    
    1,000,000Termination
      of stock purchase warrants incurred aspart
      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)
    
    
    1,563,000
    
    
    -
    
    
    242,000
 
 (1)
    Includes
      additional purchase price payments made or accrued to former owners in
      periods subsequent to various acquisitions of $1,253,000 and $1,000,000 in
      2002 and 2004, respectively.
 
 *Recent
Accounting Pronouncements*
  In May
2003, the Financial Accounting Standards Board issued Statement of Financial
Accounting Standards (“SFAS”) No. 150, “ *Accounting
for Certain Financial Instruments with Characteristics of both Liabilities and
Equity* .” SFAS
No. 150 establishes standards for how an issuer classifies and measures in its
statement of financial position certain financial instruments with
characteristics of both liabilities and equity. In accordance with the standard,
financial instruments that embody obligations for the issuer are required to be
classified as liabilities. SFAS No. 150 will be effective for financial
instruments entered into or modified after May 31, 2003 and otherwise will be
effective at the beginning of the first interim period beginning after June 15,
2003. This statement does not affect the Company at this time.
 
 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.
 
 30
 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 interim period or fiscal year beginning after June
15, 2005, or (3) for all nonpublic entities, as of the first fiscal year
beginning after December 15, 2005. Management is currently assessing the effect
of SFAS No. 123(R) on the Company’s financial statement.
  **3.**  **ACQUISITIONS**
 
 During
1997 to 2004, the Company acquired nine 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, 2003, 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, 2003 and 2004, consist of the
following:
 
 **Actual****2003**
    
    **2004**Goodwill
    
    $
    32,622,000
    
    $
    32,864,000Covenant
      not to compete
    
    
    1,000,000
    
    
    1,000,00033,622,000
    
    
    33,864,000Less
      accumulated amortization
    
    
    (6,576,000
    )
    
    (6,576,000
    )$
    27,046,000
    
    $
    27,288,000
 
 Amortization
expense totaled $80,000 and $35,000 for the years ended December 31, 2002 and
2003, respectively. 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.
 
 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.
 
 31
 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. The settlement amount
was recorded as an expense and an accrued settlement on the balance sheet as of
September 30, 2004.
 
 On July
1, 2004, the Company acquired all of the outstanding stock of International
Video Conversions, Inc. (“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 $1 million increment was earned and is
reflected as an accrued liability on the balance sheet as of December 31, 2004).
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. In connection with the acquisition, the term loan portion
of the Company’s bank facility (see Note 3) was increased by $4.7 million. 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 facility.
 
 The total
purchase consideration has been allocated to the assets and liabilities acquired
based on their respective estimated fair values as summarized below. The
purchase price allocation is subject to change and will be finalized upon review
and refinement of certain estimates and completion of valuation and appraisals.
 Cash
      and cash equivalents
    
    $
    1,205,000Inventories
    
    
    120,000Other
      current assets
    
    
    1,000Accounts
      receivable
    
    
    2,036,000Goodwill
    
    
    242,000Property,
      plant and equipment
    
    
    6,009,000Total
      assets acquired
    
    
    9,613,000Accounts
      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
    
    $
    7,000,000

32
  The
following table presents unaudited pro forma results of the combined operations
for the years ended December 31, 2002, 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:
 
 **2002**
    
    **2003**
    
    **2004**Revenue
    
    $
    82,620,000
    
    $
    76,315,000
    
    $
    69,032,000Operating
      Income
    
    
    8,943,000
    
    
    28,816,000
    
    
    3,303,000Net
      income (loss)
    
    
    3,277,000
    
    
    2,804,000
    
    
    1,456,000Basic
      earnings per share
    
    
    0.36
    
    
    0.31
    
    
    0.16Diluted
      earnings per share
    
    
    0.35
    
    
    0.29
    
    
    0.15
  **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,****2003**
    
    **2004**Land
    
    $
    -
    
    $
    5,600,000Building
    
    
    -
    
    
    5,288,000Machinery
      and equipment
    
    
    38,945,000
    
    
    48,731,000Leasehold
      improvements
    
    
    7,773,000
    
    
    8,076,000Computer
      equipment
    
    
    4,520,000
    
    
    4,818,000Equipment
      under capital lease
    
    
    291,000
    
    
    291,00051,529,000
    
    
    72,804,000Less
      accumulated depreciation and amortization
    
    
    (35,778,000
    )
    
    (41,352,000
    )$
    15,751,000
    
    $
    31,452,000
  Depreciation
expense totaled $5,258,000, $5,464,000 and $5,876,000 for the years ended
December 31, 2002, 2003 and 2004, respectively. Accumulated amortization on
capital leases amounted to $125,000 and $166,000, as of December 31, 2003 and
2004, respectively.
  **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
$99,000, $92,000 and $92,000 in 2002, 2003 and 2004, respectively.
 33
  **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. For the first two years of the term loan, the Company can
re-borrow all principal payments to finance up to 80% of capital equipment
purchases. The agreement provides for interest at the banks’ prime rate or LIBOR
plus 2.25% for the revolver, prime rate plus 0.25% or LIBOR plus 2.50% for the
term loan, and requires the Company to maintain certain financial covenant
ratios. The facilities are secured by all of the Company’s assets. The term loan
requires 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.
For financial statement purposes, as of December 31, 2003, an amount
representing the portion of the new term loan due after December 31, 2004
($6,667,000) was classified as “long-term”.
  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.
  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 is secured by the land and building.
  In
connection with the Mortgage, the Company entered into a one-year interest rate
swap contract to economically hedge the 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, by 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 banks 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 a new hedge
agreement.
  *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 years ended
December 31, 2002 and 2003:
 34
  **Increase
      (Decrease) Income****Derivative
      Fair**
      **Value
      Change**
    
    **(Provision
      for ) Benefit****from
      Income Taxes**
    
    **Net
      Derivative****Fair
      Value Change**For
      the year ended December 31, 2002:Amortization
      of cumulative-effect type adjustment
    
    $
    (104,000
    )
    $
    44,000
    
    $
    (60,000
    )Difference
      in the derivative fair value between the beginning and end of the
      year
    
    
    186,000
    
    
    (77,000
    )
    
    109,000$
    82,000
    
    $
    (33,000
    )
    $
    49,000For
      the year ended December 31, 2003: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 is 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 are expected to be highly
correlated. Also, cash receipts under the hedge instrument will offset changes
in LIBOR on the hedged item.
  The
hypothetical derivative is 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 has a zero fair market value at inception
of the hedge relationship. Hedge effectiveness will be assessed on a quarterly
basis.
 
 *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 LIBOR plus 2.25%
(4.13% as of December 31, 2004) to 6.83%. 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, 2004, are as follows:
 2005
    
    $
    2,864,0002006
    
    
    2,865,0002007
    
    
    2,870,0002008
    
    
    2,859,0002009
    
    
    2,491,000Thereafter
    
    
    6,682,000$
    20,631,000
 See Note
12 regarding revised credit facilities.
  35
  **7.**  **INCOME
TAXES:**
  The
Company’s provision for (benefit from) income taxes for the three years ended
December 31, 2004 consists of the following:
 
 **Year
      Ended December 31,********.****2002**
    
    **2003**
    
    **2004**Current
      tax (benefit) expense:Federal
    
    $
    1,280,000
    
    $
    1,820,000
    
    $
    642,000State
    
    
    333,000
    
    
    504,000
    
    
    142,000Total
      current
    
    
    1,613,000
    
    
    2,324,000
    
    
    784,000Deferred
      tax expense:Federal
    
    
    281,000
    
    
    (178,000
    )
    
    (13,000
    )State
    
    
    113,000
    
    
    (32,000
    )
    
    10,000Total
      deferred
    
    
    394,000
    
    
    (210,000
    )
    
    (3,000
    )Total
      provision for (benefit from) for income taxes
    
    $
    2,007,000
    
    $
    2,114,000
    
    $
    781,000
 
 The
following is a reconciliation of the components of the provision for (benefit
from) income taxes:
 
 **2002**
    
    **2003**
    
    **2004**Provision
      for (benefit from) income taxes per the income statement
    
    $
    2,007,000
    
    $
    2,114,000
    
    $
    781,000Extraordinary
      item tax benefit
    
    
    -
    
    
    -
    
    
    -Cumulative
      effect tax benefit of adopting SAB 101
    
    
    -
    
    
    -
    
    
    -Provision
      for (benefit from) income taxes
    
    $
    2,007,000
    
    $
    2,114,000
    
    $
    781,000
  The
composition of the deferred tax assets (liabilities) at December 31, 2003 and
December 31, 2004 are listed below:
 
 **2003**
    
    **2004**Accrued
      liabilities
    
    $
    784,000
    
    $
    587,000Allowance
      for doubtful accounts
    
    
    315,000
    
    
    228,000Other
    
    
    315,000
    
    
    495,000Total
      current deferred tax assets
    
    
    1,414,000
    
    
    1,310000Property
      and equipment
    
    
    (2,486,000
    )
    
    (3,844,000
    )Goodwill
      and other intangibles
    
    
    (1,444,000
    )
    
    (2,097,000
    )State
      net operating loss carry forward
    
    
    123,000
    
    
    -Other
    
    
    129,000
    
    
    153,000Total
      non-current deferred tax liabilities
    
    
    (3,678,000
    )
    
    (5,788,000
    )Net
      deferred tax liability
    
    $
    (2,264,000
    )
    $
    (4,478,000
    )
 
  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:
 
 ******2002**
    
    ******2003**
    
    ******2004**Federal
      tax computed at statutory rate
    
    
    34
    %
    
    34
    %
    
    34
    %State
      taxes, net of federal benefit and net operating loss limitation
    
    
    6
    %
    
    5
    %
    
    2
    %Non-deductible
      goodwill
    
    
    -
    
    
    -
    
    
    -Other
    
    
    2
    %
    
    1
    %
    
    3
    %42
    %
    
    40
    %
    
    39
    %
  36
  **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, 2004 are as
follows:
 
 2005
    
    $
    3,363,0002006
    
    
    3,318,0002007
    
    
    3,396,0002008
    
    
    2,622,0002009
    
    
    1,671,000Thereafter
    
    
    2,310,000
 
 Total
rental expense was approximately $3,106,000, $3,436,000 and $4,299,000 for the
three years in the period ended December 31, 2004, respectively.
 
 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, 2005, 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.
 
 **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 provides 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, 2004, there were 1,530,722 options
outstanding under the 1996 Plan and 1,895,028 options were available for
grant.
 
 In
December 2000, the Company’s Board of Directors adopted the 2000 Nonqualified
Stock Option Plan (the “2000 Plan”). As amended, the 2000 Plan provides 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, 2004, there were 822,225 options outstanding under the plan and
599,800 options were available for grant.
  Under
both 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 and for some options, earlier if
the market price of the Company’s common stock exceeds certain
levels.
 
 37
 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, 2001
    
    
    3,286,628
    
    $
    4.55Granted
      during 2002
    
    
    529,100
    
    
    1.76Exercised
      during 2002
    
    
    (10,000
    )
    
    1.20Cancelled
      during 2002
    
    
    (1,007,069
    )
    
    7.26Balance
      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
    
    $
    2.82
 
 Additional
information with respect to the outstanding options as of December 31, 2004 is
as follows (shares in thousands):
 
 **Options
      Outstanding******.
    
    **Options
      Exercisable****Option
      Exercise****Price
      Range**
    
    **Number
      of Shares**
    
    **Average**
      **Remaining****Contractual
      Life**
    
    **Weighted
      Average**
      **Exercise
      Price**
    
    **Number
      of****Shares**
    
    **Average****Exercise
      Price**$1.20
      - $5.38
    
    
    2,336,126
    
    
    4.1
      years
    
    $
    2.47
    
    
    1,044,664
    
    $
    2.76$7.00
      - $10.00
    
    
    16,821
    
    
    3.6
      years
    
    $
    7.78
    
    
    16,821
    
    $
    7.78
 
 **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, 2004 (in thousands except per share
data).
 **2003****Quarter
      Ended**
    
    **Year
      Ended****March
      31**
    
    **June
      30**
    
    **Sept
      30**
    
    **Dec
      31**
    
    **Dec
      31**Revenues
    
    $
    17,293
    
    $
    15,773
    
    $
    16,709
    
    $
    15,125
    
    $
    64,900Gross
      profit
    
    $
    6,439
    
    $
    5,865
    
    $
    6,993
    
    $
    5,933
    
    $
    25,230Net
      income
    
    $
    992
    
    $
    271
    
    $
    1,075
    
    $
    812
    
    $
    3,149Income
      per share:Basic
    
    $
    0.11
    
    $
    0.03
    
    $
    0.12
    
    $
    0.09
    
    $
    0.35Diluted
    
    $
    0.11
    
    $
    0.03
    
    $
    0.11
    
    $
    0.08
    
    $
    0.33
  **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
  38
  
 **Report
of Independent Registered Public Accounting Firm**
 
 To the
Board of Directors
 and
Shareholders of Point.360
 Burbank,
California
 
 Our audit
w as made for
the purpose of forming an opinion on the basic consolidated financial statements
taken as a whole.  The consolidated supplemental schedule listed in Item 8
of this Form 10-K is presented for purposes of complying with the Securities and
Exchange Commission's rules and is not a part of the basic consolidated
financial statements.  Th is schedule
ha s been
subjected to the auditing procedures applied in our audit of the basic
consolidated financial statements and, in our opinion, is fairly stated in all
material respects in relation to the basic consolidated financial statements
taken as a whole.
 
 Singer
Lewak Greenbaum & Goldstein LLP (signed)
 Los
Angeles, CA
 February
15, 2005
 _______________________________________
 
 **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, 2002
    
    $
    681,000
    
    $
    301,000
    
    $
    --
    
    $
    (181,000
    )
    $
    801,000Year
      ended December 31, 2003
    
    $
    801,000
    
    $
    121,000
    
    $
    --
    
    $
    (187,000
    )
    $
    735,000Year
      ended December 31, 2004
    
    $
    735,000
    
    $
    48,000
    
    $
    (153,000
    )
    $
    (99,000
    )
    $
    531,000
 
 39
  **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 relating to fiscal 2004 (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.
 
 40
 **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, 2003 and 2004
 Consolidated
Statements of Income - Fiscal Years Ended December 31, 2002, 2003 and 2004
 Consolidated
Statements of Shareholders’ Equity - Fiscal Years Ended December 31, 2002, 2003
and 2004
 Consolidated
Statements of Cash Flows - Fiscal Years Ended December 31, 2002, 2003 and
2004
 Notes 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,
      DubsIncorporated,
      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)
  41
 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)
 
 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.
 
 _____________________________________
 
 (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.
 42
 
 (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.
  43
 
 **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 10, 2005
 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
      10, 2005/s/
      Alan R. Steel
      Alan
      R. Steel
    Executive
      Vice President,
      Finance
      and Administration, Chief Financial Officer
      (Principal
      Accounting and Financial Officer)
    March
      10, 2005/s/
      Robert A. Baker
      Robert
      A. Baker
    Director
    March
      7, 2005/s/
      Greggory J. Hutchins
      Greggory
      J. Hutchins
    Director
    March
      14, 2005/s/
      Sam P. Bell
      Sam
      P. Bell
    Director
    March
      15, 2005/s/
      G. Samuel Oki
      G.
      Samuel Oki
    Director
    March
      15, 2005
 
 44