**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549**

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**FORM 10-K**

x                                  ANNUAL REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 for the Fiscal Year Ended **March 31,2006**

OR

o                                    TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 for the Transition Periodfrom          To          

Commission File Number **000-11071**

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**IMAGEENTERTAINMENT, INC.******(Exact name of registrant as specified in its charter)

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| **Delaware**                                   | **84-0685613**                           |
|------------------------------------------------|------------------------------------------|
| (State or other jurisdiction of incorporation) | (I.R.S. Employer  Identification Number) |

 

**20525 Nordhoff Street, Suite 200, Chatsworth,California 91311**(Address of principal executive offices, including zip code)

**(818) 407-9100**(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of theAct:  *None*

Securities registered pursuant to Section 12(g) of theAct:  *CommonStock, par value $0.0001*

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES o NO x

Indicate by check mark if the registrant is notrequired to file report pursuant to Section 13 or Section 15(d) ofthe Act. YES o NO x

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. YES x NO o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of the registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendment to this Form 10-K. o

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

Large Accelerated filer  o          AcceleratedFiler  o          Non-Accelerated Filer  x

Indicate by check mark whether the registrant is ashell Company (as defined in Rule 12b-2 of the Exchange Act). YES o NO x

The aggregate market value of the common stock heldby non-affiliates of the registrant, based upon the closing price of $4.19 forshares of the registrant’s common stock on September 30, 2005, the lastbusiness day of the registrant’s most recently completed second fiscal quarteras reported by the NASDAQ National Market®, was approximately $40,680,752. Incalculating such aggregate market value, shares of common stock owned of recordor beneficially by officers, directors and persons known to the registrant toown more than five percent of the registrant’s voting securities (other thansuch persons of whom the registrant became aware only through the filing of aSchedule 13G filed with the Securities and Exchange Commission) were excludedbecause such persons may be deemed to be affiliates. The registrant disclaimsthe existence of control or any admission thereof for any other purpose.

The number of shares outstanding of the registrant’scommon stock as of June 26, 2006: 21,296,346

**DOCUMENTS INCORPORATED BY REFERENCE**

Part III— Portions of the registrant’s proxy statement for its Annual Meeting ofShareholders to be held on October 10, 2006, are incorporated by referenceinto Part III of this report.

 

 

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**IMAGEENTERTAINMENT, INC.Form 10-K Annual ReportFor The Fiscal Year Ended March 31, 2006**

**TABLEOF CONTENTS**
| PART I   |   |      |   |                                                                                                               |   |   |   |
|---------------|--------|-----------|--------|--------------------------------------------------------------------------------------------------------------------|--------|--------|--------|
|          |   | ITEM 1.   |   | Business                                                                                                           |   |   |   |
|          |   | ITEM 1A.  |   | Risk Factors                                                                                                       |   |   |   |
|          |   | ITEM 2.   |   | Properties                                                                                                         |   |   |   |
|          |   | ITEM  3.  |   | Legal  Proceedings                                                                                                 |   |   |   |
|          |   | ITEM 4.   |   | Submission of Matters to a Vote of Security Holders                                                                |   |   |   |
| PART II  |   |      |   |                                                                                                               |   |   |   |
|          |   | ITEM 5.   |   | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |   |   |   |
|          |   | ITEM  6.  |   | Selected  Financial Data                                                                                           |   |   |   |
|          |   | ITEM 7.   |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                        |   |   |   |
|          |   | ITEM 7A.  |   | Quantitative and Qualitative Disclosures About Market  Risk                                                        |   |   |   |
|          |   | ITEM 8.   |   | Financial  Statements and Supplementary Data                                                                       |   |   |   |
|          |   | ITEM 9.   |   | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                              |   |   |   |
|          |   | ITEM 9A.  |   | Controls and Procedures                                                                                            |   |   |   |
|          |   | ITEM  9B. |   | Other  Information                                                                                                 |   |   |   |
| PART III |   |      |   |                                                                                                               |   |   |   |
|          |   | ITEM 10.  |   | Directors and  Executive Officers of the Registrant                                                                |   |   |   |
|          |   | ITEM  11. |   | Executive Compensation                                                                                             |   |   |   |
|          |   | ITEM  12. |   | Security Ownership of  Certain Beneficial Owners and Management and Related Stockholder Matters                    |   |   |   |
|          |   | ITEM  13. |   | Certain Relationships  and Related Transactions                                                                    |   |   |   |
|          |   | ITEM  14. |   | Principal Accountant  Fees and Services                                                                            |   |   |   |
| PART IV  |   |      |   |                                                                                                               |   |   |   |
|          |   | ITEM 15.  |   | Exhibits and Financial Statement Schedules                                                                         |   |   |   |
| SIGNATURES    |   |      |   |                                                                                                               |   |   |   |

 

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**PART I**

**FORWARD-LOOKING STATEMENTS**

This reportcontains forward-looking statements that involve risks and uncertainties. Ouractual results may differ materially from those discussed due to factors suchas dependence on a limited number of key customers and titles, difficulty inacquiring and protecting our exclusive programming, and intense competition inthe entertainment industry. Additional information concerning factors thatcould cause or contribute to such differences can be found in the following discussion,as well as in “Item 1A. Risk Factors” and “Item 7. Management’s Discussion andAnalysis of Financial Condition and Results of Operations.”

**ITEM 1.**                    BUSINESS

**OVERVIEW**

Weare a vertically-integrated independent home entertainment content supplier engagedin the acquisition, production and worldwide distribution of exclusive contentfor release on a variety of formats and platforms, including:
|        | · | DVD                | · | Broadcast |
|--------|--------|--------------------|--------|-----------|
|   | · | CD                 |   | ·    | traditional |
|   | · | HD-DVD             |   | ·    | cable |
|   | · | Blu-ray Disc® |   | ·    | satellite |
|   | · | UMD                |   | ·    | video on demand (VOD) |
|   | · | VHS                |   | ·    | theatrical |
|   |   |               |   | ·    | digital |

 

We are primarily engagedin the domestic acquisition and wholesale distribution of content for releaseon DVD. We acquire and exploit exclusive distribution rights to a diverse arrayof general and specialty content on DVD and other home entertainment formats,including:
|        | · | comedy                    | · | country                  |
|--------|--------|---------------------------|--------|--------------------------|
|   | · | music concerts            | · | gospel                   |
|   | · | urban                     | · | independent films        |
|   | · | television and theatrical | · | foreign and silent films |
|   | · | theatre                   | · | youth culture/lifestyle  |
|   |   |                      | · | Latin                    |

 

We also acquireexclusive rights to audio content for distribution on CD spread across avariety of genres and configurations, including:
|        | · | albums                   | · | Broadway original cast recordings             |
|--------|--------|--------------------------|--------|-----------------------------------------------|
|   | · | compilation CDs          | · | audio compilations from our live concert DVDs |
|   | · | TV and movie soundtracks |   | event                                         |
|   | · | comedy programs          |   |                                          |

 

Through ourwholly-owned subsidiary, Egami Media, Inc., we are focused on theacquisition and exploitation of content in the expanding digital distributionmarketplace for delivery systems such as
|        | · | VOD               |   |   |
|--------|--------|-------------------|--------|--------|
|   | · | streaming video   |   |   |
|   | · | download channels |   |   |

 

Egami continues toaggressively add numerous video and audio titles to its growing library ofexclusive digital rights each month. Over the past year, Egami has establisheddirect relationships with a majority of digital industry-retailers andcontinues to seek additional distribution partners as they emerge.

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We strive to growa stream of revenues by maintaining and building a library of titles that canbe exploited in a variety of formats and distribution channels. Our activelibrary currently contains:

·                  over3,000 exclusive DVD titles

·                  approximately200 CD titles

·                  digitalrights to

·                  over1,500 video titles

·                  over150 audio titles

·                  containingmore than 2,500 individual tracks

We currentlyrelease an average of over 30 new exclusive DVD titles and five new exclusiveCD titles each month.

We acquire contentmainly by entering into exclusive licensing or distribution arrangements withproducers and other content providers. We typically supplement such content bydesigning and producing additional content and value-added features. Weroutinely produce our own original entertainment content, focused on DVD liveperformance music concerts and comedy events with some of the most recognizablenames in the industry, and various forms of urban genre content. We are alsoco-producing feature horror and other genre specific titles with budgets lessthan $500,000 and up to $3.5 million through co-production agreements with:

·                  DarkHorse Entertainment

·                  GraymarkProductions

·                  AmicusEntertainment

In addition, weare co-producing a feature thriller film*Sisters*, aremake of the classic Brian De Palma film, with Sisters Wooster, Inc. tobe released under the No Remorse Films banner, headed by highly successfulindependent film producer Edward R. Pressman. Ed Pressman serves as executiveproducer of the picture. We will also look to co-produce individual films withother established independent producers.

We wereincorporated in Colorado as Key International Film Distributors, Inc. in April 1975,our present name was adopted in 1983, we reincorporated in California in November 1989and reincorporated again in Delaware in September 2005. Our principalexecutive offices are located at 20525 Nordhoff Street, Suite 200,Chatsworth, California 91311. We maintain a Web site atwww.image-entertainment.com. Except as specifically noted, the content ofthis site is not incorporated by reference and does not constitute a part ofthis report.

The followingtable sets forth the percentage of consolidated net revenues derived from thedistribution of entertainment content by format for our last three fiscal years.The financial information presented excludes that of our wholly-ownedsubsidiary, DVDPlanet, Inc., whose assets we sold in September 2003. Theinformation does not represent our business segments, but rather shows netrevenue trends by product category:

 
| ** **         | ** ** | **Fiscal Years Ended March 31** | ** ** |
|--------------------|------------|--------------------------------------|------------|
| **(in thousands)** | ** ** | **2006**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| DVD                |       | $                                    | 98,226     |   | 87.9 | % | $ | 100,374 |   | 84.8 | % | $ | 71,683 |   | 84.5 | % |
| CD                 |       | 9,094                                |       | 8.1 |   | 12,142 |   | 10.3 |   | 5,591 |   | 6.6 |   |
| Sublicense         |       | 2,819                                |       | 2.5 |   | 4,830 |   | 4.1 |   | 5,607 |   | 6.6 |   |
| UMD                |       | 802                                  |       | 0.7 |   | - |   | - |   | - |   | - |   |
| VHS                |       | 467                                  |       | 0.4 |   | 550 |   | 0.4 |   | 1,415 |   | 1.7 |   |
| Broadcast          |       | 494                                  |       | 0.4 |   | 487 |   | 0.4 |   | 544 |   | 0.6 |   |
| TOTAL              |       | $                                    | 111,902    |   | 100 | % | $ | 118,383 |   | 100 | % | $ | 84,840 |   | 100 | % |

 

**BUSINESSSEGMENTS**

We currently havetwo business segments:

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·       *Domestic (U.S. and Canada)*

·                  *International*

Our domesticsegment primarily consists of acquisition, production and distribution ofexclusive DVD content and, through Egami Media, exclusive content for digitaldistribution via video on demand, streaming video and download. Ourinternational segment includes international video sublicensing and worldwidebroadcast rights exploitation. The following table presents consolidated netrevenues, net of eliminations, by reportable business segment for the periodspresented:

 
| ** **              | ** ** | **Fiscal Years Ended  March 31,** | ** ** | ** ** | ** ** | **Fiscal Years Ended  March 31,** | ** ** | ** ** | ** ** |
|-------------------------|------------|----------------------------------------|------------|------------|------------|----------------------------------------|------------|------------|------------|
| **(in thousands)** | ** ** | **2006**                               | ** ** | **2005**   | ** ** | **% Change**                      | ** ** | **2005**   | ** ** | **2004** | ** ** | **% Change** | ** ** |
| Net revenues:           |       |                                   |       |       |       |                                   |       |       |       |   |   |   |   |
| Domestic                |       | $                                      | 108,667    |       | $          | 113,219                                |       | (4.0       | )%         | $ | 113,219 |   | $ | 78,370 |   | 44.5 | % |
| International           |       | 3,235                                  |       | 5,164      |       | (37.4                                  | )          | 5,164      |       | 6,470 |   | (20.2 | ) |
| Consolidated            |       | $                                      | 111,902    |       | $          | 118,383                                |       | (5.5       | )%         | $ | 118,383 |   | $ | 84,840 |   | 39.5 | % |

 

***Domestic***

Most of theproduct we release is in the DVD format. According to industry estimates, thereare currently more than 58,000 DVD titles available in the domestic market, ofwhich more than 3,000 are actively and exclusively distributed by us. We are aleading independent supplier of DVD content in the music, comedy, specialinterest, episodic television, urban and lifestyle genres. The following chartreflects the number of cumulative titles we have released by type of content,compared with the cumulative DVD software titles released by the industrythrough the week ended May 19, 2006, excluding discontinued titles. Thefollowing chart does not intend to indcate our market share of DVD revenues,only cumulative titles released.

 
| **Type of DVD Content**           | ** ** | **Total Number  of DVD Titles** | ** ** | **Number of  Image Titles** | ** ** | **Image  Percentage** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------|------------|---------------------------------------|------------|-----------------------|------------|
| Music                                            |       | 7,562                                          |       | 577                                   |       | 7.6                   | %          |
| Special Interest                                 |       | 12,501                                         |       | 494                                   |       | 4.0                   | %          |
| Theatrical Catalog (pre-1997)                    |       | 9,506                                          |       | 451                                   |       | 4.7                   | %          |
| Foreign Language  (including distributed lines)  |       | 4,767                                          |       | 236                                   |       | 5.0                   | %          |
| Television Programming                           |       | 3,376                                          |       | 162                                   |       | 4.8                   | %          |
| Direct to DVD                                    |       | 6,972                                          |       | 373                                   |       | 5.3                   | %          |
| All Other                                        |       | 14,024                                         |       | 789                                   |       | 5.6                   | %          |
| Total Releases — Cumulative through 5/19/06 |       | 58,708                                         |       | 3,082                                 |       | 5.2                   | %          |

*                Source:  DVD Release Report Revised 5/17/06*

We believe thatthe value gained through the ability to entertain people at home for areasonable price at convenient times, the opportunity to choose from a verybroad selection of programming, the unique and compelling interactiveexperience of DVD menus, and the audio and video quality of the DVD format,will continue to make DVD a preferred, prepackaged medium of home entertainmentfor millions of consumers. Many DVDs also offer special features, enhancementsand ancillary materials, such as special menu design, multiple audio tracks,behind-the-scenes footage, director commentaries, interviews and discographies,all of which we are able to develop in-house.

*ExclusiveAcquisition.*We generally acquire exclusive rights to ourcontent. We acquire our exclusive titles from a wide range of content holders,including:

·                  independentcontent suppliers

·                  producers

·                  musicartists

·                  recordlabels

·                  artistmanagement

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We also produceour own original entertainment content focused on DVD live performance stand-upcomedy, music concerts and urban genre content, and feature horror and othergenre films. We produce, market and sell our exclusive content according toexclusive license or distribution agreements. We actively pursue and secureboth domestic (U.S. and Canada) and international distribution rights toexclusive titles in a range of home entertainment formats.

In return forexclusive license rights, we pay royalties to our licensors. Royalties areexpressed as a percentage of our wholesale net revenues derived from titlesales. Typically, we pay royalty advances that are recouped against royaltiesearned on a title-by-title basis or, if cross-collateralized, against groups oflicensed titles from the same licensor. Our license agreements generallyprovide for a minimum distribution term of at least five years and oftenconsiderably longer. Some license agreements contain provisions for anextension of the distribution term if we meet specified performance milestonesor if we are still unrecouped at the end of the distribution term.

In return forexclusive distribution rights, we generally tender net wholesale revenues tocontent suppliers, which are expressed as a percentage of wholesale revenuesafter subtracting our distribution fee and recouping costs allocated to the contentowner such as production, manufacturing, music publishing, and marketing fees. Insome cases, the net profit of a title is split between us and the contentsupplier according to a contractual percentage. In many cases, we pay andrecoup advances or minimum guarantees on an exclusive distribution deal in amanner similar to an exclusive licensing arrangement.

While our corebusiness remains the domestic acquisition and distribution of content on DVD,we seek to secure and exploit exclusive content with the broadest possiblegrant of home entertainment programming rights. As part of our strategic goal,we may finance all or part of the production of some of our entertainmentcontent. The rights we retain in connection with our self-financed productionsgenerally cover all territories throughout the world, all now-known andhereafter-devised video home entertainment formats, and other formats for anextended term.

Because of ourgrowing library of exclusive titles in a wide variety of genres, we believe thatwe are positioned to benefit from the widespread support of the traditional DVDformat and the HD-DVD and/or Blu-ray Disc® high-definition formats. We intendto continue expanding our exclusive DVD library.

*EgamiMedia.*Our wholly-owned subsidiary, Egami Media, engagesin the exclusive wholesale distribution of the digital rights to our catalogueof audio and video content. The demand for the types of programming found inour catalogue continues to increase as new retailers enter the primarily onlinemarketplace. While big-budget theatrical programs are becoming available inlimited ways online, the vast majority of available online content is stillniche or affinity video titles such as classic television shows, live music,live comedy, special interest and other programs.  Egami seeks to differentiate itselfcompetitively by being a one-stop source for the large, diverse collection ofentertainment represented by our digital catalogue.

Egami enters intononexclusive distribution arrangements with retail and consumer facing entitieswhose business models are solely or partially the digital delivery of content. Deliverywill be in the form of secure encoded files with playback options beingcontrolled by embedded Digital Rights Management (DRM). In video, the consumerwill find various purchasing options that include:

·                  Downloadto Own

·                  Downloadto Rent (VOD)

·                  Subscriptionbased rental models (SVOD)

Download to Own isessentially the digital equivalent of buying a DVD. Download to Rent is alsoreferred to as VOD and is becoming a key transactional component to most of ourpartner retailers. Subscription based rental models (SVOD) are essentially thedigital equivalent of a club-type model, where users pay recurring monthly feesin exchange for access to a library without individual transaction charges.

The audiomarketplace is more mature, yet audio business models continue to evolve. Egamiis selling full albums, individual tracks and also supportingsubscription-based access to our library of content. Additionally, Egami isworking closely with several audio retailers as they develop plans to adddigital video to their offerings.

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The mobile orwireless space is also a developing channel for Egami. As technical advancesoccur, the delivery of video to mobile phones is becoming more commonplace. Weare working with third-party content suppliers by providing video content foremerging subscription based services.

Emerging retailchannels for Egami include kiosk-based sale of audio and video content,delivery of video content via closed college campus networks and through publiclibraries, advertising supported online models and various proprietary set-topbox retail initiatives.

*ImageEntertainment (UK), Inc.*In February 2005, welaunched our wholly-owned subsidiary Image UK, which acts as our exclusivecontent acquisition agent and is focused on acquiring content for exclusivedistribution in North America and throughout the world from its London office. Rightsacquired with the assistance of Image UK are actually held by us. Additionally,production and distribution services are performed by our personnel out of ourheadquarters in Chatsworth, California. Fiscal year expenses for the leasedoffice and related expenses, including salaries, are approximately £20,000(approximately $34,000) per month, increasing to approximately £1,500(approximately $2,500) per month at the end of August due to a new office lease.

*HomeVision Acquisition and Criterion Library of Special Edition DVD Programming.*In August 2005, we acquired Home Vision Entertainment, a publisher anddistributor of home entertainment programming with 130 active DVD titles, for$8.0 million in cash. In connection with the acquisition, we signed a long-termexclusive distribution agreement with The Criterion Collection for theremaining distribution rights (which were controlled by Home Vision) toCriterion’s 290-title DVD library. Prior to the signing of the agreement,Image and Home Vision shared distribution of Criterion’s programming.

*FilmProduction.*With Dark Horse, we have completed principalphotography and are currently in post-production on three feature films, *Driftwood*  a ghoststory about a boys’ reformatory directed by Tim Sullivan (*2001Maniacs, Detroit Rock City*), *Splinter*, amulticultural action-adventure supernatural thriller starring Edward JamesOlmos and Tom Sizemore, and *Monarch of the Moon*,a stylized feature designed to pay homage to the classic science-fiction moviesof the 1950s. Through Dark Horse, we also acquired *Destination Mars*,a feature similar to *Monarch of the Moon*.We are currently in the early development stage of a script to be directed byfamed director John Landis (*American Werewolf inLondon, Animal House, Beverly Hills Cop III, Blues Brothers, Coming to America,Into the Night, Kentucky Fried Movie, Trading Places*). We have alsorecently begun pre-production of one additional Dark Horse project entitled*My Name Is Bruce* starring and to be directed by renownedgenre actor Bruce Campbell.

Our agreement withGraymark has yielded three films which have been delivered and are scheduledfor late 2006 and early 2007 releases. These films include the horror film *The Hunt* directed by Fritz Kiersch (*Children ofthe Corn*) and starring veteran actor Cliff De Young (*The Hunger*), the thriller *Surveillance*starring Emmy award-winning actor Armand Assante (*ParadiseAlley*, *Unfaithfully Yours*, *Private Benjamin*, *The Mambo Kings*,*Fatal Instinct, Judge Dredd*) anddirected by Kiersch, and the vampire horror movie *SoulsMidnight* starring Assante. We are also in production on the urbanlegend ghost story *Fingerprints*,the debut film of up-and-coming actress Kristin Cavallari (*Laguna Beach*),and also starring Lou Diamond Phillips (*La Bamba*, *Stand and Deliver*).

With Amicus, weare in the early development stage on one horror film. The film, appropriatelyentitled *Stuck*, is based on the true story of awoman who hits a homeless man with her car and then lets him die in her garagewhile he is still stuck in her windshield, and is written and to be directed bywell-known horror director Stuart Gordon (*Re-Animator*, *From Beyond*, *Dolls*).

An agreement withContentFilm has focused primarily on content acquisition, as the co-productionportion of our agreement has been assigned to highly successful independentfilm producer Edward R. Pressman (*Bad Lieutenant, Conan theBarbarian, The Cooler, The Crow, Das Boot, Sisters, Talk Radio, Thank You ForSmoking*). With ContentFilm, we have acquired feature films *Evil Aliens* and *Wilderness Survival forGirls*. We have completed principal photography and are inpost-production on the remake of Brian De Palma’s classic thriller *Sisters*, which is executive produced by Ed Pressman*.*We are in negotiations for other films to co-produce.

We are solelyresponsible for financing the film budgets for the Dark Horse co-productionsand are co-financiers of our other co-productions.

For our theatricalco-productions, we usually receive a longer distribution term and a share ofthe picture’s copyright.

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* *

*FilmCo-Production Budgets,*funded in fiscal 2006 unlessotherwise stated

Dark Horse

*Driftwood*- $1.25 million

*Monarchof the Moon* - $111,000

*Splinter*- $437,000

*My Nameis Bruce* - $1.5 million (fiscal 2007)

John LandisProject - tentatively $3,000,000 (our commitment $1.5 million - fiscal 2007)

Graymark

*The Hunt*- $427,000 (our funded commitment $214,000)

*Surveillance*- $629,000 (our funded commitment $314,000)

*SoulsMidnight* - $650,000 (our funded commitment $163,000)

*Fingerprints*- $650,000 (our funded commitment $276,000 )

Amicus

*Stuck*- tentatively $2.8 million (our commitment $1.4 million - fiscal 2007)

Sisters Wooster 

*Sisters*$3.5 million (our funded commitment $1.4 million)

*NoNonexclusive Distribution.*Except for a small number ofdigital titles distributed by Egami, we do not generally distributenonexclusive content, such as DVD releases of major motion pictures.

*AdditionalValue-Added Services.*We provide a full range ofvalue-added services relative to our licensed content and many of ourexclusively distributed titles, including:
|        | · | creation of packaging         | · | distribution                     |
|--------|--------|-------------------------------|--------|----------------------------------|
|   | · | DVD authoring and compression | · | for some titles, the addition of |
|   | · | menu design                   |   | enhancements such as             |
|   | · | video master quality control  |   | ·                           | multiple audio tracks |
|   | · | manufacturing                 |   | ·                           | commentaries |
|   | · | marketing                     |   | ·                           | foreign language tracks |
|   | · | sales                         |   | ·                           | behind-the-scenes footage |
|   | · | music clearance               |   | ·                           | interviews |
|   | · | warehousing                   |   | ·                           | discographies |

 

These services aretypically performed in-house, with the exception of DVD, CD and UMD discmanufacturing and tape replication, package printing, and packaging of thefinished product which are generally performed by third party vendors.

*DistributionServices*. We recently launched a new initiative calledImage Entertainment Distribution Services, which offers a menu of distributionservices to choose from, including sales, marketing, distribution andcollections to independent audio and video labels. This new initiativeleverages our direct selling and retail relationships, existing distributioninfrastructure, and emerging Vendor Managed Inventory (VMI) capabilities.

*Manufacturing.*Typically, a content supplier delivers a title master and artwork to us,and our in-house post-production facility creates a sub master withspecifications for the necessary format and on-screen menus for each title. Ourin-house authoring and compression team then generally performs the worknecessary to prepare a DVD master for manufacturing. Occasionally, because ofthe large volume of our exclusive releases, we may use an outside facility toperform such services. Our in-house creative services department, staffed withgraphic designers, copywriters and proofreaders, creates original andinnovative packaging fundamental to the marketing success of our product. Duringfiscal 2006 and in the years prior, we used Deluxe Media Services, Inc.,formerly Ritek Global Media, to manufacture and package our domestic DVDprogramming. We have reached an agreement in principle with Sonopress LLC to doso, subject to their final credit approval, and plan to move our replicationduring the second quarter of fiscal 2007. We primarily use U-Tech Media USA dbaGlory Tech LLC for CD manufacturing. Sony DADC Global currently manufacturesall UMD programming.

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*Marketing.*Our in-house marketing department directs marketing efforts towardconsumers, DVD and CD retailers, and DVD and CD player retailers. Our marketingefforts involve:

·                  point-of-saleadvertising

·                  printadvertising in trade and consumer publications

·                  national televisionand radio advertising campaigns

·                  Internetadvertising, including viral and social network marketing campaigns

·                  minimal directresponse campaigns

·                  dealer incentiveprograms

·                  trade showexhibits

·                  bulletinsfeaturing new releases and catalogue promotions

We also haveaccount-specific marketing programs where we work directly with retailers tooptimize and customize print advertising and other advertising programs topromote our exclusive product. The creation of specialized in-store displaysand celebrity appearances are other examples of account-specific marketingprograms. We occasionally implement Internet promotional activities thatinclude product tie-ins, sweepstakes, and giveaways associated with onlineretail customers, and the creation of genre-specific boutiques withindirect-to-consumer Web sites.

Our Web site at www.image-entertainment.comhelps promote us and our exclusive content. The Web site includes pressreleases, information regarding our exclusive titles, and information ofgeneral interest to the home entertainment consumer.

*Customers.*We distribute our titles domestically through our Las Vegas, Nevadadistribution center. We sell our products to:

·                  traditionalretailers

·                  specialtyretailers

·                  Internetretailers

·                  wholesale distributors

·                  alternativedistribution

·                  direct-to-consumerprint catalogs

·                  direct responsecampaigns

·                  subscriptionservice/club sales

·                  home shoppingtelevision channels

·                  othernon-traditional sales channels

                Some of our key sell-through customers in alphabeticalorder include:
|        | · | AEC One Stop Group                                                               | · | Ingram Entertainment, Inc.          |
|--------|--------|----------------------------------------------------------------------------------|--------|------------------------------------------|
|   |   |                                                                             |   |                                     |
|   | · | Amazon.com, Inc.                                                            | · | K-Mart                                   |
|   |   |                                                                             |   |                                     |
|   | · | Barnes & Noble                                                          | · | Paradox Entertainment (f/k/a Vid Canada) |
|   |   |                                                                             |   |                                     |
|   | · | Baker & Taylor                                                          | · | Sears                                    |
|   |   |                                                                             |   |                                     |
|   | · | Best Buy Co., Inc.                                                          | · | Target                                   |
|   |   |                                                                             |   |                                     |
|   | · | Borders Group Inc.                                                               | · | Tower Records                            |
|   |   |                                                                             |   |                                     |
|   | · | Costco                                                                           | · | Trans World Entertainment                |
|   |   |                                                                             |   |                                     |
|   | · | Critic’s Choice                                                             | · | Wal-Mart (Anderson Merchandisers)        |
|   |   |                                                                             |   |                                     |
|   | · | Handleman Company                                                                |   |                                     |
|   |   |                                                                             |   |                                     |
|   | · | Infinity Resources (Critics Choice, Deep Discount  DVD and CD and DVDPlanet.com) |   |                                     |

 

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In addition, ourkey rental-retail hybrid customers are:

·                  Blockbuster Inc.

·                  Movie Gallery, Inc.(including Hollywood Video)

·                  Netflix, Inc.

Our specialmarkets division is designed to take advantage of our large and diverse catalogand specifically targets niche sales opportunities. Special markets retailersto whom we have sold product in alphabetical order include:

·                  Armyand Air Force Exchange Service (a.k.a. AAFES)

·                  BigIsland Publishing

·                  BigLots

·                  ColumbiaHouse

·                  CrutchfieldCorporation

·                  DiscoveryChannel

·                  DynamicDisc Distribution

·                  GuitarCenter

·                  HotTopic

·                  IslandView Entertainment

·                  MetropolitanOpera Guild

·                  Movies4 Sale

·                  Overstock.com

·                  VideoAction Sports (Champs, Dick’s, Foot Locker, Sport Chalet, Sportmart, etc.)

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On a consolidatedbasis, Anderson Merchandisers (who supplies Wal-Mart) accounted for 11% of ourfiscal 2006 net revenues. In fiscal 2005, Anderson Merchandisers, Best Buy andAEC One Stop accounted for 17%, 12% and 10%, respectively, of our net revenues,and in fiscal 2004, Best Buy and AEC One Stop accounted for 17% and 12% of ournet revenues. No other customers accounted for net revenues individually inexcess of 10% of our total net revenues for fiscal 2006, 2005 or 2004.

We allow retailcustomers to return a portion of their unsold inventory on a quarterly basis. Wereserve for estimated returns at the time the sale is recognized, based in partupon our historical returns experience and knowledge of specific productmovement within distribution channels. Our inventory returns, as a percentageof our gross distribution (as opposed to net) revenues, were 21.9% in fiscal2006, 18.8% in fiscal 2005 and 19.2% in fiscal 2004, respectively. Returns ofdefective product have been minimal and are generally covered by manufacturers’warranties.

As of June 1,2006, we had approximately $3.9 million of backlog orders, 98% from DVDproduct, from domestic customers compared with approximately $5.0 million ofbacklog orders, 70% from DVD product, as of June 1, 2005. We expect tofill 100% of the backlog orders, less any cancelled orders, this fiscal year.

***International***

*InternationalSublicensing.*We hold worldwide distribution rights toover 450 of our DVD titles and over 130 of our CD titles. We have an exclusivesublicense agreement for the distribution of our DVD content, primarilymusic-related DVDs, with Sony BMG for Europe, Africa, and most of the MiddleEast, an exclusive sublicense agreement with Digital Site, an affiliate of RayCorporation, for Japan, and an exclusive sublicense agreement with Warner MusicGroup for Australia and New Zealand. These agreements contain terms andconditions similar to those governing our underlying rights agreements. SonyBMG, Digital Site and Warner Music pay royalties based on either retail orwholesale revenues they generate, and are responsible for sales, taxes,marketing, publishing, manufacturing and distribution of our content in theirrespective territories. We have similar sublicenses with others for smallerterritories.

*WorldwideBroadcast.*Buyers of our standard and high-definitionbroadcast content are typically cable, pay-per-view, or satellite broadcasters,and sometimes terrestrial (free) television or in-flight/on-ship broadcasters. Undera typical broadcast license we receive payment of a one-time, fixed,non-refundable fee for a multi-year exploitation term and in many instances fora specified number of airings. With respect to pay-per-view, we typicallyreceive a non-refundable advance against royalties that are based on apercentage of customer buys. Our obligations under broadcast licensing areusually only to provide a broadcast master of the title and to ensure thatmusic synchronization rights are secured.

We have an exclusive sales agency agreement with London-based NBDTelevision Ltd., who sublicenses worldwide the majority of our currentbroadcast television catalogue of programming (in excess of 200 programs) aswell as our new release broadcast television acquisitions. NBD represents usfor conventional television broadcast sales, whether standard orhigh-definition, including cable, pay-per-view, video on demand, satellitetelevision, and sales to non-theatrical venues. Programs that were sublicensedto third parties for broadcast prior to January 2004 will be handled byNBD upon the expiration of the existing sublicenses. The agreement with NBDexpires in January 2008.

**COST STRUCTURE**

Our mostsignificant costs and cash expenditures relate to acquiring content forexclusive distribution and, more recently, the funding of content production orco-production for exclusive distribution. Agreements to acquire programmingtypically come in the form of either an exclusive license agreement, where wepay royalties for the exclusive distribution rights, or an exclusivedistribution agreement, where we generally receive distribution fees and paynet profits after recoupment of our upfront costs. We generally base our offersof advances against future royalties (or, for distribution agreements, advancesagainst future net profit payments and in many cases production funding) on theexpected success of a title’s performance at retail, actual cost of theproduction, and competition for the title’s exclusive distribution rights.

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Upon entering intoa typical exclusive license agreement, we pay, in advance, royalties whichnormally become due to the content supplier 45 days following the quarter whichthe sale of DVD, CD, UMD and VHS units of the title to our retail customers hasoccurred. Royalties are contractually expressed as a percentage of net revenues.Upon our recoupment of the advance, we pay the content supplier royaltyoverages at the same rate. If we do not recoup our initial advance by the endof the agreement’s term, the content supplier receives no additional royaltiesbut is not typically liable for reimbursement of our unrecouped advance. Royaltyadvances may be used by the content supplier to actually produce the content incases where the content has not yet been created. Under these exclusive licenseagreements, we are responsible for manufacturing, packaging, menu design,authoring and compression, package design and layout, selling, marketing anddistribution expenses, and sometimes for music publishing in the case ofmusic-related DVDs and CDs.

Under a typicalexclusive distribution agreement, we may pay upfront fees, which are expressedas advances against future net profits, or we may pay for the cost of thecontent’s production in advance. Our net profits for these deals usually takethe form of our distribution fee which is deducted first. Any remaining netprofits after we recoup our incurred costs and additional costs such as thecost of the content’s production are generally paid to the content supplier. Wemay also split any remaining net profits with the content supplier according tocontractual percentages. If net profits are not achieved, the content supplierreceives only the production costs or distribution fees advanced, if any. Again,we recoup our incurred costs before any net profit disbursement is made to thecontent supplier.

Inaddition to advances, upfront fees and production costs, the other significantcosts we incur are for:

·                  DVDand CD replication

·                  packaging

·                  advertising,promotion, and market development funds provided retail customers

·                  domesticshipping costs from self-distribution of exclusive content

·                  personnelcosts

·                  musicpublishing on exclusive music-related DVD and CD titles

Our financialfocus is on achieving long-term, sustainable growth and profitability. We alsoseek to improve our cash flow position in order to continue licensing, orentering into exclusive distribution agreements for, high quality DVD and otherentertainment content and funding operations.

**COMPETITION**

When acquiringdistribution rights for exclusive content, we continue to face increasingcompetition from:

·                  Major MotionPicture Studios

·                  Sony Pictures

·                  Disney

·                  Fox

·                  Paramount

·                  Universal

·                  Warner

·                  Mini-Majors

·                  Lions Gate

·                  The WeinsteinCompany

·                  New Line

·                  Major MusicLabels

·                  Sony BMG

·                  EMI

·                  Universal

·                  Warner MusicGroup

·                  IndependentMusic Labels

·                  Independent DVDand CD Content Suppliers

For limited retailshelf space, we also continue to face increasing competition from:

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·                  major motionpicture studios

·                  independent DVDand CD suppliers

·                  major andindependent music labels who offer DVD content

·                  other homeentertainment providers

Besides limitedretail shelf space, we also face competition for retailer “open to buy”dollars, which are the purchasing budgets that retailers allocate to purchasenew release or catalogue titles.

***Competitionfor Content***

We face increasingcompetition from other independent distribution companies, major motion picturestudios and music labels in securing exclusive content license and distributionrights. Although DVD player-household penetration (through sales of stand-aloneDVD players and DVD-based video game player systems) and retail shelf space forhome video formats have started to reach a saturation point, companies arestill viewing DVD licensing and distribution as an attractive business. Many,including New Line, Lions Gate, and several of the major studios, are expandingefforts in the DVD licensing market, sometimes in the form of direct-to-videomotion pictures. Because the home video rights to most newly released andcatalogue motion pictures are already owned by the major studios, the marketfor high-profile DVD content available to an independent supplier is limited. Moreover,the market for high-profile music-related DVD content is also limited as majorand independent record labels continue to increase the number of music-relatedtitles released on DVD through their own labels.

In light of theincrease in demand and limitation in supply, obtaining quality DVD content atreasonable prices is becoming ever more challenging. Our internal analyses andforecasts, which are designed with the goal of timely advance recoupment,attempt to limit the upfront advances against future royalties or, fordistribution agreements, production and net profit payments we are willing topay to secure content rights. Accordingly, we may not be able to remaincompetitive against offers from competitors who may at times be willing to paylarger advances. This challenge is compounded when competitors who lack broadexpertise in the field of DVD licensing occasionally offer advances or otherterms for content which we believe to be unrealistic based upon our owninternal forecasts and historical experience in particular genres. Althoughsuch unrealistic offers might have adverse effects on these competitors’businesses in the medium- and long-term, the short-term effect appears to be anartificial inflation in content valuations, which effectively decreases our abilityto obtain quality content. Additionally, as we see more and more opportunitiesfor higher-profile content, we are increasingly finding ourselves incompetition with major motion picture studios, the “mini-majors” and majormusic labels, who tend to have greater financial resources and the ability tooffer higher advances by leveraging their market power (including significantinfluence on retailer shelf space allotment) with retailers in order to obtainlarger quantities of product purchases.

With that said, webelieve that we will continue to compete successfully in obtaining exclusiverights to home entertainment content. This is due in large part to our abilityto offer an array of other assets to our program suppliers, including:

·                                          thehigh quality of expertise and service our employees provide

·                                          ourstatus as an independent which allows freedom from the major labels, morecreative control to the content creator, comparatively fewer obstacles incontent creation, marketing and distribution, and comparatively simpleraccounting for royalties and net profits to the supplier

·                                          ourlong history and solid reputation of working effectively with artists, theirmanagement and other valuable suppliers of entertainment programming

·                                          thequality of our finished titles

·                                          ourspecialized marketing expertise in areas such as comedy, urban, Latin,music-related, Broadway and special interest titles

·                                          ourwide-ranging in-house services

·                                          ourdirect and long-standing relationships with mass merchants and traditional andonline retailers of entertainment titles

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***Competitionfor Retail Shelf Space***

Our exclusivecontent competes for a finite amount of shelf space against a growing supply ofentertainment content from other suppliers. New DVD releases generally exceed 200titles a week. We believe this competition can be especially challenging forindependent labels like us, because the new DVD releases of major studios oftenhave extremely high visibility and sales velocity in the millions of units, andtypically require more shelf space to support. In light of the impact of majorstudio releases, our expenses with respect to providing market developmentfunds and cooperative advertising dollars to our retail customers for itemssuch as in-store displays and store circulars continue to increase, even as theavailability of these opportunities continues to decrease. This selling ofshelf real estate, whether real or virtual, is becoming more expensive as thetotal number of DVD releases continues to grow. With the exception of our morepopular new titles and top-selling catalogue titles, it can be a challenge toobtain the product placement necessary to maximize sales, particularly amongthe limited number of major retailers who comprise our core customers. Additionally,even though the shelf space in many retail stores may not be shrinking, it isno longer growing at the rates we had previously experienced, and we are alsobeginning to perceive a retailer trend toward greater visibility for titles atthe expense of quantity (i.e. “face out” rather than “spine out” DVD placement).This has the effect of reducing the total number of titles actually carried bya retailer, and since we tend to carry and acquire many different titles, thistrend may have a disproportionate effect on us compared to the major studios.

Retailers are alsoincreasingly looking for studios and independents to pay to secure display andshelf space within their stores. Even some successful Internet retailers nowrequire paid participation in these types of programs in order to ensurevisibility and positioning on their Web sites. Some of these programs can costas much as 6% or more of a retailer’s total order, although we may also realizesignificant advertising and marketing benefits from such programs, especiallyif they grant competitive benefits over other studios and independents that areunable or unwilling to pay. As competition in our industry continues toincrease, we expect that more retailers will adopt these types of programs,which would result in downward pressure on our gross margins.

*VendorManaged Inventory (VMI)*

Under a VMIsystem, product suppliers are responsible for monitoring, stocking, andfulfilling directly to individual retail stores and outlets. Larger retailers,who have been transacting business via VMI with the major studios for years,are starting to require smaller independents (i.e. product suppliers other thanmajor studios, music labels and “mini-majors”) to adopt this method ofinventory management. An existing large retail customer of ours plans torestrict content suppliers from shipping product directly to its stores unlessthey carry a required minimum number of national titles. Image, along withother independents, has formed a consortium of program suppliers to consolidateshipments in order to satisfy this retailer. Under this arrangement, eachmember of the consortium retains its existing direct-selling and direct-billingrelationship with this retailer. Our VMI group is currently one of only threeindependent groups partnering with this retailer. Consortium shipments to thiscustomer will consolidate products from all suppliers in this group, which willresult in larger shipments with freight costs shared among the members. We havefully implemented all of the necessary VMI software and systems, and are currentlyin the final stages of deploying our VMI program with this customer. We expectour VMI system to be fully tested and deployed by August 1, 2006. We willevaluate the possibility of deploying our VMI system at other retail customersas opportunities arise.

With respect tolong-term benefits, we expect the implementation of VMI relationships withretail customers to:

·                                          sellmore units and reduce returned items by better matching inventory to real-timedemand

·                                          reducepotential overproduction and excess inventory quantities by more accuratelyforecasting orders

·                                          reduceprocessing and warehousing fees by maintaining a leaner supply chain

·                                          increaseour importance as a direct supplier of participating retail partners

***Competitionfor Retailer Open to Buy Dollars***

We compete withother content suppliers for limited open to buy dollars allocated by retailersto purchase new release or catalogue DVD and CD titles. Open to buy dollars arebecoming more scarce for independents like us, since such dollars are oftendevoted to high-profile new releases from major studios, particularly duringthe holiday season. Reduced wholesale DVD pricing instituted by the majorstudios and labels, coupled with their ongoing catalogue campaigns andmarketing muscle, has also increased competition for open to buy dollars. Moststudios and labels are subsidiaries of much larger media conglomerates thathave financial resources far greater than ours.

 

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We believe thattitles from an independent content supplier like us continue to be attractiveto retailers because of the gross margins retained by the retailers from thesale of independent titles. In contrast, there is a great deal of pricingcompetition among retailers for the new release theatrical blockbusters, assuch major hits are often advertised as loss leaders to bring in retail traffic.We do not sell new release major studio titles.

***IncreasingCompetition***

As our industrymatures, with DVD set-top and DVD game player penetration of U.S. televisionhouseholds having exceeded 70% at the close of calendar 2005, and the amount ofretail space allocated for DVD programming leveling off, the competition level amongcontent suppliers will continue to rise. The major studios remain consistentand prolific in their ability to bring new theatrical titles to retailers. Theyhave large libraries of content to release on DVD. New independent suppliersare continually emerging, further adding to the competition. The additionalpromotional opportunities and open to buy dollars may be severely compromisedby the new major theatrical programming, new independent suppliers and the vastcatalogues of content controlled by the major studios.

***IndustryTrends***

According to AdamsMedia Research (Hollywood Aftermarket report dated September 30, 2005),DVD set-top penetration of television households will reach 72.5% through December 31,2005, excluding DVD game players, with 81.0 million of 111.7 million televisionhouseholds having at least one DVD player. Adams Media expects this penetrationto reach 90.2% within the next five years. This represents an estimated 4.5%annual compound growth rate in DVD set-top player households. Additionally,Adams Media estimates that DVD game player households without a set-top DVDplayer amounted to 5.9 million, or 5.3% of television households, through December 31,2005. They expect this number to decline to 0.9 million, or 0.8% of televisionhouseholds, within the next five years.

According to AdamsMedia (Hollywood Aftermarket report dated September 30, 2005), consumerDVD sell-through spending will increase 12.3% to $17.3 billion in 2005, from$15.4 billion in 2004. Consumer DVD sell-through spending is expected to grow34.7% to $23.3 billion through 2010, a compound annual growth rate ofapproximately 6.1%. Net supplier revenue from DVD sell-through was $14.0billion in 2005, up 11.1% from $12.6 billion in 2004. Net supplier revenue fromDVD sell-through is expected to grow 31.4% to $18.4 billion through 2010, acompound annual growth rate of approximately 5.6%. Annual DVD disc buys per DVDset-top household were 14.8 discs in 2005, at an average price of $14.69 perdisc, slightly lower than 15.8 discs per household in 2004, at a lower averageprice than 2004’s $15.01 per disc. VHS sell-through consumer spending continuesto decline rapidly, down from $1.2 billion in 2004 to $475 million in 2005.

We believe thecontinuing popularity of relatively high-priced television content on DVDillustrates the consumer appetite for non-feature DVD content. Catalogue (i.e.all content—including newly produced specialty and non-feature content—thatdoes not qualify as a new release feature film) DVD content is necessarily ourfocus in light of our diverse array of general and specialty content and theunavailability of new release feature films to us. Adams Media reports(Hollywood Aftermarket report dated April 4, 2006) that the new releasefeature market share of revenues continues to grow more slowly than cataloguemarket share. In 2004, 50.2% of total DVD revenues (including rental) wererepresented by new release features, while 49.8% represented catalogue categories.In 2005, only 48.5% were features while catalogue grew to 51.5%.

As evidenced byour selling patterns, mass merchants, warehouse-style retailers, Internetretailers and DVD distributors are growing their DVD revenues at the expense oftraditional mall-based and stand-alone DVD-only retailers. The overall economicclimate and the uncertainty surrounding some retailers’ efforts to reorganizeor restructure their businesses may lead to an increased risk of customerbankruptcy within the DVD retail space as well as an increased percentage ofproduct returns to us. Indeed, the bankruptcy of Musicland Holding Corp. in January 2006appeared to confirm this current reality. The Musicland bankruptcy filing had asignificant impact on the DVD industry, particularly on independents like uswho were unsecured creditors of Musicland. We have also witnessed higherreturns in the months following the Musicland filing as a result of retailersbecoming even more cautious and Trans World Entertainment Corp. (who acquiredMusicland and its inventories) consolidating its combined DVD stocks. Ourproduct returns, as a percentage of our gross distribution revenues, were 21.9%in fiscal 2006, 18.8% in fiscal 2005 and 19.2% in fiscal 2004, respectively.

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DVD retailers whoalso specialize in CD sales are becoming increasingly vulnerable to mountingpressure from warehouse-style and online discounters, who now routinely offerCDs for sale, and from illegal downloading of music from the Internet and othermusic piracy. Many CD retailers have tried to reduce the impact of thesedownward pressures by also selling DVDs, video games and other merchandise. Nevertheless,as the Musicland bankruptcy again demonstrates, reorganizations,restructurings, and a significant number of store closures among CD retailersappear to support a continuing industry trend toward consolidations andreductions within the retail space, including retail space dedicated to DVD.

Meanwhile, our DVDand CD revenues from mass merchants and warehouse-style retailers haveincreased. The larger retailers typically return titles which do not meet theirinternal minimum sales velocities. To save costs, other retailers with multipleretail locations return titles with low sales velocities in a particular storeback to their vendors, like us, and reorder the same titles for sale in adifferent retail store. To save the costs of returns processing at their owndistribution centers, retailers generally require their vendors to incur suchcosts. This practice has contributed to our higher returns percentages inrecent years. We believe that the DVD and CD return rates experienced by majorstudios and record labels are substantially higher than our return rates, dueto the sheer volume of big-budget theatrical and audio new releases sold intoretail. As noted above, our VMI system should improve sales and market dataavailable to us. We believe that the VMI system should increase sales velocityand decrease returns and shipping costs, although implementation has not yetoccurred. We expect our VMI system to be fully deployed at a major retailcustomer by our second fiscal quarter, and the projected cost of the system’ssoftware will be shared, at least, initially by the consortium meeting thisretailer’s minimum stocking requirements.

The typical DVDbuying consumer has largely shifted from a catalogue programming-focused earlyadopter to a mass market buyer driven by high-profile, big-budget theatricalfilms. Both major studio and independent DVD suppliers now see that the primarydrivers of revenues are new releases, which generate both retail and consumerinterest and also help drive the sale of catalogue programming. We have adiverse catalogue of content, and according to DVD Release Report Revised5/4/05, we are the third-largest source for music on DVD with 577 titles inactive release, behind only the “majors” Sony BMG and Universal, and we are thetop source for special interest programming on DVD with 494 titles in activerelease. We typically add an average of over 30 new DVD titles per month, withcontent spanning over many genres, to our current catalogue of over 3,000active DVD titles. In addition, we typically add an average of five new CDtitles per month, and our current active catalogue contains approximately 200audio titles. Sales of our catalogue titles are affected by the strength of ournew releases, continued customer demand and the availability of retail shelfspace and retailer open to buy dollars.

**TRADEMARKS**

We have obtainedfederal registrations of our trademarks:

·                  Image

·                  ImageEntertainment

·                  theImage Entertainment logo

·                  ImageMusic Group

We have filed a federaltrademark application for “Egami Media a Subsidiary of Image Entertainment.”  It is our policy to protect and defend ourtrademark rights.

**EMPLOYEES**

As of June 1, 2006,we had 187 full-time employees and two part-time employees employed by us, fourfull-time employees employed by Egami Media, and two full-time employeesemployed by Image UK. Ten of our employees, including all of our executiveofficers and senior vice presidents, are covered by employment agreements, withthe remainder being at-will employees.

**EXECUTIVEOFFICERS OF THE REGISTRANT**

Executive officers serveat the pleasure of our board of directors. There is no family relationshipbetween any executive officer or director. The following table sets forthinformation regarding our executive officers at June 1, 2006:
| Executive Officer    | ** ** | **Age** | ** ** | **Position & Background**                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|----------------------|------------|---------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Martin W.  Greenwald |       | 64      |       | Chairman of the Board, Chief Executive Officer and  President since April 1981. Mr. Greenwald is a 1964 graduate of  Fairleigh Dickinson University. Mr. Greenwald has served as a board  member of the Permanent Charities Committee of the Entertainment Industries,  an umbrella organization which coordinates charitable contributions from the  entertainment industries.                                                                                                                  |
| David A.  Borshell   |       | 41      |       | Chief Operating Officer  since July 2000. Senior Vice President, Sales, Marketing and Operations  from December 1994 to June 2000. Prior to 1994, Mr. Borshell  has held various positions at Image since starting as an Account Executive in  February 1986. Mr. Borshell is a contributor to the Digital  Entertainment Group, an industry trade association devoted to fostering  consumer awareness of the DVD format, as well as future digital home  entertainment formats. |
| Jeff M. Framer       |       | 45      |       | Chief Financial Officer  since April 1993. Controller from September 1990 to  March 1993. Mr. Framer was a Senior Manager, KPMG LLP, from  July 1989 to September 1990; and a Manager, KPMG LLP, from  July 1988 to June 1989. Mr. Framer received his B.S. in  Business Administration and Accounting Theory and Practice from California  State University at Northridge in 1984. Mr. Framer is a Certified Public  Accountant.                             |

 

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**LEGALPROCEEDINGS**

In the normal course ofbusiness, we are subject to proceedings, lawsuits and other claims, includingproceedings under government laws and regulations relating to employment andtax matters. While it is not possible to predict the outcome of these matters,it is the opinion of management, based on consultations with legal counsel,that the ultimate disposition of known proceedings will not have a materialadverse impact on our financial position, results of operations or liquidity.

**ITEM 1A.**                      RISK FACTORS

You shouldcarefully consider and evaluate all of the information in this report,including the risk factors listed below. If any of these risks occur, ourbusiness, results of operations and financial condition could be harmed, theprice of our common stock could decline, and future events and circumstancescould differ significantly from those anticipated in the forward-lookingstatements contained in this report.

Risks Relating toOur Business.

**WeHave a High Concentration of Sales From Relatively Few Titles.**Our top five fiscal 2006 new releaseexclusive titles *Ron White: You Can’t FixStupid* DVD and CD, *Chicago and Earth Wind &Fire: Live at the Greek* DVD, *Kiss: Rock The Nation Live*DVD, the original *Twilight Zone TV series: Seasons 3*DVD,  and *Beef 3* DVD accounted for approximately 11% of our fiscal2006 net revenues. Our top ten fiscal 2006 new release exclusive titlesaccounted for approximately 15% of our fiscal 2006 net revenues. Althoughcatalogue sales of these titles continue to be relatively strong, sales forthese titles nevertheless have decreased over time and will probably continueto do so until our rights expire. Net revenues from new release DVD titles,where a new release title is defined as released during fiscal 2006, accountedfor approximately 51% of fiscal 2006 net DVD revenues and net revenues fromcatalogue DVD titles, where catalogue is defined as a title first released in aprevious fiscal year, accounted for approximately 49% of fiscal 2006 net DVD revenues.Revenues from new release and catalogue DVD titles accounted for approximately65% and 35% of fiscal 2005 net DVD revenues, respectively. If we cannot acquiretitles of equal or greater strength and popularity, our future net revenueswould be negatively impacted.

**We Have aHigh Concentration of Sales to Relatively Few Customers.**Forthe year ended March 31, 2006, Anderson Merchandisers (who suppliesWal-Mart) accounted for 11% of our net revenues. For the year ended March 31,2005, Anderson Merchandisers, Best Buy and AEC One Stop Group accounted forapproximately 17%, 12%, and 10%, respectively, of our net revenues. At March 31,2006, Anderson Merchandisers and AEC One Stop accounted for 13% and 12%,respectively, of our gross accounts receivables. Additionally, our top fivecustomers accounted for over 39% of our fiscal 2006 net revenues. Anycombination of these customers filing for bankruptcy or significantly reducingtheir purchases of our programming would have an adverse effect on ourfinancial condition, results of operations and liquidity. Our top 25 customersaccounted for approximately 83% of our fiscal 2006 net revenues. We are not anexclusive supplier to any of our retail customers, and there is no guaranteethat we will continue recognizing significant revenue from sales to anyparticular customer. If we are unable to maintain the sale of our titles attheir current levels to any these five customers, and are unable to find othercustomers to replace these sales, there would be a negative impact on ourrevenues and future profitability.

**WeMay Need Additional Funding to Continue Acquiring Desirable Programming.**Availabilityof working capital is a substantial factor in our ability to produce and/oracquire new content. Therefore, maximizing available working capital iscritical to our business operations. We may need to raise additional funds toacquire the rights to content or to create content we find desirable. Shouldadditional funds be raised through the issuance of equity or convertible debtsecurities, the percentage ownership of our existing stockholders may bereduced. If adequate funds are not available or unavailable on acceptableterms, we may find we are unable to fund expansion, continue offering productsand services, take advantage of acquisition opportunities, develop or enhanceservices or products, and/or respond to competitive pressures in the industry.

**Failureof Our Strategic Alliances Could Have a Material Adverse Affect on Our Business.**We have co-productiondeals in place with Dark Horse, Graymark and Amicus, and we plan to continue our strategy ofdeveloping key alliances with other third party content producers. Wewill rely on our co-producers to develop and produce films. Particularly whenproduced by independent filmmakers, each film is a separate business venturewith its own management, employees, equipment and budgetary requirements. Thereare substantial risks associated with film production, including contractproblems with, or disability of, directors, actors and other key artistic andtechnical personnel, weather and other delays, damage to sets, equipment orfilm, and the inability of production personnel to comply with budgetary orscheduling requirements. Such problems could materially increase the cost ofproduction, increase the amount of time between our expenditure of funds andreceipt of revenues, 

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or cause the project to be abandoned at any stage iffurther expenditures do not appear commercially feasible. Accordingly, there isno assurance that we will be successful in our strategic alliances, and anyfailure of our present and future alliances to produce commercially viablecontent at an acceptable cost could have a material adverse effect on ourbusiness. Additionally, there is no assurance that we will be able to findfurther desirable strategic alliances as we continue pursuing new co-productiondeals and similar relationships.

**OurCurrent DVD and CD Genre Concentrations May Become Unpopular With OurRetail Customers and End Consumers, Which May Adversely Affect OurBusiness.**During fiscal 2005, our DVD title genreconcentration was heavily weighted toward music-related DVD programming. Duringfiscal 2006 we were unable to further grow our audio business. Our audiobusiness generated approximately 8% of our total net revenues, compared toapproximately 10% in fiscal 2005. We may not be able to successfully continueto produce or acquire content in the same genres, or that we will achieve thesame strength within the genres we were successful with in fiscal 2006. If wecannot compete successfully in the home entertainment market for higher-profileDVD and CD content, our business may be adversely affected.

**InventoryObsolescence May AdverselyAffect Our Business.**We maintain a substantial investment inDVD and CD inventory, and if we overestimate the demand for a particular title,we may retain significant quantities of that title in our warehouse. Retainedinventory occupies valuable storage space and may become obsolete as ourdistribution term for the title expires. Although we may sell such inventory ata steeply discounted price toward the end of the distribution term in order torecoup our manufacturing, storage and other costs, there is no guarantee that amarket will exist for a given title, even at the steeply discounted price. Additionally,our license and/or distribution agreements sometimes contain terms, such asminimum royalties per unit and music publishing fees, which effectively preventus from steeply discounting the price on some titles.

**TheTransition to a New DVD Manufacturer May Adversely Affect Our Business.**Weintend to transfer our replication from Deluxe to Sonopress during our secondquarter of fiscal 2007 ending September 30, 2006. Any failure of Sonopressto manufacture and deliver our product in a timely manner and with the sameconsistent quantity and quality that we and our customers have come to expectmay adversely affect our revenues and profits. Additionally, should the needarise, we may be adversely affected by the period of time that we would need todirect manufacturing duties to another company.

**ProblemsDistributing Our Programming Internationally May Adversely Affect OurBusiness.**We distribute our programming internationally. As aresult, our business may be subject to various risks inherent in internationaltrade, many of which are beyond our control. Risks faced in distributing ourprogramming internationally include: cancellation or renegotiation of contracts, changes in laws and policiesaffecting international trade (including taxes), credit risk, fluctuatingforeign exchange rates and controls, civil strife, acts of war, guerillaactivities, insurrection, terrorism, changing retailer and consumer tastes andpreferences with regard to our programming, differing degrees of protection ofour intellectual property, cultural barriers, and potential instability offoreign economies and governments, and of which may adversely affect ourinternational sales. To date, we have not entered into foreign currencyexchange contracts.

**TheMajority of International Revenues Are Generated By Three Sublicensees.**Revenuesgenerated from our international business segment are primarily derived fromthe manufacturing, marketing and distribution efforts of Sony BMG, Warner MusicGroup and Digital Site. Should any of Sony BMG, Warner or Digital Site defaulton their respective sublicense agreements with us or fail to successfullyperform, an important part of our business strategy, financial condition,results of operations and cash flows could be negatively impacted.

**We HaveDirect and Indirect Foreign Currency Exchange Risk.**Althoughour Sony BMG and Digital Site sublicense agreements are U.S. Dollardenominated, with these parties reporting to us and paying us in U.S. Dollars,the underlying Sony BMG sales transactions are in Euros and the underlyingDigital Site sales transactions are in Yen. On June 1, 2006, the Euro wasequivalent to approximately U.S. $1.29 and the Yen was equivalent toapproximately U.S. $0.008917. Should the U.S. Dollar strengthen compared toeither the Euro or the Yen, our sublicensors’ reported royalties to us on atitle-by-title basis and in the aggregate would decline (assuming consistent unitsales) and thus reduce our revenues recognized.

**We Havean Accumulated Deficit and May Incur Additional Losses.**Wesustained a net loss for fiscal 2006, and although we were profitable in fiscal2005, we also sustained net losses for the three fiscal years preceding 

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fiscal 2005. Our accumulated deficit at March 31,2006, was $9.7 million. Due to the inherent unpredictability of high-profilecontent acquisition and competition for limited retail shelf space, we mayincur losses again in the future.

**Inabilityto Maintain Relationships with Our Program Suppliers and Vendors May AdverselyAffect Our Business.**We receive a significant amount of ourrevenue from the distribution of those DVDs for which we already have exclusiveagreements with program suppliers. We can give no assurances, however, thattitles in production which have been financed by us will be timely delivered asagreed or of the expected quality. Delays or inadequacies in delivery,including rights clearances, could negatively impact the performance of anygiven quarter or fiscal year. We can give no assurance that such content willultimately be purchased in internally forecasted quantities by our retailcustomers or ultimately desired by the end-consumer. We also cannot be surethat we will be able to renew these exclusive rights as existing agreementswith program suppliers expire. We also cannot assure you that our currentprogram suppliers will continue to support the DVD format in accordance withour exclusive agreements, that our current content suppliers will continue tolicense titles to us on the current terms or on terms favorable to us, or thatwe will be able to establish new beneficial supplier relationships to ensureacquisition of exclusive titles in a timely and efficient manner.

**The FullExploitation of Our Rights Requires Us to Conduct Business in Areas Where OurExpertise Is Limited.**In order to fully exploit some of therights we have acquired, we are required to conduct business in sectors (e.g.Internet, rental, broadcast, video on demand, in-flight, satellite) where weare not as experienced as we are in the DVD and home video sectors. Accordingly,when exploiting such sectors in which we are less experienced, we may realize agreater proportion of costs, or we may not realize as much of a proportion ofrevenue, as we would in the DVD and home video sectors.

**Failureto Effectively Implement Our Sales and Marketing Efforts May AdverselyAffect Revenues.**Our sales team may be unable to continue tosuccessfully compete against the more extensive and well-funded salesoperations of our current and future competitors, which could adversely affectour revenues.

**Lossof Key Personnel May Adversely Affect Our Business.**Oursuccess greatly depends on the performance of our executive management,including President and Chief Executive Officer Martin Greenwald, ChiefOperating Officer David Borshell, and Chief Financial Officer Jeff Framer, aswell as our five senior vice presidents responsible for the critical areas ofcontent acquisition, legal, marketing & product development,operations, and sales. The loss of the services of key persons of our executiveand senior management could have a material adverse effect on our operatingresults and financial condition.

**WeMay Not Successfully Optimize and Operate Our Warehouse and DistributionFacility, and Our Business Could Be Harmed.**Domesticwholesale distribution of our exclusive programming is fulfilled from a singlewarehouse and distribution facility in Las Vegas, Nevada. If we are unable tooperate this facility for any reason, it could significantly limit our abilityto meet customer demand. Because it is difficult to predict sales increases ordeclines, we may not manage our facility in an optimal way, which may result inexcess inventory, warehousing and distribution problems. Our failure to handleinventory properly could result in unexpected costs, delays and harm to ourbusiness and reputation.

**Occurrenceof Events for Which We Are Not Insured May Adversely Affect Our Business.**Wemaintain insurance to protect ourselves against various risks related to ouroperations. This insurance is maintained in types and amounts that we believeto be reasonable depending upon the circumstances surrounding each identifiedrisk. However, we may elect to limit coverage or not to carry insurance forsome risks because of the high premiums associated with insuring those risks orfor various other reasons. For example, we do not carry earthquake insurance inlight of the steep increase in premiums in Southern California after theNorthridge earthquake on January 17, 1994. Occurrence of events for whichwe are not insured may affect our cash flows and overall profitability.

Risks Relating toOur Industry.

**OurSuccess Depends on the Unpredictable Commercial Success of Our Programming.**Operatingin the entertainment industry involves a substantial degree of risk. Each musicperformance, feature film or other programming title is an individual artisticwork, and unpredictable audience reactions primarily determine commercialsuccess. The commercial success of a title also depends upon the quality andacceptance of other competing programs or titles released into the marketplace,critical reviews, the availability of alternative forms of entertainment andleisure 

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activities, general economic conditions and othertangible and intangible factors, all of which are subject to change and cannotbe predicted with certainty. Our success will depend in part on the popularityof our content which, in turn, depends on our ability to gauge and predictexpected popularity. Even if a film achieves success during its theatricalrelease, the popularity of a particular program and its ratings may diminishover time, which may have a material adverse affect on our business, results ofoperations or financial condition. Timing and timeliness are also sometimesrelevant to a program’s success, especially when the program concerns a recentevent or historically relevant material (e.g. an anniversary of a historicalevent which focuses media attention on the event and accordingly spurs interestin related content).

**DecreasingRetail Shelf Space May Limit Sales of Our Programming**. Weface increasing competition from major motion picture studios, music labels andother independent content suppliers for limited retail shelf space and retaileropen to buy dollars. Although the amount of retail shelf space for DVDs hadpreviously been growing in approximate correlation to the growth rate inpenetration of DVD players, the leveling off of DVD player penetration hasresulted in a similar leveling off in retail shelf space growth. It is withinthis changing environment that our exclusive content competes for a finiteamount of shelf space against a growing supply of entertainment content. Becausethe new DVD releases of major studios often have extremely high visibility andsales velocity in the millions of units, which typically require more shelfspace to support, we may not be able to afford or obtain the product placementnecessary to maximize sales, particularly among the limited number of majorretailers that are our core customers, which could result in decreased revenuesand gross margins. See “Competition” above.

**DVDSales Are Not Sustaining the Same Level of Growth as Before.**Webelieve that consumer interest in the DVD format is due partly to interest inbuilding the consumer’s personal DVD library of desired entertainmentprogramming. Although our exclusive titles have generally shown stable salesover extended periods, as consumers build their DVD libraries, or with theintroduction of new home entertainment formats, DVD sales may decline andadversely affect our operations. In addition, the leveling off of DVD playerpenetration has clearly resulted in a similar leveling off in DVD sales growth.See “Industry Trends” above.

**Our FilmProduction Efforts May Not be Financially Successful.**Ourco-produced films are more expensive to create than our DVD co-productions, andthe time between our expenditure of funds and receipt of revenues is longer. Whilemuch of our programming is sold to retailers on a sell-through basis, thefinancial success of our filmed programming will depend on our ability togenerate higher sales to retailers who primarily rent programming such asBlockbuster, Movie Gallery, Hollywood Entertainment (now a wholly-ownedsubsidiary of Movie Gallery) and Netflix, as well as to mass merchants such asWal-Mart, Costco and Target. Our filmed programming may not ultimately be asdesirable to our target customers as we would hope, which would lead to lowerthan expected sales, decreased profit margins or losses.

**Failureto Effectively Implement a Transition to Vendor Managed Inventory (VMI) May AdverselyAffect Our Business.**Larger retailers are starting to movetoward a VMI system whereby independent suppliers like us would be responsiblefor monitoring, stocking and fulfilling directly to individual retail storesand outlets. We currently have one major customer who is requiring VMI in thenear future, and other customers are likely to follow suit. We have fullyimplemented all the necessary VMI software and systems and are currently in thefinal stages of deploying our program at this retail customer (expected to befully deployed August 1, 2006). We will evaluate additional opportunitiesto deploy our VMI system at other retail customers. We cannot assure you thatother implementations with other customers will be done in a timely andeffective manner or that the VMI software we have implemented will beacceptable to other retail customers. Implementation of VMI requires capitalexpenditures for initial setup, installation and integration. In addition,ongoing fees will be paid for software maintenance/support, item planning,order management and picking, packing, labeling and shipping of product. Failureto implement VMI in a timely manner with other customers could result indecreased opportunities for shelf space or decreased margins, andmay require us to sell to VMI customers indirectly through third-partieswho have already implemented VMI. While we should be able to add othercustomers without significant additional costs or time once we implement VMI,there can be no assurance this will be the case, and VMI implementation mayrequire additional freight charges as inventory is sent directly to retailstores and outlets in smaller packages with greater frequency.

**ConflictingHigh-Definition DVD Formats May Cause Inefficiencies.**Currently,two major platforms are competing to become the dominant high-definition format,and talks to unify the platforms have been unsuccessful. The HD-DVD and Blu-rayDisc® platforms have both recently launched. For many of our titles, we holdrights to both platforms, but simultaneously supporting both platforms 

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will cause increased production costs and decreasedefficiencies with respect to inventory management and sales. Moreover,competing platforms may cause a delay in high-definition player marketpenetration, and mainstream acceptance of high-definition DVD in general, asconsumers may decide to wait and see which platform prevails before purchasinga player.

**WeMay Not Be Able to Keep Pace with Technological Advances.**Theentertainment industry in general, and the music and motion picture industriesin particular, are continuing to undergo significant changes, primarily due totechnological developments. Because of the rapid growth of technology, shiftingconsumer tastes and the popularity and availability of other forms ofentertainment, it is impossible to predict the overall effect these factorscould have on potential revenue from, and profitability of, distributingentertainment programming. It is also impossible to predict the overall effectthese factors could have on our ability to compete effectively in a changingmarket.

**AnIncrease In Product Returns May Adversely Affect Our Business.**Aswith the major studios and other independent companies in this industry, weexperience a relatively high level of product returns as a percentage of ourrevenues. Our allowances for sales returns may not be adequate to coverpotential returns in the future, particularly in the case of consolidationwithin the home video retail marketplace which, when it occurs, tends to resultin inventory consolidation and increased returns. Our experience over two ofthe past three years has been one of increasing return rates, and we expectthis trend to continue.

****Decreasing Retail Prices for DVDs May NegativelyImpact Our Revenues.****The home entertainmentprogramming market in which we compete is rapidly evolving and intenselycompetitive. Many of our competitors, including major studios, are increasinglyoffering programming, particularly DVD programming, at lower prices. They maybe able to produce or secure content on more favorable terms and may be able toadopt more aggressive pricing policies than we are able to adopt. While westrive to improve our operating efficiencies and leverage our fixed costs sothat we can afford to pass along these savings to our customers in the form oflower prices, the industry trend of lowering prices may, over time, lead tohigher levels of competition and, therefore, lost sales, decreased profitmargins or decreased overall revenues.

**IllegalPiracy May Reduce Our Revenues.**The music industry isfacing a major challenge in the form of illegal piracy resulting from Internetdownloading and/or CD recorders. This piracy has negatively affected industryrevenues and profits. Although we currently derive only 8% of our revenues fromaudio CDs, we are hopeful that our proportional revenues in this sector willincrease. Additionally, according to In-Stat, DVD recorders are graduallygaining greater market penetration: shipments of personal video recorders (PVR)reached 19 million in calendar 2005, a 60% increase over calendar 2004. As DVDrecorders, PVRs and high-speed Internet connections become more popular, andthe storage capacity of personal computers increases, we may face greaterpiracy concerns with respect to our core DVD business.

**Others’Failure to Promote Our Programming May Adversely Affect Our Business.**Decisionsregarding the timing of release and promotional support of programming which welicense and distribute are important in determining the success of a particularmusic concert, feature film or related product. We may not control the mannerin which a particular artist, film or related product is marketed and promoted,and we may not be able to fully control our corresponding DVD or CD release. Althoughartists, record companies, studios and producers have a financial interest inthe success of any such concerts or films distributed by us, any marketing orpromotional decision or restriction by such persons may negatively affect thesuccess of our titles. Additionally, the availability of retailer programsrelating to product placement, co-op advertising and market development funds,and our ability and willingness to pay for such programs, are also importantwith respect to promoting our exclusive titles.

**IfDVD Cannot Compete Successfully with Other Formats of Home Entertainment, OurRevenues May Be Negatively Impacted.**The DVD formatcompetes with other formats of in-home entertainment, such as network,syndicated, cable and pay-per-view television, and home satellite systems. TheDVD format also competes with new and emerging technologies in theentertainment industry, such as entertainment programming on the Internet,video on demand, high-definition television, digital videotape, and opticaldiscs with greater storage capacity. These alternate home entertainment formatsand emerging content delivery technologies could negatively impact the overallmarket for our DVD sales, especially if we are unable to continue to adapt andexploit the development and advancement of such technology.

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** **

**IfWe Cannot Continue to Secure DVD License and Distribution Rights, Our Business May BeMaterially Adversely Affected.**We cannot assure you that wewill be able to continue to secure DVD and other license and distributionrights on terms acceptable to us. See “Competition” above. Major motionpicture studios have normally not granted, nor are they expected to grant,exclusive DVD licenses to us for new releases and popular catalogue titles. Instead,the major motion picture studios will most likely continue to sell DVD titlesdirectly to retailers. We expect to continue to license exclusive DVD and otherhome entertainment format content, but we cannot assure you that we can remaincompetitive against licensing entities with greater financial resources or thatindependent program suppliers will not distribute their programming themselves.In addition, our success will continue to be dependent upon our ability toidentify and secure rights to exclusive content that appeal to consumers.

**WeMay Not Possess Satisfactory Rights in Our Properties.**Althoughwe require satisfactory chain of title information to our exclusively licensedcontent, the risk exists that some programs may have a defective chain of title.The validity and ownership of rights to some titles can be uncertain and may becontested by third parties.

**OurResults of Operations Fluctuate Based on Seasonality and Variability.**Wehave generally experienced higher sales of DVDs and CDs in the quarters ended December 31and March 31 due to increased consumer spending associated with theyear-end holidays. Accordingly, our revenues and results of operations may varysignificantly from period to period, and the results of any one period may notbe indicative of the results of any future periods. In addition to seasonalityissues, other factors have contributed to variability in our DVD and CD netrevenues on a quarterly basis. These factors include:

·                                          thepopularity of exclusive titles in release during the quarter;

·                                          latedelivery or non-delivery of DVD or CD content or rights clearances by ourcontent providers;

·                                          ourmarketing and promotional activities;

·                                          ourrights and distribution activities;

·                                          theavailability of retailer shelf-space;

·                                          thelevel of retailer open to buy dollars;

·                                          theextension, termination or non-renewal of existing license and distributionrights; and

·                                          generaleconomic changes affecting the buying habits of our customers, particularlythose changes affecting consumer demand for home entertainment-hardware,packaged media and digital content

**Protectingand Defending against Intellectual Property Claims May Have a MaterialAdverse Effect on Our Business.**Our ability to compete in thehome entertainment industry depends, in part, upon successful protection of ourproprietary and intellectual property. We protect our property rights to ourproductions through available copyright and trademark laws and licensing anddistribution arrangements with reputable international companies in specificterritories and media for limited durations. Despite these precautions,existing copyright and trademark laws afford only limited practical protectionin some jurisdictions. In some jurisdictions of our distribution, there are nocopyright and/or trademark protections available. As a result, it may bepossible for unauthorized third parties to copy and distribute our productionsor portions or applications of our intended productions. In addition, litigationmay be necessary in the future to enforce our intellectual property rights, toprotect our trade secrets, to determine the validity and scope of theproprietary rights of others or to defend against claims of infringement orinvalidity. Any such litigation could result in substantial costs and theresulting diversion of resources could have an adverse effect on our business,operating results or financial condition. From time to time, we may alsoreceive claims of infringement of other parties’ proprietary rights. Regardlessof the validity or the success of the claims, we could incur significant costsand diversion of resources in defending against such claims, which could havean adverse effect on our business, financial condition or results of operations.

Risks Relating toOur Stock.

**OurSecond-Largest Shareholder Has Nominated a Competing Slate of Directors for OurUpcoming Annual Meeting.**Lions Gate Entertainment Corp. isour second-largest shareholder, holding approximately 4 million shares representingapproximately 19% of the company. In a filing with the Securities and ExchangeCommission, Lions Gate states that it “believes Image’s current Board is notacting in the best interests of Image and its stockholders” in light of ourindependent committee’s October 31, 2005, decision to reject Lions Gate’s$4.00 per share offer to purchase all of our outstanding shares. On June 5,2006, Delaware’s Court of Chancery ruled that the classification of our Boardof Directors will be effective beginning with the upcoming annual stockholders’meeting to be held on October 10, 2006. Lions Gate has nominated acomplete slate of potential Board members to compete for the six seats 

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up for election. Should Lions Gate’s slate obtain morevotes than our existing slate of directors who are up for re-election, then thecomposition of the Board of Directors will change, which will likely result ina change to our overall strategic direction.

LionsGate’s disclosure may encourage others to make similar or different proposals. Ifsuch a transaction were to occur, owners of shares of our common stock wouldbecome owners of another company’s stock, and be subject to all of the risksand uncertainties of that company including those disclosed in any publicfilings with the SEC. If our board of directors or its special committeedetermine the proposal is unfavorable, they may adopt additional defensivemeasures. In addition, future purchases or sales of our stock by Lions Gate, orby third parties based on speculation, new reports, or future public filingsrelating to the proposal or our response, may cause the price of our commonstock to fluctuate significantly. Lions Gate may decide at any time to sell allor a significant portion of its shares of our stock, particularly if its slateof nominees is rejected by our stockholders, which could cause the price of ourcommon stock to fall dramatically.

**Our StockPrice May Be Subject to Substantial Volatility, and You May Lose Allor a Substantial Part of Your Investment.**Our commonstock is traded on The NASDAQ National Market®. There is a limited public float, andtrading volume historically has been limited and sporadic. Over the last year,the closing price of our common stock ranged between $2.68 and $5.36 per shareon volume ranging from 2,240 to over 4.7 million shares per day. As a result,the current price for our common stock is not necessarily a reliable indicatorof our fair market value. The price at which our common stock will trade may behighly volatile and may fluctuate as a result of a number of factors,including, without limitation, the number of shares available for sale in themarket, quarterly variations in our operating results, and actual oranticipated announcements of new releases by us or competitors, including LionsGate, the gain or loss of significant customers, changes in the estimates ofour operating performance, market conditions in our industry and the economy asa whole.

**AnyFuture Sales of Equity May Significantly Impact the Market Price of OurCommon Stock.**We currently have S-3 and S-4registration statements for the issuance of our securities in exchange foreither cash or other securities on file with the Securities and ExchangeCommission. Future sales of substantial amounts of our common stock, includingshares that we may issue upon exercise of outstanding options and warrants,could adversely affect the market price of our common stock. Further, if weraise additional funds through the issuance of common stock or securitiesconvertible into or exercisable for common stock, the percentage ownership ofour stockholders will be reduced and the price of our common stock may fall.

**We May Incur Increased Costs asa Result of Laws and Regulations Relating to Corporate Governance Matters.**Lawsand regulations affecting public companies, including the provisions of theSarbanes-Oxley Act of 2002 and rules adopted or proposed by the Securitiesand Exchange Commission and by NASDAQ, will result in increased costs to us aswe evaluate the implications of any new rules and respond to theirrequirements. If our public float exceeds $75 million at the end of oursecond fiscal quarter on September 30, 2006, we will become anaccelerated filer and be subject to additional regulatory requirements,including Section 404 of Sarbanes-Oxley which would require usto include in our annual report for the period ending March 31, 2007 areport by management on our internal control over financial reporting and anaccompanying auditor’s report. The additional costs and efforts to do socould be substantial. If we remain a non-accelerated filer, we will not have tocomply until March 31, 2008. New rules could make it more difficultor more costly for us to obtain certain types of insurance, including directorand officer liability insurance, and we may be forced to accept reduced policylimits and coverage or incur substantially higher costs to obtain the same orsimilar coverage. The impact of these events could also make it more difficultfor us to attract and retain qualified persons to serve on our board ofdirectors, our board committees or as executive officers. We cannot predict orestimate the amount of the additional costs we may incur or the timing of suchcosts to comply with any new rules and regulations.

**ITEM 2.**                    PROPERTIES

Our headquarters are located in Chatsworth, Californiaand consists of approximately 62,000 square feet on one floor of a multi-tenantbuilding. The monthly rent is $1.27 per square foot, on a gross basis, orapproximately $78,000 per month, and increases approximately 3% annually. Theoffice lease has an initial 10-year term with two five-year options. Thelease started on July 1, 2004, upon completion of approximately $1.5million in tenant improvements. Substantially all of the tenant improvementexpenses were borne by the landlord. Althougha base level 

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of operating expenses is included in the rent payment,we will be responsible for a percentage of actual annual operating expenseincreases capped at 5% annually.

We also lease our 76,000 square foot warehouse and distributionfacility located in Las Vegas, Nevada. The monthly rent is approximately$39,000, subject to annual adjustment based on increases in the consumer priceindex, and the lease will terminate on November 4, 2012. In addition, welease approximately 4.07 acres of adjacent vacant land in the event we need toexpand our current warehouse and distribution facility. The monthly rent isapproximately $9,000 and the lease will terminate on November 4, 2007. Beginningin January 2004, we leased an additional 10,000 square foot warehousestorage space in Las Vegas, Nevada for a monthly rent of approximately $6,000for an initial term of two years and later extended to April 30, 2007. Beginning in October 2005, we leased anadditional 5,000 square foot warehouse storage space in Las Vegas, Nevada for amonthly rent of approximately $3,000 on a month to month basis.

Image UK leasesapproximately 500 square feet of business space in London inside the offices ofContentFilm plc, located at 19 Heddon Street 3rd Floor, London W1B 4BG. ImageUK currently pays £7,500 (approximately $14,000) per quarter in rent toContentFilm, which includes a prorated share of utilities and use ofContentFilm’s common areas. We have mutually agreed with ContentFilm toterminate the lease as of the end of August 2006, and we have recently signed anew, one-year lease with MWB Business Exchange Centres for office space at77 Oxford Street, London WID 2ES, commencing August 28, 2006, at arate of approximately £4,750 (approximately $8,662) per month, which rateincludes VAT, utilities, cleaning, security, insurance and other fees.

We believe thatour current office and warehouse space is adequate to meet our needs, and thatadditional facilities will be available for lease, if necessary, to meet ourfuture needs.

**ITEM 3.**                    LEGALPROCEEDINGS

On March 16,2006, Lions Gate filed a lawsuit against us in the Delaware Court of Chancery.On June 5, 2006, the court ruled that our board of directors does notbecome classified until our 2006 annual meeting of stockholders to be held onOctober 10, 2006, and that all of our board seats are up for election atthe next annual meeting. The court also issued a declaration that our boarddoes not have the authority to amend our bylaws, and that it does not have theauthority to amend our certificate of incorporation without a vote of ourstockholders.

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

None.

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** **

**PART II**

**ITEM 5.**                    MARKET FORREGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OFEQUITY SECURITIES

Our common stocktrades on The NASDAQ National Market® under the symbol DISK. The table belowpresents the quarterly high and low closing prices on the NASDAQ during thepast two fiscal years.

 
| **Fiscal Year Ended March 31, 2006** | ** ** | **High** | ** ** | **Low** | ** ** |
|---------------------------------------------------------------|------------|----------|------------|---------|------------|
| Quarter ended  June 30, 2005                             |       | $        | 5.360      |    | $          | 2.700 |   |
| Quarter ended  September 30, 2005                        |       | $        | 4.430      |    | $          | 2.680 |   |
| Quarter ended  December 31, 2005                         |       | $        | 4.150      |    | $          | 3.020 |   |
| Quarter ended  March 31, 2006                            |       | $        | 3.730      |    | $          | 3.200 |   |

 
| **Fiscal Year Ended March 31, 2005** | ** ** | **High** | ** ** | **Low** | ** ** |
|---------------------------------------------------------------|------------|----------|------------|---------|------------|
| Quarter ended  June 30, 2004                             |       | $        | 3.950      |    | $          | 2.720 |   |
| Quarter ended  September 30, 2004                        |       | $        | 4.140      |    | $          | 3.590 |   |
| Quarter ended  December 31, 2004                         |       | $        | 6.480      |    | $          | 4.230 |   |
| Quarter ended  March 31, 2005                            |       | $        | 6.690      |    | $          | 5.280 |   |

 

As of June 26,2006, there were 1,237 holders of record of our common stock. As of May 12,2006, we estimate there were 3,686 beneficial owners of our common stock.

Our Amended andRestated Loan and Security Agreement with Wells Fargo Foothill prohibits ourpayment of dividends. We have never paid a cash dividend on our common stockand we presently intend to retain any future earnings for business development.

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**ITEM6.**                    SELECTEDFINANCIAL DATA

The selectedfinancial data presented below was derived from our consolidated financialstatements and should be read in conjunction with the financial statements, thenotes thereto and the other financial information included therein.

 
| ** **                                                         | ** ** | **Years  Ended March 31,** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------|------------|
| **(In thousands, except per share data)** | ** ** | **2006**                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Statement of Operations Data:**                                  | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenues                                                       |       | $                          | 111,902    |   | $ | 118,383 |   | $ | 84,840 |   | $ | 86,929 |   | $ | 76,135 |   |
| Operating costs and  expenses                                      |       | 111,378                    | (1)        | 112,380 | (2) | 85,106 |   | 82,924 | (5) | 72,797 | (7) |
| Earnings (loss) from  operations                                   |       | 524                        |       | 6,003 |   | (266 | ) | 4,005 |   | 3,338 |   |
| Interest expense, net                                              |       | 707                        |       | 665 |   | 818 |   | 1,359 |   | 1,711 |   |
| Other expense (income)                                             |       | (3                         | )          | 49 |   | (213 | ) | 698 |   | 192 |   |
| Earnings (loss) from  continuing operations before income taxes    |       | (180                       | )          | 5,289 |   | (871 | ) | 1,948 |   | 1,435 |   |
| Income tax expense  (benefit)                                      |       | 27                         |       | 162 | (3) | 6,244 | (4) | 1,306 | (6) | 562 |   |
| Earnings (loss) from  continuing operations                        |       | (207                       | )          | 5,127 |   | (7,115 | ) | 642 |   | 873 |   |
| Loss from discontinued  operations                                 |       | —                     |       | — |   | 2,441 |   | 1,096 |   | 1,068 |   |
| Earnings (loss) before  cumulative effect of accounting change     |       | (207                       | )          | 5,127 |   | (9,556 | ) | (454 | ) | (195 | ) |
| Cumulative effect of  accounting change                            |       | —                     |       | — |   | — |   | (3,766 | ) | — |   |
| Net earnings (loss)                                                |       | $                          | (207       | ) | $ | 5,127 |   | $ | (9,556 | ) | $ | (4,220 | ) | $ | (195 | ) |
| Earnings (loss) per  share:                                        |       |                       |       |   |   |   |   |   |   |   |   |
| Continuing  operations                                             |       |                       |       |   |   |   |   |   |   |   |   |
| Basic                                                              |       | $                          | (.01       | ) | $ | .27 |   | $ | (.39 | ) | $ | .04 |   | $ | .06 |   |
| Diluted                                                            |       | $                          | (.01       | ) | $ | .26 |   | $ | (.39 | ) | $ | .04 |   | $ | .06 |   |
| Discontinued  operations                                           |       |                       |       |   |   |   |   |   |   |   |   |
| Basic                                                              |       | $                          | —     |   | $ | — |   | $ | (.13 | ) | $ | (.07 | ) | $ | (.07 | ) |
| Diluted                                                            |       | $                          | —     |   | $ | — |   | $ | (.13 | ) | $ | (.07 | ) | $ | (.07 | ) |
| Earnings  (loss) before cumulative effect of accounting change     |       |                       |       |   |   |   |   |   |   |   |   |
| Basic                                                              |       | $                          | (.01       | ) | $ | .27 |   | $ | (.52 | ) | $ | (.03 | ) | $ | (.01 | ) |
| Diluted                                                            |       | $                          | (.01       | ) | $ | .26 |   | $ | (.52 | ) | $ | (.03 | ) | $ | (.01 | ) |
| Cumulative  effect of accounting change                            |       | $                          | —     |   | $ | — |   | $ | — |   | $ | (.22 | ) | — |   |
| Net  earnings (loss) per share:                                    |       |                       |       |   |   |   |   |   |   |   |   |
| Basic                                                              |       | $                          | (.01       | ) | $ | .27 |   | $ | (.52 | ) | $ | (.25 | ) | $ | (.01 | ) |
| Diluted                                                            |       | $                          | (.01       | ) | $ | .26 |   | $ | (.52 | ) | $ | (.25 | ) | $ | (.01 | ) |
| Weighted  average shares outstanding                               |       |                       |       |   |   |   |   |   |   |   |   |
| Basic                                                              |       | 21,273                     |       | 19,100 |   | 18,250 |   | 16,812 |   | 15,821 |   |
| Diluted                                                            |       | 21,273                     |       | 19,912 |   | 18,250 |   | 17,002 |   | 15,898 |   |

----

(1)             Includes$1,566,000 charge associated with the Chapter 11 filing of Musicland HoldingCorp. and $248,000 impairment charge associated with software not utilized. Alsoincludes a $562,000 credit to cost of sales from the reversal of an overaccrualfor music publishing liabilities associated with a DVD series.

(2)             Includesa $499,000 non-recurring noncash credit related to the discontinuation of ourinternational distribution of DVDs through subdistributors.

(3)             Incometax expense reflects the use of net operating losses against taxable income.

(4)             Incometax expense reflects establishing a valuation allowance against 100% of netdeferred tax assets.

(5)             Includesthe reduction to gross margin of $480,000 for estimated subdistributor returnsand inventory write downs as a result of our transition from direct Europeandistribution to European sublicense.

(6)             Includesa provision for a valuation allowance against deferred tax assets of $551,000relating primarily to foreign tax credits.

(7)             Includes$1,818,000 in one-time noncash credit relating to the discontinuation of ourlaserdisc operations and a $696,000 write down of advance royalties, relatingto a line of programming, to estimated fair value.

 
| ** **                     | ** ** | **March 31,** | ** ** |
|--------------------------------|------------|--------------------|------------|
| **(In thousands)**        | ** ** | **2006**           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Balance  Sheet Data:**       | ** ** | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total assets                   |       | $                  | 87,675     |   | $ | 75,186 |   | $ | 64,132 |   | $ | 74,251 |   | $ | 81,898 |   |
| Total  liabilities             |       | 46,032             |       | 33,353 |   | 41,797 |   | 42,586 |   | 49,390 |   |
| Net stockholders’  equity |       | 41,643             |       | 41,833 |   | 22,335 |   | 31,665 |   | 32,508 |   |
|                                |            |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**ITEM 7.**                    MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The followingdiscussion and analysis should be read together with “Item 1. Business,” “Item1A. Risk Factors,” “Item 6. Selected Financial Data” and the consolidatedfinancial statements, the related notes thereto and other financial informationcontained elsewhere in this report.

**Forward-Looking Statements**

This reportincludes forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995. Other than statements of historicalfact, all statements made in this report are forward-looking, including but notlimited to statements regarding industry prospects, future results ofoperations or financial position, and statements of our intent, belief andcurrent expectations about our strategic direction, prospective and futureresults. In some cases forward-looking statements may be identified by wordssuch as “will,” “should,” “expect,” “anticipate,” “believe,” “estimate,” “continue,”“future,” “intend” or similar words. Forward-looking statements involve risksand uncertainties that are inherently difficult to predict, which could causeactual outcomes and results to differ materially from our expectations,forecasts and assumptions. The following important factors, in addition tothose discussed above, could affect our future results and could cause thoseresults to differ materially from those expressed in such forward-lookingstatements:

·                                          changesin company-wide or business-unit strategies, which may result in changes in thetypes or mix of businesses in which the we are involved or choose to invest

·                                          changesin U.S. and global financial and equity markets, including market disruptionsand significant interest rate fluctuations, which may impede our access to, orincrease the cost of, external financing for its operations and investments

·                                          increasedcompetitive pressures, both domestically and internationally, which may, amongother things, affect the performance of our business operations and profitmargins

·                                          changesin the mix of titles sold to customers and/or customer spending patterns

·                                          legaland regulatory developments that may affect the protection of intellectualproperty

·                                          theimposition by foreign countries of trade restrictions on motion picture ortelevision content requirements or quotas, and changes in international taxlaws or currency controls

·                                          technologicaldevelopments that may affect the distribution of our products or create newrisks to our ability to protect our intellectual property

·                                          changingpublic and consumer taste, which may among other things, affect theentertainment and consumer products businesses generally

Allforward-looking statements should be evaluated with the understanding ofinherent uncertainty. The inclusion of such forward-looking statements shouldnot be regarded as a representation that contemplated future events, plans orexpectations will be achieved. Unless otherwise required by law, we undertakeno obligation to release publicly any updates or revisions to any suchforward-looking statements that may reflect events or circumstances occurringafter the date of this report. Important factors that could cause or contributeto such material differences include those discussed in “Item 1A. Risk Factors”above. You are cautioned not to place undue reliance on such forward-lookingstatements.

**Overview**

*Revenue Sources*

Our primary sourceof revenues continues to be derived from the acquisition and distribution ofexclusive DVD content in North America, which accounted for over 88% of ouroverall net sales in fiscal 2006. A complementary source of revenues in fiscal2006 was derived from the distribution of CD content in North America, whichaccounted for over 8% of our fiscal 2006 net revenues.

Internationally,we primarily receive royalty income from sublicenses with Sony BMG, WarnerMusic and Digital Site for the distribution of our exclusive DVD content.

25

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Revenues fromdigital distribution of our exclusive content rights are beginning to grow. Netrevenues generated by Egami Media in its first full year of operation totaled$178,000.

*Cost Structure*

Our mostsignificant costs and cash expenditures relate to acquiring content forexclusive distribution and, more recently, the funding of content production orco-production for exclusive distribution. Additionally, the costs of consumeradvertising, product promotion and market development funds provided to ourretail customers continue to increase. Other significant costs include DVD andCD manufacturing, employee compensation and freight expense.

*Acquisition of Exclusive Rights*

We intend tomaintain our content rights acquisition focus on genres that have beensuccessful in the past, even while seeking out early trend opportunities inadvance of mainstream acceptance in an effort to keep acquisition costs lowerby bringing titles to market before spikes in demand drive up acquisitioncosts, especially in growing genres such as urban and Latin where we possesssignificant expertise. We obtain our content from a variety of sources,including but not limited to content rights holders, producers, businessmanagement firms, law firms, talent agencies, independent film studios andrecord labels, the artists themselves and content finders.

*Fiscal 2006 Highlights*

·                  Netrevenues decreased 5.5% to $111,902,000, compared to $118,383,000 for fiscal2005

·                  Grossprofit margins decreased 0.5% to 24.8%, compared to 25.3% for fiscal 2005

·                  Sellingexpenses increased to 9.6% of net revenues, up from 8.3% of net revenues forfiscal 2005

·                  Generaland administrative expenses were up $2.4 million in absolute dollars for fiscal2006, due primarily to bad debt charges associated with Musicland Holding Corp.’sbankruptcy filing of approximately $1.6 million, an asset impairment charge of$248,000 and the incremental expenses of subsidiaries Egami and Image UK whichwere only in existence for one quarter in the prior fiscal year

·                  Netloss was $207,000, or $.01 per diluted share, compared to net earnings of$5,127,000, or $.26 per diluted share for fiscal 2005

·                  Netloss of $.01 per diluted share for fiscal 2006 includes a $.07 charge perdiluted share as a result of the January 12, 2006 Chapter 11 bankruptcyfiling by our customer Musicland

·                  Totalliabilities increased to $46.0 million due primarily to increased borrowingsunder our line of credit for the acquisition of Home Vision Entertainment and the funding of advances paid for newrelease and future content

·                  On October 14,2005, we completed consolidation of newly acquired Home Vision into ourexisting facilities

·                  On October 31,2005, the special committee of our board of directors rejected an unsolicitedacquisition proposal from Lions Gate Entertainment Corp. and ended discussionswith them

·                  On October 31,2005, we adopted a stockholder rights plan

·                  On November 4,2005, we amended our revolving credit line to provide a seasonal increase toour maximum borrowing availability from $21 million to $25 million each yearfrom October 31 through April 15

·                  On February 8,2006, we entered into an amended distribution agreement with a content providerand as a result dismissed all related litigation and arbitration proceedings

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·                  On March 29,2006, our board of directors accelerated the vesting on of our all outstandingstock options

·                  On April 10,2006, we engaged Lazard Frères & Co. LLC as our sole financial advisor

·                  On June 6,2006, Lions Gate nominated a competing slate of six Board nominees for electionat the upcoming annual stockholders’ meeting scheduled for October 10,2006

·                  On June 23,2006, we further amended our revolving credit facility, reducing the requiredminimum  EBITDA covenants effective on ago-forward basis

·                  In June 2006,we reached an agreement in principle with Sonopress LLC, subject to their finalcredit approval, for a five-year disc replication agreement and immediatelythereafter will receive a non-interest bearing $10 million advance againstfuture replication to be repaid at $0.20 per disc manufactured, plus a $0.042administrative charge per disc manufactured until the advance is repaid.

The highlightsabove are intended to identify some of our more significant events andtransactions during our fiscal year 2006, and recent events which occurredafter the fiscal year end. However, these highlights are not intended to be afull discussion of our results for the year. These highlights should be read inconjunction with the following discussion of “Results of Operations” and “Liquidityand Capital Resources” and with our consolidated financial statements andfootnotes accompanying this report.

We will continueseeking the highest-quality programming available to independents such asourselves to market and distribute in many genres. The following listidentifies some of our higher-profile titles released in fiscal 2006, as wellas some projected higher-profile titles scheduled for release in fiscal 2007:

*Seefollowing page*

 

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| ***Titles Released in Fiscal Year 2006***                     | ** **                                          |
|---------------------------------------------------------------|-----------------------------------------------------|
| *** ***                                                  | ** **                                          |
| **DVD Titles**                                                | **Features/Other:**                                 |
| ** **                                                    |                                                     |
| **Comedy:**                                                   | *Brooklyn  Bound*                                   |
| ** **                                                    | *Callas  Forever*                                   |
| *Ron White: You Can’t Fix Stupid*                        | *Justice*                                           |
| *Jim Gaffigan: Beyond The Pale*                               | *Dark*                                              |
| *Bill, Jeff, Larry and Ron Box*                               | *Merci  Docteur Rey*                                |
| *Gilbert Gottfried: Dirty Jokes*                              | *My Name  is Nobody*                                |
| *Bill Maher: I’m Swiss*                                  | *Searching  For the Wrong-Eyed Jesus*               |
| *Eddie Griffin: Voodoo Child*                                 | *Eve’s  Christmas*                             |
| *Richard Lewis: Hell Trilogy*                                 | *Football  Factory*                                 |
| *Just For Laughs: Gags Volumes 1 and 2*                       | *Witches  of the Caribbean*                         |
| *Just For Laughs: Stand-up Volumes 1 and 2*                   | *Grimm*                                             |
| *Latinologues Volumes 1 and 2*                                | *Volcanoes  of the Deep Sea (filmed in IMAX)*       |
| *Laffapalooza Five & Six and Box (with  Jamie Foxx)* | ** **                                          |
| *Howie Mandel: First Special*                                 | **Criterion  Branded:**                             |
| *Red Skelton Collection*                                      | * *                                            |
| * *                                                      | *3 Films  By Louis Malle*                           |
| **TV:**                                                       | *Bad  Timing*                                       |
| ** **                                                    | *Angel  at My Table*                                |
| *Chronicles of Narnia - Remastered*                           | *Kind  Hearts and Coronets*                         |
| *Combat: Seasons 4 and 5*                                     | *Metropolitan*                                      |
| *Combat: Complete Series*                                     | *Pickpocket*                                        |
| *Twilight Zone: Definitive Edition Seasons 3 — 5*        | *Harakiri*                                          |
| *Twilight Zone: 80’s Seasons 2 and 3*                    | *Heaven  Can Wait (1943)*                           |
| *Dick Van Dyke: Complete Box Set*                             | *Tales  of Hoffmann*                                |
| *Nowhere Man (Complete TV Series)*                            | *Hoop  Dreams*                                      |
| *Naked City (Classic TV) Box Set*                             | *Jules  And Jim*                                    |
| *Saved By the Bell: New Class Seasons 3  through 7*      | *La bete  Humaine*                                  |
| * *                                                      | *Le  Samourai*                                      |
| **Music-Related:**                                            | *Man Who  Fell To Earth*                            |
| ** **                                                    | *Masculin  Feminin*                                 |
| *Chicago and Earth Wind & Fire: Live at  the Greek*  | *Naked*                                             |
| *Kiss: Rock The Nation Live*                                  | *Ran*                                               |
| *Taste of Chaos*                                              | *Rebel  Samurai: Sixties Swordplay Classics Box*    |
| *Moody Blues: Lovely to See You Live*                         | *Shoot  the Piano Player*                           |
| *Rockin’ the Corps: An American Thank You*               | *Traffic*                                           |
| *Daryl Hall and John Oates Tour Kind of Soul Live*            | *Ugetsu*                                            |
| *Chick Corea Rendezvous Box*                                  | *The  Virgin Spring*                                |
| *Mint Condition Live From the 9:30 Club*                      | *Wages  of Fear*                                    |
| *Candide*                                                     | *Young  Mr. Lincoln*                           |
| *Yes: Songs From The Tsongas*                                 | * *                                            |
| *Bob Dylan: Gotta Serve Somebody (Gospel Songs)*              | **CD  Titles**                                      |
| *Cream: Farewell Concert (Extended Version)*                  | ** **                                          |
| *Diplomats & Friends*                                | *Ron  White: You Can’t Fix Stupid*             |
| *The Eels: With Strings: Live at Town Hall*                   | *The  Source Presents Hip Hop Hits Volumes 10*      |
| *Ray Charles: 50 Years in Music*                              | *Mint  Condition: Livin’ the Luxury Brown*     |
| *Tanya Tucker: Live at Billy Bob’s Texas*                | *Mint  Condition: Live From the 9:30 Club*          |
| *Rat Pack (West-End Original Cast)*                           | *Tanya  Tucker: Live at Billy Bob’s Texas*     |
| * *                                                      | *Live at  Billy Bob’s Texas (Multiple Titles)* |
| **Urban:**                                                    | *Billy  Gilman: Every Thing and More*               |
| ** **                                                    | *Face To  Face: Shoot The Moon*                     |
| *Beef III (QD3*Collection*)*                                  | *Sondheim  Sings: Vol. I and II*                    |
| *Letter to the President (QD3*Collection*)*                   | *Rockin’  The Corps: An American Thank You*    |
| *Fronterz*                                                    | *Taste  of Chaos*                                   |
| *The Industry (Simmons-Lathan)*                               | *Maxim  En Espanol Rockz*                           |
| *History Makers (Simmons Lathan)*                             | *Gilbert  Gottfried: Dirty Jokes*                   |
| *Hood of The Living Dead*                                     | *Las  Vegas: TV Soundtrack*                         |
| *Got Ganked*                                                  | *Charmed:  TV Soundtrack*                           |
| *I Got Five On It*                                            | *Moody  Blues: Lovely To See You Live*              |
| *One Love: The Game The Life*                                 | *Saw II:  Film Soundtrack*                          |
| *One Love: True Ballin*                                       | * *                                            |

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** **
| ***Projected Titles for Fiscal Year 2007***           | *Beef  Box Set*(QD3 Collection)                             |
|-------------------------------------------------------|-------------------------------------------------------------|
| *** ***                                          | * *                                                    |
| **DVD Titles**                                        | **Features/Other:**                                         |
| *** ***                                          | * *                                                    |
| **Comedy:**                                           | *Evil  Aliens*(ContentFilm)                                 |
|                                                       | *Wilderness  Survival for Girls*(ContentFilm)               |
| *Jeff Dunham: Arguing with Myself*                    | *Driftwood*(Dark Horse)                                     |
| *Jamie Kennedy: Unwashed: The Stand-Up Special*       | *Destination  Mars*(Dark Horse)                             |
| *The Pee-wee Herman Show: Live at the Roxy Theatre*   | *Monarch  of the Moon*(Dark Horse)                          |
| *The Next Big Thing*                                  | *Splinter*(Dark Horse)                                      |
| *Goodnight, We Love You*(Phyllis  Diller)             | *The  Hunt*(Graymark*)*                                     |
| *An Evening with Paul Lynde*                          | *Surveillance*(Graymark)                                    |
| *The Complete Kathy and Mo Show*                      | *Souls  Midnight*(Graymark)                                 |
| *Bob & Tom Radio: The Comedy Tour*           | *Patlabor:  The Movie 1 & 2*(Anime)                |
| *25 Years of Improv Comedy*                           | *Her  Majesty*                                              |
| * *                                              | *Goodnight,  Joseph Parker*                                 |
| **TV:**                                               | *Rising  Son:**The Legend of Skateboarder**Christian Hosoi* |
| ** **                                            | (QD3 Collection)                                            |
| *Tommy Lee Goes to College*                           | * *                                                    |
| *The Munsters: America’s First Family of Fright* | **Criterion  Branded:**                                     |
| *Vincent*(Leonard Nimoy)                              | * *                                                    |
| *Combat!: “Best of” Series*                 | *Mr. Arkadin:  The Complete*(Orson Welles)             |
| *Lancelot Link: Secret Chimp*(Original  Series)       | *Fists  in the Pocket*                                      |
| * *                                              | *Koko: A  Talking Gorilla*                                  |
| **Music-Related:**                                    | *Canterbury  Tale, A*                                       |
| ** **                                            | *Dazed  and Confused*                                       |
| *Chuck Berry: Hail! Hail! Rock ‘n’ Roll*    | *Elevator  To The Gallows*                                  |
| *Korn: Live on the Other Side*                        | *Harlan  County USA*                                        |
| *Austin City Limits Music Festival 2005*              | *Kicking  and Screaming*                                    |
| *Yanni: Live! The Concert Event*                      | *Olivier’s  Shakespeare (Box Set)*                     |
| *Yes: 9012 Live*                                      | * *                                                    |
| *Four Tops: 50**th Anniversary Concert*          | **CD  Titles**                                              |
| *Bastards of Young*                                   | ** **                                                  |
| *Who The Hell Is Pete Doherty?*                       | *7**th Heaven:*TV Soundtrack                           |
| *Afro Punk*                                           | *KRS  One: Life*                                            |
| *Steppenwolf*                                         | *Jamie  Kennedy: Unwashed*                                  |
| *Megadeth*                                            | *Jonah  Smith*                                              |
| * *                                              | *Yanni:  Live from Las Vegas*                               |
| **Urban:**                                            | *Austin  City Limits Music Festival 2005*                   |
| ** **                                            | *Afro  Punk*                                                |
| *Russell Simmons Presents: Hip Hop Laws of Success*   | *Billy  Gilman*                                             |
| *One Love 3: Pure Heat*                               | *Megadeth*                                                  |
| *Just For Kicks.*                                     | *The  Source Presents Hip Hop Hits Volume 11*               |
| *Black And Blue: Legends Of The Hip-Hop Cop (QD3*     | *Live at  Billy Bob’s*(multiple titles)                |
| *Collection)*                                         | * *                                                    |
| *Art of 16 Bars (QD3 Collection)*                     | * *                                                    |

* *

**Engagement of Lazard Frères &Co. LLC as Sole Financial Advisor**

On April 10, 2006, our special committee composed of independentdirectors engaged Lazard Frères & Co. LLC as sole financialadvisor. Lazard’s mandate was to assist the special committee in itsdetermination of our strategic options. These options include the acquisitionof or merger into one or more companies, the sale of our company, a “goingprivate” transaction, brokering the buyback or placement of stock held by oneor more existing shareholders, issuance of additional securities (debt, equity,common or preferred) in a private placement or a shelf registration pull-down,strategic distribution alliances with one or more companies, financing of oneor more feature films, locating or creating a feature film development fund,expanding existing sources of funding or finding new ones, and other options. Wedo not intend to provide ongoing disclosure with respect to the exploration ofstrategic alternatives or the progress of the special committee’s process.

 

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**Acquisition and Consolidation of Home VisionEntertainment**

On August 1,2005, we acquired all of the outstanding capital stock of Public Media, Inc.,a Delaware corporation, d.b.a. Home Vision Entertainment, from Adrianne Furnissand Charles Benton for $8 million in cash, and changed its name to Home VisionEntertainment, Inc. We completed the consolidation of all of Home Vision’soperations into our existing facilities in Chatsworth and Las Vegas and closedtheir Chicago corporate headquarters and warehouse and distribution facility inOctober 2005.

Home Vision was aprivately-held, Chicago-based publisher and distributor of home entertainmentprogramming, specializing in independent, foreign and fine art films. Inaddition to releasing its own exclusive titles under the Home Vision label italso co-distributed with us the special edition DVD library of The CriterionCollection.

Home Vision wasour first acquisition target with the corporate goal of enhancing our libraryof exclusive programming, distribution channels and sources of revenue. Webelieve the acquisition offered us cost savings synergies by leveraging ourinfrastructure. We believe the purchase price paid was fair considering theexpected increase in revenue streams originating from the rights acquired, thenet assets acquired, the expected cost savings our infrastructure afforded usand the expected increase in importance to retailers as a result of the addedexclusive brands.

The Home Vision library contains over 130 activetitles, including the BBC productions of C.S. Lewis’ classic books *The Chronicles of Narnia*, *Day of theDolphin* starring Academy Award winner George C. Scott, *Allegro Non Troppo*, George Orwell’s *Animal Farm*,the *Zatoichi*collection (a.k.a. The BlindSwordsman), and *The Yakuza Papers.*In addition toacquiring the Home Vision library, we continue releasing new titles on amonthly basis under the Home Vision label.

The purchase price was financed by our existingrevolving line of credit with Wells Fargo Foothill. The acquisition wasaccounted for as a purchase and accordingly the results of operations of HomeVision are included in our consolidated results of operations from August 1,2005.

We also entered into a consulting agreement with Ms. Furniss,Home Vision’s former President and Chief Executive Officer, who assisted withour consolidation and will assist us in our content acquisition efforts. Paymentsunder this agreement will total $500,000 for the three-year term of theagreement. We also entered into an employment and consulting agreement withHome Vision’s former Chief Financial Officer, who also assisted us with theconsolidation. Payments under this agreement will total approximately $245,000over the one-year term of the agreement.

**Exclusive Distribution Agreement with TheCriterion Collection**

On August 1, 2005, we also entered into anexclusive distribution agreement with The Criterion Collection, a Delawarecorporation, to exclusively distribute their DVD titles in North America.

The agreement formalized previous distributionarrangements with us and Home Vision whereby we exclusively supplied differentretailers with Criterion’s titles. We now receive more favorable purchasediscounts on Criterion’s DVD content as a consolidated purchaser, compared towhen we purchased as separate entities with Home Vision.

We believe The Criterion Collection to be the world’spremier producer of “special edition” home video programming, in whichcritically acclaimed domestic and foreign films are transferred to DVD with thehighest quality of picture and audio, and special features including interviewswith producers, directors and talent, behind-the-scenes footage, documentaries,featurettes, and more. The Criterion Collection currently containsapproximately 290 active DVD titles in its library and releases an average of 3-4new titles each month.

The Criterion Collection has produced special editionsof titles such as Kurosawa’s *Seven Samurai and Ran*,Scorsese’s *Last Temptation of Christ*, Hunter S.Thompson’s *Fear and Loathing in Las Vegas*, *Hoop Dreams*, and *My Own Private Idaho.*The Criterion Collection also controls the distribution of The Merchant IvoryCollection, including *Howard’s End*starring Anthony Hopkins and Vanessa Redgrave, and *Maurice*starring Hugh Grant and Ben Kingsley. Through its affiliate Janus Films, TheCriterion Collection is also responsible for another library of excellentprogramming, including Kurosawa’s *Rashomon* andCocteau’s *Beauty and the Beast*. Pursuant to thedistribution

30

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agreement, we are now the exclusive distributor forall of these programming lines and titles on DVD and all other optical discformats.

We are payingCriterion a $1.5 million non-recoupable distribution fee, payable monthly overthe first twelve months of the term. Should we meet minimum purchase levelsover the initial three years, the term continues through December 31, 2010.We also have the option to extend the term through December 31, 2010, withthe payment of two additional $500,000 non-recoupable payments on January 1,2009 and 2010. If we suffer a major decline in purchases that cannot beattributed to a lack of titles, Criterion has the right to terminate theagreement in years four and five, but we believe this is unlikely. We haveaccrued the unpaid portion of the $1.5 million fee as a component of royaltyand distribution fee advances at March 31, 2006, and are amortizing thefee over the five-year term to cost of sales in accordance with Statement ofPosition No. 00-2. Amortization for the fiscal year ended March 31,2006 was $185,000.

**Lions Gate Proposal**

On August 30, 2005, we received an unsolicited proposal from Lions Gate Entertainment Corp. to acquire all of our outstanding shares. Our board of directors formed a special committee to consider and evaluate the proposal. After entering into a confidentiality agreement, we provided Lions Gate with extensive information (with competitive information redacted) to assist in its due diligence process, and Lions Gate made a revised proposal. On October 31, 2005, the final proposal was rejected on the ground that it was substantially below what the special committee would find acceptable for stockholders.

**Stockholder Rights Plan**

On October 31,2005, we adopted a stockholder rights plan. The plan is intended to protect theinterests of the stockholders from coercive, abusive or unfair takeover tactics.Many public companies and approximately half of the companies on the “Fortune 500”list and two-thirds of the companies on the “Fortune 200” list haverights plans similar to the one we have adopted.

Prior to adoptingthe rights plan, the board was concerned that a person or company could acquirecontrol of the company without paying a fair premium for control or withoutoffering a fair price to all stockholders and that, if a competitor acquiredcontrol of the company, the competitor would have a conflict of interest andcould use any acquired influence over, or control of, the company to thedetriment of our stockholders. We consider the rights plan to be very valuablein protecting both our stockholders’ rights to retain their equity investmentin the company and the full value of that investment.

We believe therights plan represents a sound and reasonable means of addressing the complexissues of corporate policies. Issuance of the rights does not in any wayadversely affect our financial strength or interfere with our business plan. Theissuance of the rights has no dilutive effect, will not affect reportedearnings per share, is not taxable to the company or to stockholders, and willnot change the way in which stockholders can trade our shares. The rights willonly become exercisable upon the occurrence of certain triggering events, andare then intended to operate to protect stockholders against being deprived oftheir rights so they can share in the full measure of our long-term potential.

Continuing ourgrowth and maximizing long-term stockholder value continue to be major goals ofthe board and management.

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**Acceleration of Vesting ofOutstanding Unvested Stock Options**

On March 29,2006, the Compensation Committee of our Board of Directors approved, and ourfull Board ratified, the acceleration of vesting for all outstanding unvestedstock options granted under the our equity compensation plans. In connectionwith the vesting acceleration, the Compensation Committee and the Board alsoimposed a holding period on the shares underlying the accelerated options,which would prevent the sale or other transfer of such shares until the datethe shares would have vested under the original vesting schedule of therespective option, except that the holding period will end upon the close of achange in control transaction. Approximately 402,500 unvested stock optionswere accelerated with an exercise price below the closing price of $3.73 on March 29,2006 (i.e. in-the-money), and approximately 724,830 unvested stock options wereaccelerated with an exercise price above the closing price (i.e.out-of-the-money). The action to accelerate the vesting of unvested stockoptions enables us to minimize recognizing future compensation expenseassociated with our outstanding options upon our adoption of SFAS No. 123R.The fair value of such stock-based compensation that would have been recordedas compensation expense over the remaining vesting periods for the fiscal 2006-2011periods, had we not accelerated the vesting, totaled $1,883,000 (approximately$650,000 for our 2007 fiscal year, beginning April 1, 2006, andapproximately $1,233,000 over the remaining vesting period of the options).

**Potential Acquisitions**

We continue to seek out viable acquisition targets to enhance our library of exclusive programming, distribution channels and sources of revenue. On September 23, 2005, we filed a shelf registration statement that gives us the ability to sell our common stock in one or more offerings to raise cash for acquisitions, debt repayment or working capital and other general corporate purposes. We also filed an acquisition shelf registration statement with the Securities and Exchange Commission to ensure that registered shares of our common stock are available to use as consideration in connection with our acquisition of the assets, businesses or securities of other companies, whether by purchase, merger or other form of business combination. The shares may be offered in separate transactions or, in the aggregate, in a single transaction.

**Subsequent Event — Agreement in Principle for aNew Disc Replication Agreement and Related Advance**

In June 2006,we reached an agreement in principle with Sonopress LLC, for a five-yearreplication agreement to act as our exclusive manufacturer of our DVDrequirements. This will include the HD-DVD and Blu-ray Disc® high-definitionformats. At our option, they may also replicate our CD requirements. We willreceive an interest-free $10 million advance against future replication fromSonopress, to be repaid at $0.20 per disc manufactured, plus payment of a$0.042 administrative fee per disc manufactured until the advance is repaid. Alloutstanding amounts under the advance are subordinated to all of ourobligations outstanding to Wells Fargo Foothill. Until the advance is repaid, Sonopresswill take a security interest in all the Company’s assets in second positionbehind Foothill. The proceeds from the advance will be used to reduce amountsoutstanding under our revolving credit facility with Foothill. The replicationprices under this agreement are less than the current pricing under our currentreplication agreement with Deluxe. For future reporting periods, we will imputeinterest on the amounts outstanding under the advance during the periods andrecord such amount as interest expense with a corresponding reduction to costof sales.

**Liquidityand Capital Resources**

Our workingcapital generally comes from two sources:

·                                          operatingcash flows

·                                          borrowingavailability

In December 2004,we raised approximately $14.2 million in net proceeds through the sale of ourcommon stock. In October 2004, we received a recoupable but non-refundable$2.0 million royalty advance in connection with a new Japan sublicenseagreement. We used the proceeds of the private placement and the royaltyadvance to repay our then-outstanding borrowing under our revolving line ofcredit and term loan facilities with Wells Fargo Foothill.

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*Sony BMGRecoupment*

We received a $3.0 million initial royalty advanceunder the Sony BMG agreement in March 2003, fully recoupable from revenuesgenerated by Sony BMG against quarterly royalties due to us under the agreement.Based upon actual quarterly sales of our programming in the territories, SonyBMG recoups quarterly royalties from the $3.0 million previously advanced. SonyBMG had provided additional quarterly royalty advances such that for the firstthree years of the agreement term through December 31, 2005, the advanceoutstanding to us at any given time was maintained at $3.0 million. During thefirst three quarters of the fourth year of the term (the nine months ending September 30,2006), Sony BMG will reduce, through recoupment, the outstanding royaltyadvance to $1.5 million. Once the entire royalty advance is recouped, Sony BMGwill continue to pay quarterly royalties based on revenues generated. Duringthe fourth quarter of the fourth year of the term (the quarter ending December 31,2006), Sony BMG may recoup the entire remaining balance of $1.5 million by notre-advancing royalties quarterly. The agreement contains a formula to pay anadditional lesser advance at the beginning of the fifth and final year of theterm (calendar 2007) which is to be recouped by Sony BMG during that year. Wemust repay any outstanding unrecouped royalty advance within 30 days followingthe final Sony BMG reporting at the conclusion of Sony BMG’s sell-off periodafter expiration of the five-year term. At March 31, 2006, approximately$2.3 million of the last $3 million advance is classified as a component ofdeferred revenue in the accompanying balance sheet.

*RevolvingCredit and Term Loan Facility*

On August 10, 2005, we entered into an Amendedand Restated Loan and Security Agreement with Wells Fargo Foothill. Theagreement replaces the existing Loan and Security Agreement, dated December 28,1998, as amended. The more significant amended terms of the agreement are asfollows, with other terms remaining generally unchanged:

·                  The maximumrevolving credit line limit was decreased to $21 million from $23 million(actual borrowing availability remains substantially based upon eligible tradeaccounts receivable levels);

·                  The agreementterm was extended two years through December 29, 2009;

·                  The prime andLIBOR interest rate options on borrowings were reduced from prime plus 0.75%(or LIBOR plus 3.5%) to (a) prime plus 0.50% (or LIBOR plus 3.0%) if ouraverage availability under the revolving line is less than $7.5 million and (b) primeplus 0.25% (or LIBOR plus 2.75%) for availability between $7.5 million and $15million. For availability greater than $15 million rates drop to prime (orLIBOR plus 2.50%);

·                  The unused linefee was reduced to 0.125% from 0.25%;

·                  The clearanceday charge and servicing fee were eliminated;

·                  Allowableaccounts receivable dilution, depending upon then-availability, and customerreceivable concentration limits were favorably increased;

·                  Earlytermination fees were increased;

·                  The tangible networth covenant was eliminated; and

·                  The minimumearnings before interest taxes depreciation and amortization (EBITDA) covenantwas revised beginning with the quarter ended June 30, 2005, and aprovision to the EBITDA covenant was also added, such that we may not incur twoconsecutive fiscal quarters of EBITDA losses, beginning with the quarter endingSeptember 30, 2005.

On November 4,2005, at our request, Foothill further amended the credit facility to providefor a higher maximum revolving credit limit during each monthly period from October 31through April 15. During this period each year, the maximum borrowinglimit under our revolving credit line will be increased from $21 million to $25million (actual borrowing availability remains substantially based uponeligible trade accounts receivable levels).

On June 23, 2006, at our request, Foothillfurther amended the credit facility to:

·                  waive ourrequired compliance with the minimum EBITDA requirement for the twelve monthsended March 31, 2006

·                  reduce theminimum EBITDA covenant on a go forward basis, to $3.5 million for the twelvemonths ending June 30, 2006, $3.75 million for the twelve 

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months ending September 30,2006, $4.25 millon for twelve months ending December 31, 2006 and March 31,2007 and $5 million of each twelve month-ended quarterly measurement periodthereafter

·                  amend theprovision that we may not incur two consecutive fiscal quarters of EBITDAlosses, beginning with the quarter ending September 30, 2005 to alsoexclude the period ended March 31, 2006 and period ending June 30,2006

·                  consent allowingus to enter the new replication agreement with Sonopress, receive the relatedadvance as well as allow Sonopress to take a subordinated security interest inour assets

·                  increase ourearly termination fees to 1.5%  on themaximum revolving credit amount (either $21 million or $25 million as notedabove) and any outstanding borrowings under the capital expenditures lineamount through June 30, 2007 and to 1% through June 30, 2008. Priorto the amendment, our early termination fees were 0.75% through September 30,2006 and 0.50% thereafter.

At March 31,2006, we had cash of $1,079,000 and borrowing availability of $6.6 million and$1 million, respectively, under our revolving credit and term loan facilitieswith Foothill. Comparatively, at March 31, 2005, we had cash of $6,339,000and borrowing availability of $17.3 million, and $1 million, respectively,under our revolving credit and term loan facilities. At March 31, 2006, wehad $11.5 million borrowed under the line with $1.5 million borrowed at primeplus 0.25% (8% at March 31, 2006) and $10.0 million borrowed at LIBOR plus3.00% (ranging from 7.69 to 7.87% at March 31, 2006).

*OtherSources and Uses of Working Capital for Fiscal 2006*

We used cash flowsfrom operations of $6.0 million during fiscal 2006, as compared with cash flowsprovided by operations of $6.9 million for fiscal 2005. Our pretax loss fromoperations was $180,000 for fiscal 2006. During fiscal 2006 as compared tofiscal 2005 we used substantial operating cash toward advance royalties,recoupable production costs and distribution fees for the acquisition ofexclusive content for new release and future releases.

During fiscal2006, we advanced $1.5 million upon execution of the exclusive distribution agreementwith The Criterion Collection. We also advanced and accrued approximately $4.0million in production funding for titles to be released in the future under ourfeature film co-production agreements with Dark Horse, Graymark, Amicus andSisters Wooster and advanced an additional $6.0 million during fiscal 2006 forcontent to be released in the future under exclusive license and distributionagreements. We will be able to recoup these advances against future royalties,distribution fees and profit participations payable. Gross trade receivablesdecreased over $7.4 million as a result of increased collection efforts.

We incurred $1.1million in capital expenditures in our continuing effort to improve ourinformation technology infrastructure. We fully repaid our subordinated notepayable to Ritek and our capital lease obligations by $1.4 million duringfiscal 2006. We financed the August 2005 Home Vision acquisition of $8million and the above expenditures and repayments of debt from cash flows fromoperations, cash available on hand and through our revolving line of credit,borrowings under which increased to $11,500,000 at March 31, 2006, downfrom $16,118,000 at our third quarter ended December 31, 2005, and up fromno outstanding borrowings at March 31, 2005.

We believe thatprojected cash flows from operations, borrowing availability under ourrevolving line of credit, cash on hand, and trade credit will provide thenecessary capital to meet our projected cash requirements for at least the next12 months. Should we find attractive corporate acquisitions, we may seekadditional debt or equity financing in order to fund the transaction, in theform of bank financing, convertible debt, or the issuance of convertiblepreferred or common stock.

*ContractualObligations and Commercial Commitments*

The followingtable summarizes our contractual obligations at March 31, 2006, and theeffects such obligations are expected to have on liquidity and cash flow infuture periods:

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| ** **                                       | ** ** | **Payments due by period** | ** ** |
|--------------------------------------------------|------------|----------------------------|------------|
| **(in thousands)**                          | ** ** | **2007**                   | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| Contractual  obligations:                        |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Operating lease  obligations                     |       | $                          | 1,689      |   | $ | 1,656 |   | $ | 1,658 |   | $ | 1,702 |   | $ | 1,745 |   | $ | 4,653 |   | $ | 13,103 |   |
| Licensing and  exclusive distribution agreements |       | 12,444                     |       | 2,839 |   | — |   | — |   | — |   | — |   | 15,283 |   |
| Employment  agreements                           |       | 2,398                      |       | 2,415 |   | — |   | — |   | — |   | — |   | 4,813 |   |
| Total                                            |       | $                          | 16,531     |   | $ | 6,910 |   | $ | 1,658 |   | $ | 1,702 |   | $ | 1,745 |   | $ | 4,653 |   | $ | 33,199 |   |

 

Advances andguarantees included in the table above, under licensing and exclusive distributionagreements, are prepaid and thus recoupable against future royalties,distribution fees and profit participations earned by our exclusive programsuppliers in connection with revenues generated by those rights. As we havehistorically, we expect to fund these commitments through recoupment ofexisting advances, our existing bank line of credit, and other working capital.Included in the table above under licensing and exclusive distributionagreements are approximately $3.8 million in royalty, distribution fee andproduction advances which were accrued as a component of accrued royalty anddistribution fee advances in the accompanying balance sheet at March 31,2006.

We do not expectour obligations for property and equipment expenditures, including informationtechnology related expenditures, to exceed $2.5 million per year.

*VendorManaged Inventory (VMI)*

Under a VMIsystem, product suppliers are responsible for monitoring, stocking, andfulfilling directly to individual retail stores and outlets. Larger retailers,who have been transacting business via VMI with the major studios for years,are starting to require smaller independents (i.e. product suppliers other thanmajor studios, music labels and “mini-majors”) to adopt this method ofinventory management. An existing large retail customer of ours plans torestrict content suppliers from shipping product directly to its stores unlessthey carry a required minimum number of national titles. Image, along withother independents, has formed a consortium of program suppliers to consolidateshipments in order to satisfy this retailer. Under this arrangement, eachmember of the consortium retains its existing direct-selling and direct-billingrelationship with this retailer. Our VMI group is currently one of only threeindependent groups partnering with this retailer. Consortium shipments to thiscustomer will consolidate products from all suppliers in this group, which willresult in larger shipments with freight costs shared among the members. We havefully implemented all of the necessary VMI software and systems, and arecurrently in the final stages of deploying our VMI program with this customer. Weexpect our VMI system to be fully tested and deployed by August 1, 2006. Wewill evaluate the possibility of deploying our VMI system at other retailcustomers as opportunities arise. Implementation of VMI requires a capitalexpenditure of approximately $40,000 for initial setup, installation andIntegration. In addition, ongoing fees will be paid for softwaremaintenance/support, item planning, order management and picking, packing,labeling and shipping of product.  Forthis initial retail customer, fixed software and services fees and variableinventory handling costs should be partially offset by reduced freight expensesfrom consolidated shipments. At this time, we cannot accurately estimate thenet increase in expenses as a result of this system.

With respect tolong-term benefits, we expect the implementation of VMI relationships withretail customers to:

·                  Sellmore units and reduce returned items by better matching inventory to real-timedemand

·                  Reducepotential overproduction by more accurately forecasting orders

·                  Reduceprocessing and warehousing fees by maintaining a leaner supply chain

·                  Increaseour importance as a direct supplier to participating retail partners

*Distribution Agreement and Related Music Publishing Liability*

As of March 31,2006, we have accrued approximately $1.6 million for mechanical licensing feesfor audio programs that we now believe have not been paid by one of our contentproviders as contractually required. We have also recorded a correspondingrecoupable music publishing advance for these anticipated music publishingpayments, included as a component of royalty and distribution fee advances inthe accompanying balance sheet, as of March 31, 2006.

On February 8,2006, we entered into an amended agreement with the content provider, whichgrants us the exclusive right to distribute as many additional contentprovider-branded titles as necessary to fully recoup any outstanding unpaidmechanical licensing and other unrecouped costs. We will continue to receiveour standard distribution fee on all units sold. The amended agreement gives usthe right but not the obligation to discharge any 

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unpaid music publishing fees required. All relatedlitigation and arbitration proceedings have been dismissed. We believe we willrecover all of the $1.6 million in advances through profit participations fromfuture titles and future sales of previously released titles from this contentprovider.

*Long-Term Debt*

Long-term debt at March 31, 2006 and 2005 consisted ofthe following:

 
| **(In thousands)**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|
| Subordinated  note payable — Ritek Taiwan |       | $        | —     |     | $          | 1,337 |   |
| Current portion  of long-term debt             |       | —   |       | 1,337    |       |
| Long-term debt less  current portion           |       | $        | —     |     | $          | — |   |

 

Our subordinated note payable to Ritek was fully repaid in accordancewith its terms by March 31, 2006.

*Debt Instruments and Related Covenants*

Our loan agreements with Wells Fargo Foothill requireus to comply with minimum financial and operating covenants.

On August 10, 2005, the minimum EBITDA covenantwas revised beginning with the quarter ended June 30, 2005. A provision tothe EBITDA covenant was also added, such that we may not incur two consecutivefiscal quarters of EBITDA losses, beginning with the quarter ending September 30,2005.

On June 23, 2006, at our request, Foothillfurther amended the credit facility to:

·                  waive ourrequired compliance with the minimum EBITDA requirement for the twelve monthsended March 31, 2006

·                  reduce theminimum EBITDA covenant on a go forward basis. The required minimum EBITDA wasamended to $3.5 million for the twelve months ending June 30, 2006, $3.75million for the twelve months ending September 30 2006, $4.25 million forthe twelve months ending December 31, 2006 and March 31, 2007 and $5million of each twelve month-ended quarterly measurement period thereafter

·                  amend theprovision that we may not incur two consecutive fiscal quarters of EBITDAlosses, beginning with the quarter ending September 30, 2005 to alsoexclude the period ended March 31, 2006 and the period ending June 30, 2006

We were not in compliance with the covenantestablishing a minimum EBITDA, as defined by Foothill, of $4,250,000 for thetwelve months ended March 31, 2006. Our EBITDA, as defined by Foothill,was $3,506,000, or $744,000 short of the required minimum. At our request,Foothill has waived this minimum EBITDA requirement for the 12 monthmeasurement period ended March 31, 2006 and reduced the EBITDA covenantminimums on a go-forward basis. We were in compliance with all financial andoperating covenants at March 31, 2006, and expect to be in compliance withall covenants for the foreseeable future.

*Off-BalanceSheet Arrangements*

We currently donot have any off-balance sheet arrangements.

**CriticalAccounting Policies**

The discussion andanalysis of our financial condition and results of operations are based uponour financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States. Generallyaccepted accounting principles require management to make estimates, judgmentsand assumptions that affect the reported amounts of assets, liabilities,revenues and expenses, and the disclosure of contingent assets and liabilities.

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We base our estimates on experience and on variousother assumptions that we believe to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that may not be readily apparent from other sources. Ouractual results may differ from those estimates.

We consider ourcritical accounting policies to be those that involve significantuncertainties, require judgments or estimates that are more difficult formanagement to determine, or that may produce materially different results whenusing different assumptions. We consider the following accounting policies tobe critical:

*Revenue Recognition*

We recognize revenue upon meeting the recognitionrequirements of American Institute of Certified Public Accountants Statement ofPosition (SOP) 00-2, *Accounting byProducers or Distributors of Films* and Staff Accounting Bulletin No. 104, *Revenue Recognition*. Revenues from home videodistribution are recognized net of an allowance for estimated returns, as wellas related costs, in the period in which the product is available for sale byour customers (at the point that title and risk of loss transfer to thecustomer, which is generally upon receipt by the customer, and in the case ofnew releases, after “street date” restrictions lapse). We recognize revenuesfrom domestic and international broadcast licensing and home video sublicensing,as well as associated costs, when the titles are available to the licensee andother recognition requirements of SOP 00-2 are met. We defer feesreceived in advance of availability, usually in the case of advances receivedfrom Sony BMG, Digital Site, Warner Music Group and other international homevideo sublicensees, and for broadcast, until other revenue recognitionrequirements have been satisfied. Provisions for uncollectible accountsreceivable are provided at the time of sale. As of March 31, 2006,deferred revenue totaled $5,751,000, up from $5,392,000, at March 31,2005.

*Royaltyand Distribution Fees*

For each reportingperiod, we estimate the ultimate total revenues to be received throughout atitle’s exclusive license or distribution period from exploitation of thattitle in multiple home entertainment formats. While we charge royalty anddistribution fee advances to operations as related revenues are earned,estimates of ultimate revenues are important in determining whether we shouldrecord additional royalty and distribution fee expense as cost of sales in anygiven reporting period. We amortize royalty and distribution fee advances toexpense in the same ratio that the current period revenues for a title or groupof titles bear to the estimated remaining unrecognized ultimate revenues forthat title. Additionally, in circumstances required by SOP 00-2, werecognize additional amortization to the extent that capitalized advanceroyalty and distribution fees exceed their estimated fair value in the periodwhen estimated.

We base ourestimates of ultimate revenue for each title on the historical performance ofthat title, similar titles and specific genre performance. We attempt toreflect in our estimates the most current available information on the title. Weupdate such estimates based upon the actual results of each format’s revenueperformance. Estimates of ultimate revenues on a title-by-title basis aresubject to substantial uncertainty. Factors affecting future actual performanceinclude focus from the sales and marketing department (including advertising,promotions and price reductions), availability of retail shelf space, retailcustomer product placement and advertising, maintenance of adequate inventorylevels, concert touring by the artist in the case of music-related DVDs andCDs, retail sell-through, and ultimately continued end-user consumer demand. Anyof the above factors can contribute to a title’s actual performance exceedingour expectations prior to release or failure to meet pre-release expectations. Overestimationof ultimate revenues would cause unamortized costs to be amortized at a slowerrate or a delay in adjusting costs to their fair value until such timeestimates are reduced, causing unamortized costs to be overstated and increasedamortization of costs in a later period. Underestimation of ultimate revenueswould cause unamortized costs to be amortized more quickly until ultimaterevenue estimates are increased, causing unamortized costs to be understatedand decreased amortization of costs in a later period.

*InventoryValuation*

For each reportingperiod, we evaluate our ending inventories for excess quantities andobsolescence. This evaluation includes analysis of historical sales levels bytitle, format and genre, and projections of future demand. In addition, wewrite down inventories that are considered obsolete or overstocked. Remaininginventory balances are adjusted to approximate the lower-of-cost or marketvalue, and result in a new basis in such inventory until sold. If future demandor market conditions are less favorable than our projections, additionalinventory write downs may be required, and would be reflected in cost of salesin the period the revision is made. Future demand will be dependent 

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upon the continued retail customer acceptance of ourcontent, future demand by end-user consumer, advertising, promotions and pricereductions, market conditions (either favorable or unfavorable) and futurewarehouse storage limitations. Should projections of future inventory demand beoverstated, the value of inventory would be overstated and current cost ofsales understated, with future cost of sales overstated. Conversely, shouldprojections of future demand be understated, the value of inventory would beunderstated and the current cost of sales overstated, with future cost of salesunderstated.

*Allowancefor Sales Returns and Doubtful Accounts Receivable*

For each reportingperiod, we evaluate product sales and accounts receivable to estimate theireffect on revenues due to product returns, sales allowances and other creditsgiven and delinquent accounts. Our estimates of product sales that will bereturned and the amount of receivables that will ultimately be collectedrequire the exercise of judgment and affect reported revenues and net earnings.In determining the estimate of product sales that will be returned, we analyzehistorical returns (quantity of returns and time to receive returned product),historical pricing and other credit memo data, current economic trends, andchanges in customer demand and acceptance of our products, including reorderactivity. Based on this information, we reserve a percentage of each dollar ofproduct sales where the customer has the right to return such product andreceive a credit memo. Actual returns could be different from our estimates andcurrent provisions for sales returns and allowances, resulting in futurecharges to earnings. Estimates of future sales returns and other credits aresubject to substantial uncertainty. Factors affecting actual returns includeretailer financial difficulties, the perception of comparatively poor retailperformance in one or several retailer locations, limited retail shelf space atvarious times of the year, inadequate advertising or promotions, retail pricesbeing too high for the perceived quality of the content or other comparablecontent, the near term release of similar titles, and poor responses to packagedesigns. Underestimation of product sales returns and other credits wouldresult in an overstatement of current revenues and lower revenues in futureperiods. Conversely, overestimation of product sales returns would result in anunderstatement of current revenues and higher revenues in future periods.

Similarly, weevaluate accounts receivable to determine if they will ultimately be collected.In performing this evaluation, significant judgments and estimates areinvolved, including an analysis of specific risks on a customer-by-customerbasis for our larger customers and an analysis of the length of timereceivables have been past due. Based on this information, we reserve an amountthat we believe to be doubtful of collection. If the financial condition of ourcustomers were to deteriorate or if economic conditions were to worsen,additional allowances might be required in the future. Underestimation of thisallowance would cause accounts receivable to be overstated and current periodexpenses to be understated. Overestimation of this allowance would causeaccounts receivable to be understated and current period expenses to beoverstated.

*Valuationof Deferred Income Taxes*

Income taxes are accounted for under the asset andliability method. Deferred tax assets and liabilities are recognized for thefuture tax consequences attributable to differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax bases and operating loss and tax credit carry forwards. Deferredtax assets and liabilities are measured using enacted tax rates expected toapply to taxable income in the years in which those temporary differences areexpected to be recovered or settled.  Wemust assess the likelihood that our deferred tax assets will be recovered fromfuture taxable income, and to the extent that it is more likely than not thatsuch deferred tax assets will not be realized, we must establish a valuationallowance. The establishment, or increase, of a valuation allowance increasesincome tax expense for such year.

*Establishmentof Valuation Allowance on Net Deferred Tax Assets*. Wehave a valuation allowance against 100% of our net deferred tax assets, whichare composed primarily of net operating loss (NOL) carry forwards, resulting inincome tax expense of $6,244,000 for the year ended March 31, 2004. Eventhough we have fully reserved these net deferred tax assets for book purposes,we would still be able to utilize them to reduce future income taxes payableshould we have future earnings. To the extent such deferred tax assets relateto NOL carry forwards, the ability to use such NOLs against future earningswill be subject to applicable carry forward periods. As of March 31, 2006,we had net operating loss carry forwards for Federal and state tax purposes of$7,806,000 and $1,862,000, respectively, which are available to offset taxableincome through 2024 and 2014, respectively.

Although we had apretax loss of less than $200,000 for fiscal 2006 and pretax earnings of$5,289,000 for fiscal 2005, we do not possess a strong earnings history. Weenjoyed the benefits of a strong schedule of new DVD and 

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CD releases during fiscal 2005. In light of theextremely strong retail success of a relatively few individual titles, wecannot provide assurances that our fiscal 2007 DVD and CD new releases willperform as well as, or better than, our fiscal 2005 and 2006 releases.

**Resultsof Operations**

***Net Revenues***

Approximately 90% of consolidated net revenues weregenerated from our worldwide sale of DVDs during fiscal 2006, compared to 89%and 91% in fiscal 2005 and 2004, respectively. CDs contributed approximately 8%of consolidated net revenues for fiscal 2006, compared to 10% and 7% of fiscal2005 and 2004, respectively. The following table presents consolidated netrevenues by reportable business segment for the fiscal years ended March 31:

 
| ** **    | ** ** | **2006**           | ** ** | **2005**   | ** ** | **% Change**  | ** ** | **2005**   | ** ** | **2004** | ** ** | **% Change** | ** ** |
|---------------|------------|--------------------|------------|------------|------------|--------------------|------------|------------|------------|----------|------------|-------------------|------------|
| ** **    | ** ** | **(in thousands)** | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| Net revenues: |       |               |       |       |       |               |       |       |       |     |       |              |       |
| Domestic      |       | $                  | 108,667    |       | $          | 113,219            |       | (4.0       | )%         | $        | 113,219    |              | $          | 78,370 |   | 44.5 | % |
| International |       | 3,235              |       | 5,164      |       | (37.4              | )          | 5,164      |       | 6,470    |       | (20.2             | )          |
| Consolidated  |       | $                  | 111,902    |       | $          | 118,383            |       | (5.5       | )%         | $        | 118,383    |              | $          | 84,840 |   | 39.5 | % |

 

*Fiscal 2006 Compared to 2005 and 2004*

*Domestic Revenue*

Net revenues were down primarily due to weakness inthe retail DVD marketplace during the first six months of our fiscal yearcoupled with fewer fiscal 2006 breakout DVD new releases. We began fiscal 2006having to compete with our record revenue performance in fiscal 2005.  In fiscal 2005, we benefited from new releasesof stand-up comedy shows we produced featuring “Blue Collar” comedians Larrythe Cable Guy, Ron White and Bill Engvall, and a combined two-titles-in-one DVDfrom a fourth Blue Collar comedian, Jeff Foxworthy. These four then-new releasetitles generated over $22 million in net sales during fiscal 2005 compared to$5.4 million generated as catalogue titles in fiscal 2006. Our then-perennialbest-selling music DVD catalogue title *Eagles:Hell Freezes Over*, to whichour rights expired in June 2005, contributed $1.8 million in net revenuesin fiscal 2005 but only minimal revenues in fiscal 2006.

We were able to make up much of this deficit in fiscal2006 though increased revenues associated with our acquisition of Home Visionin August 2005 and some higher performing new releases during the fiscalyear. Through the Home Vision acquisition, we acquired the exclusive rights tothe BBC production of C.S. Lewis’ classic books *TheChronicles of Narnia*which contributed over $8.4 million for fiscal2006. The Criterion Collection contributed $26.1 million to fiscal 2006 netrevenues, a 91% increase over fiscal 2005. The Criterion Collection net revenueperformance during the last eight months of fiscal 2006, starting from the August 2006effective date of our exclusive distribution agreement with them, is up 141%compared to the same time period in the prior year when distribution was sharedwith Home Vision. Net revenues generated from the Criterion Collection were$22.9 million for the eight months ended March 31, 2006, up from $9.5million for the same period in the prior year. In February 2006, WaltDisney Pictures and Walden Media announced that they will release *The Chronicles of Narnia: Prince Caspian* as the nexttheatrical installment of the “Narnia Chronicles”. This should bode well for usas our Chronicles box set includes the BBC production of *PrinceCaspian*. Criterion’s new release schedule for fiscal 2007 should bestrong and we expect continued strong performance from their catalog ofpreviously released DVD programming.

Our CD revenues were down 25%, to $9.1 million forfiscal 2006 compared to $12.1 million for fiscal 2005, due to weakerperformance of our catalogue CD titles, especially during the first six monthsof the fiscal year. CD revenues were $5.6 million for fiscal 2004. Our audiodepartment plans to focus specific attention during fiscal 2007 on setting upcatalogue promotions to stimulate retailer demand for our audio titles in hopesof reversing this trend with retail.

Our top ten new release DVD and CD titles contributedapproximately 16%, 29% and 15% of domestic net revenues for fiscal 2006, 2005and 2004, respectively. Included in the top ten new release titles for fiscal2006 were both the DVD and CD releases of *Ron White: You Can’t FixStupid*, *Chicago and Earth Wind &Fire: Live at the Greek* DVD, *Kiss: Rock The Nation Live*DVD, the original *Twilight Zone TV series: Seasons 3, 4 and 5*DVD,*The Source Presents Hip Hop Hits Vol. 10*CD,*Beef 3* DVD and *MintCondition: Livin’ the Luxury Brown* CD.

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Our inventory returns, as a percentage of our grossdistribution revenues, were 21.9% in fiscal 2006, 18.8% in fiscal 2005 and19.2% in fiscal 2004. We are selling more programming to larger retailers, whotend to return a higher percentage of their purchases, both to us and to themajor studios. Many of these retailers have chosen not to process their ownstore returns at their own distribution center level, but instead return themto their vendors, including us, for credit. A retailer may return a title fromone store while ordering the same title for another store. We have increasedour allowances for sales returns in expectation of this trend continuing forthe foreseeable future.

We have also provided increased market developmentfunds to our customers for which are taken as a credit against revenues and arerecorded by us as a reduction in revenues. These market development fundexpenditures totaled $5,329,000, $4,530,000 and $2,437,000, or 4.7%, 3.8% and3.0% of net domestic revenues, before reduction for such market developmentfunds, for fiscal 2006, 2005 and 2004, respectively.

*International Revenue*

Our internationally generated revenues havesignificantly decreased over the last several years due to lower royaltyrevenues reported by our international sublicensees. Because of language barriersand cultural differences, much of our successful new release programming — particularlyurban and comedy titles — has not been released internationally or has not soldas well as in North America. Only our high profile non-urban music event DVDprogramming is performing well overseas. Our international revenues for fiscal2006 were negatively affected by the loss of our then-perennial best sellinginternational title*Eagles: Hell Freezes Over* as of June 30, 2005. Our international net revenues from the saleof our Eagles titles during fiscal 2005 were $1,133,000, or 22% ofinternational net revenues.

We believe internal restructuring at Sony BMGassociated with their merger in 2004 and management reshuffling in early 2006had a negative impact on the sales performance of our titles in Europe, theMiddle East and Africa during the last half of fiscal 2005 and throughoutfiscal 2006.

We continue our efforts to acquire programming thatsells well not only domestically, but also internationally. Music-related DVDshave done well internationally and we believe the urban music and documentarygenres have revenue growth potential overseas. Our UK office, while primarilyacquiring content for North American distribution, is also beginning to seekworldwide exclusive distribution rights.

Broadcast sales increased to $494,000 for fiscal 2006,up from $487,000 for fiscal 2005 and down from $544,000 for fiscal 2004.

***Cost of Sales***

The following table presents consolidated cost ofsales by reportable business segment and as a percentage of related-segment netrevenues for the fiscal years ended March 31:

 
| ** **     | ** ** | **2006**           | ** ** | **2005**   | ** ** | ** **         | ** ** | **2005**   | ** ** | **2004** | ** ** | ** ** | ** ** |
|----------------|------------|--------------------|------------|------------|------------|--------------------|------------|------------|------------|----------|------------|------------|------------|
| ** **     | ** ** | **(in thousands)** | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| Cost of sales: |       |               |       |       |       |               |       |       |       |     |       |       |       |
| Domestic       |       | $                  | 81,748     |       | $          | 84,827             |       |       |       | $        | 84,827     |       | $          | 61,331 |   |   |   |
| International  |       | 2,420              |       | 3,608      |       |               |       | 3,608      |       | 5,264    |       |       |       |
| Consolidated   |       | $                  | 84,168     |       | $          | 88,435             |       |       |       | $        | 88,435     |       | $          | 66,595 |   |   |   |

 

 
| ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | **% Change** | ** ** | ** ** | ** ** | ** ** | ** ** | **% Change** | ** ** |
|-------------------------------------------|------------|------------|------------|------------|------------|-------------------|------------|------------|------------|------------|------------|-------------------|------------|
| As a percentage  of segment net revenues: |       |       |       |       |       |              |       |       |       |       |       |              |       |
| Domestic                                  |       | 75.2       | %          | 74.9       | %          | 0.3               | %          | 74.9       | %          | 78.3       | %          | (3.4              | )%         |
| International                             |       | 74.8       |       | 69.9       |       | 4.9               |       | 69.9       |       | 81.4       |       | (11.5             | )          |
| Consolidated                              |       | 75.2       | %          | 74.7       | %          | 0.5               | %          | 74.7       | %          | 78.5       | %          | (3.8              | )%         |

 

We are now classifying production cost amortization asa component of cost of sales and therefore a reduction to gross profit marginsfor all periods presented. We previously reported amortization of productioncosts as a separate line item within operating costs and expenses. Because wedisclose programming production costs as a component of inventory, 

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we believe classification of the related expense ofsuch costs as a component of cost of sales is more meaningful. Amortization ofdomestic and international non-recoupable production costs, as a percentage ofnet revenues, for the three years ended March 31, 2006, were 4.1%, 3.4%and 4.7%, respectively.

*Fiscal 2006 Compared to 2005*

*Domestic Gross Margins*

Domestic gross margins, as a percentage of segment netrevenues, decreased by 0.3% to 24.8% for fiscal 2006, from 25.1% for fiscal2005 and from 21.7% for fiscal 2004. The decrease in segment gross profitmargins for fiscal 2006 as compared to fiscal 2005 was due to multiple factors:

·                  We experienced asignificant increase in net revenues generated by The Criterion Collection DVDsfor fiscal 2006. Criterion contributed approximately 24% of fiscal 2006 domesticnet revenues, significantly up from approximately 12% for fiscal 2005. Werecognize a gross margin of approximately 24% on Criterion net revenues,bringing down the average gross margin on fiscal 2006 net sales.

·                  We increased theamount of market development funds provided to our customers, which is recordedas a reduction of revenues and thus has a negative effect on gross margins. Thesemarket development fund expenditures, as percentages of domestic net revenues,were 4.7% and 3.8%, before reduction for such market development funds, forfiscal 2006 and 2005, respectively. We expect the trend of increasing marketdevelopment funds paid to customers to continue for the foreseeable future.

·                  We increased thecomparable fair value write downs of royalty and distribution fee advances as aresult of lower ultimate revenue forecasts for some of our exclusiveprogramming in accordance with SOP-002 by $586,000 for fiscal 2006 over2005.

·                  We amortizedapproximately $185,000 of the $1.5 million fee resulting from the new Criterionexclusive distribution agreement.

·                  We increased thecomparable write down to the lower of cost or market value for inventories by$412,000 for fiscal 2006 over 2005.

·                  Amortization ofnon-recoupable production costs increased by $467,000 for 2006 over 2005 as aresult of incremental amortization of titles acquired in the Home Visionacquisition as well as increased amortization of costs associated with titlesproduced in the UMD format, which we believe has a short product life cycle.

·                  Duringthe fourth quarter we reversed an overaccrual of music publishing liabilitieson a DVD series, partially offsetting the decline in gross margins. During thefourth quarter we were notified by a content holder that the actual negotiatedmusic publishing rate for DVD titles licensed from this content supplier waslower than the estimated rate at which we accrued. Without the actual rateknown at the time of release of the related DVDs, we accrue music publishingliability at an estimated maximum rate as we sell the programs. Accordingly, wereversed approximately $562,000 in accrued music publishing as a credit to costof sales during the fourth quarter to reflect the comparably lower actualnegotiated music publishing rate.

*Fiscal 2005 Compared to 2004*

The increase in segment gross profit margins forfiscal 2005 was primarily due to increased net revenues from sales ofexclusively licensed programming, which typically generates higher grossmargins than exclusively distributed programming.

Offsetting the increase in domestic gross margins forfiscal 2005 as compared to fiscal 2004 were increases in market developmentfunds offered to our retail customers. These market development fundexpenditures were 3.8% and 3.0% of net domestic revenues, before reduction forsuch market development funds, for fiscal 2005 and 2004, respectively.

 

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*International Gross Margins*

Gross margins for the international segment are basedupon royalty income generated by sales of our exclusive programming by oursublicensees. The gross margins we report will fluctuate depending upon thesales mix of titles sold by our sublicensees, the sales programs they have inplace during the period, and royalty rates to our content suppliers based uponthose reported royalties. We expect gross margins for this segment to continueto fluctuate higher and lower in future periods as a result of the factorsmentioned above.

***Selling Expenses***

The following tables present consolidated sellingexpenses by reportable business segment and as a percentage of related segmentnet revenues for the fiscal years ended March 31:

 
| ** **                                | ** ** | **2006**           | ** ** | **2005**   | ** ** | **% Change**  | ** ** | **2005** | ** ** | **2004** | ** ** | **% Change** | ** ** |
|-------------------------------------------|------------|--------------------|------------|------------|------------|--------------------|------------|----------|------------|----------|------------|-------------------|------------|
| ** **                                | ** ** | **(in thousands)** | ** ** | ** ** | ** ** | **(in thousands)** | ** ** |
| Selling expenses:                         |       |               |       |       |       |               |       |     |       |     |       |              |       |
| Domestic                                  |       | $                  | 10,647     |       | $          | 9,795              |       | 8.7      | %          | $        | 9,795      |              | $          | 5,902 |   | 66.0 | % |
| International                             |       | 103                |       | 58         |       | 77.6               |       | 58       |       | 184      |       | (68.5             | )          |
| Consolidated                              |       | $                  | 10,750     |       | $          | 9,853              |       | 9.1      | %          | $        | 9,853      |              | $          | 6,086 |   | 61.9 | % |
| As a percentage  of segment net revenues: |       |               |       |       |       |               |       |     |       |     |       |              |       |
| Domestic                                  |       | 9.8                | %          | 8.7        | %          | 1.1                | %          | 8.7      | %          | 7.5      | %          | 1.2               | %          |
| International                             |       | 3.2                |       | 1.1        |       | 2.1                |       | 1.1      |       | 2.8      |       | (1.7              | )          |
| Consolidated                              |       | 9.6                | %          | 8.3        | %          | 1.3                | %          | 8.3      | %          | 7.2      | %          | 1.1               | %          |

 

*Fiscal 2006 Compared to 2005 and 2004*

*Domestic Selling Expenses*

Domestic sellingexpenses for fiscal 2006 reflect a continuing trend of higher advertisingexpenses as a percentage of net revenues. We incurred a $262,000 increase inexpenses for television and radio advertising as well as a $365,000 increase inco-operative advertising expenses. We saved $161,000 by switching to Internetdelivery of sell sheets instead of paper sell sheets delivered via mail. Wealso reduced our print advertising by $238,000. Personnel costs, including wages,benefits and internal sales commissions, were up $486,000 for fiscal 2006 overfiscal 2005 due to added sales personnel and annual raises.

Egami sellingexpenses were $196,000 for fiscal 2006, its first full year of operation,composed primarily of personnel costs.

Print, television,radio and co-operative advertising increased $1,727,000, and special eventaudio and video promotions and publicity consultant expense increased $344,000for fiscal 2005 as compared to the prior year. Personnel costs, includingwages, benefits and sales commissions, were up $1,055,000 for fiscal 2005 overfiscal 2004 due to added sales personnel and annual raises. Sales commissionspaid to outside consultants increased by $263,000 for fiscal 2005, primarily asa result of a significant increase in fiscal 2005 sales to Target. Rent expenseallocated to the domestic selling department in excess of fiscal 2004 was$157,000. Lastly, travel and entertainment expenses were higher by $155,000over that of fiscal 2004.

Print, television, radio and cooperative advertising,audio and in-store promotions are increasingly important to our retailcustomers and influence the size and breadth of their initial orders for ourtitles. The likelihood of our larger retailers placing an order for our DVD andCD titles in a significant quantity is enhanced with a convincing outlay ofmarketing funds to increase product awareness and sales to the end consumer. Itis common and increasingly necessary to spend from seventy cents to in excessof one dollar per unit in order to effectively promote the availability of ahigher-profile title at retail.

We spent approximately $4,904,000, or 4.4% of netrevenues , $4,632,000, or 3.9% of net revenues and $2,445,000, or 2.9% of netrevenues, for title promotion and advertising in fiscal 2006, 2005, and 2004, respectively, almost entirely fordomestic wholesale distribution.

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In fiscal 2005, wesignificantly expanded our sales and marketing department personnel infrastructurein certain key areas in an effort to increase:

·                  salesopportunities with Wal-Mart

·                  specific focuson catalogue product promotion and sales (specifically product in release overone year)

·                  face-to-facesales coverage of key national customers

·                  marketing andsales efforts to grow our audio only brands

·                  marketing andsales efforts to grow our feature film genre, specifically rental customersales

·                  sales of urbanand Latin content

·                  salesadministration for the above initiatives

*International Selling Expenses*

Our international selling expenses reflect increasedinternational promotion of our titles. Fiscal 2005 segment selling expenseswere significantly lower than fiscal 2004 because Sony BMG, Digital Site andWarner Music Group, our primary international sublicensees, are responsible forthe majority of selling expenses relating to sales of our programminginternationally. Our segment expenses for the fiscal 2005 period reflect a fullperiod of Sony BMG sales and marketing responsibility, whereas fiscal 2004 didnot.

***General and AdministrativeExpenses***

The following tables present consolidated general andadministrative expenses by reportable business segment and as a percentage ofrelated segment net revenues for the fiscal years ended March 31:

 
| ** **                               | ** ** | **2006**            | ** ** | **2005**   | ** ** | **% Change**   | ** ** | **2005**   | ** ** | **2004** | ** ** | **% Change** | ** ** |
|------------------------------------------|------------|---------------------|------------|------------|------------|---------------------|------------|------------|------------|----------|------------|-------------------|------------|
| ** **                               | ** ** | **(in  thousands)** | ** ** | ** ** | ** ** | **(in  thousands)** | ** ** | ** ** | ** ** |
| General and  administrative expenses:    |       |                |       |       |       |                |       |       |       |     |       |              |       |
| Domestic                                 |       | $                   | 16,014     |       | $          | 13,651              |       | 17.3       | %          | $        | 13,651     |              | $          | 11,937 |   | 14.4 | % |
| International                            |       | 446                 |       | 441        |       | 1.1                 |       | 441        |       | 488      |       | (9.6              | )          |
| Consolidated                             |       | $                   | 16,460     |       | $          | 14,092              |       | 16.8       | %          | $        | 14,092     |              | $          | 12,425 |   | 13.4 | % |
| As a percentage of segment net revenues: |       |                |       |       |       |                |       |       |       |     |       |              |       |
| Domestic                                 |       | 14.7                | %          | 12.1       | %          | 2.6                 | %          | 12.1       | %          | 15.2     | %          | (3.1              | )%         |
| International                            |       | 13.8                |       | 8.5        |       | 5.3                 |       | 8.5        |       | 7.5      |       | 1.0               |       |
| Consolidated                             |       | 14.7                | %          | 11.9       | %          | 2.8                 | %          | 11.9       | %          | 14.6     | %          | (2.7              | )%         |

 

*Fiscal 2006 Compared to 2005 and 2004*

*Domestic General and Administrative Expenses*

In our third quarter we incurred a bad debt charge of$1.6 million as a result of the January 12, 2006, bankruptcy filing ofMusicland. We also incurred an impairment charge for the cumulative cost of athird-party software program totaling $248,000. We also incurred increases inlegal expenses of $432,000, with approximately $247,000 relating to the LionsGate legal matter and incurred increased personnel costs of $484,000 due toadditional personnel and annual raises. Additionally, the general andadministrative expenses of Egami and Image UK totaled $202,000 and $409,000,respectively, for fiscal 2006, their first full year of operation. Expenses forEgami are primarily personnel and expenses for Image UK are primarily personneland rent and utilities associated with the leased office space. The overallincreased expenses were offset, in part, by reduced expenses of $431,000 forconsulting and professional services in connection with information technologysystems and accounting, net of increased investment banking fees and reducedexpenses of $679,000 due to the lack of performance-based bonuses for fiscal2006.

The Musiclandcharge reflects the net expense after reversing royalties and distribution feesotherwise payable by us had we collected the Musicland trade receivable. Wehave written off as uncollectible the entire Musicland trade receivablesbalance at March 31, 2006. The bad debt charge represents $.07 per dilutedshare for fiscal 2006.

For fiscal 2006, Musicland accounted for less than 5%of our net revenues. We believe the bankruptcy will continue to negativelyimpact our short-term revenues, but we also believe the bankruptcy should nothave a long-term negative effect on our revenues as we expect traditional andonline retailers to absorb Musicland’s share of the DVD and 

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CD market. Trans World Music Entertainment Corporation,a customer of ours, received United States Bankruptcy Court approval for theasset acquisition of Musicland. It has been reported that Trans World retained approximately335 of Musicland’s best performing stores and liquidated the remaining 65stores. The remaining 400 stores not acquired by Trans World of the more than800 stores that Musicland operated were closed through the bankruptcy process.

In fiscal 2005, we accrued performance-based bonusesof $659,000 compared to none for fiscal 2004. Rent expense for our then-newheadquarters in excess of rent for our old headquarters in fiscal 2004 was$329,000. We incurred increased depreciation expense of $256,000 for fiscal2005, resulting from our increased capital expenditures in the areas ofinformation technology, furniture, leasehold improvements and equipment. Expenditureson information technology and accounting and royalty consulting and temporarysupport contributed $414,000 of the increase in fiscal 2005, primarilyattributable to the support of the first and second phases of our Oracleimplementation implemented in fiscal 2004, and the fiscal 2005 implementationof order management software, including accounting and information technologyinfrastructure support. Lastly, personnel costs were up $221,000 for fiscal2005, largely due to annual raises. Offsetting the fiscal 2005 increases werelower legal expenses of $233,000. In the prior year we had higher litigationexpenses relating to our efforts to protect our rights from infringers.

***Other Income and Expenses***

Other income for fiscal 2006 was minimal. Otherexpenses for fiscal 2005 consisted primarily of losses on disposal of fixedassets. Other income for fiscal 2004 primarily consisted of foreign currencytransaction gains and a minority interest in the net loss of Aviva.

***Interest Expense***

Interest expense, net of interest income, for fiscal2006 increased 6.3% to $707,000, or 0.6% of consolidated net revenues, from$665,000, or 0.6% of consolidated net revenues for fiscal 2005. The increasewas attributable to a higher weighted average interest rate for fiscal 2006. Interestexpense for fiscal 2004 was $818,000 or 1.0% of consolidated net revenues. Thedecrease in fiscal 2005 from 2004 was attributable to lower weighted averageoutstanding debt levels during fiscal 2005 compared to fiscal 2004, principallyas a result of paying down our revolving credit facility with proceeds from ourDecember 2004 private placement.

***Income Taxes***

We recorded Federal and California state alternativeminimum tax for fiscal 2006, 2005 and 2004. We utilized net operating losscarry forwards to offset taxable earnings which resulted in a Federal andCalifornia alternative minimum tax due to limitations on the utilization ofthese net operating losses. We also recorded a Texas state tax expense forfiscal 2006.

Income taxes are accounted for under the asset andliability method. Deferred tax assets and liabilities are recognized for thefuture tax consequences attributable to differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax bases and operating loss carry forwards. Deferred tax assets andliabilities are measured using enacted tax rates expected to apply to taxableincome in the years in which those temporary differences are expected to berecovered or settled.  We must assess thelikelihood that our deferred tax assets will be recovered from future taxableincome, and to the extent that it is more likely than not that such deferredtax assets will not be realized, we must establish a valuation allowance. Theestablishment, or increase, of a valuation allowance increases income taxexpense for such year.

*ValuationAllowance on Net Deferred Tax Assets*

In assessing the realizability of a deferred tax asset, Statement ofFinancial Accounting Standards (SFAS) No. 109 requires that all availableevidence, both positive and negative, be considered to determine whether, basedon the weight of that evidence, a valuation allowance is needed. SFAS No. 109further provides that “cumulative losses in recent years” are significantpieces of negative evidence to overcome when determining whether it is “morelikely than not” that the recorded deferred tax assets will be realized in thefuture by reducing future income taxes payable. Such cumulative losses fromprior years must be considered on a pretax consolidated basis from alloperations. In addition to fiscal 2004 pretax losses for both continuing anddiscontinued operations, we also incurred aggregate net pretax losses forfiscal years 2003 and 2002. Accordingly, during fiscal 2004 we established avaluation allowance against 100% of 

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our net deferred tax assets, which were composedprimarily of operating loss carry forwards, resulting in a fiscal 2004 taxexpense of $6,244,000.

Although in fiscal2005 we had pretax earnings of $5,289,000, we did not possess a strong earningshistory. We enjoyed the benefits of a strong schedule of new DVD and CDreleases during fiscal 2005 which we rightfully believed that we would bechallenged to duplicate or exceed in fiscal 2006. We continue to maintain a100% valuation allowance against our net deferred tax assets at March 31,2006.

Even though we have fully reserved our net deferred tax assets for bookpurposes, we would still be able to utilize them to reduce future income taxespayable, should we have future earnings. To the extent such deferred tax assetsrelate to NOL carry forwards, the ability to use such NOL carry forwardsagainst future earnings will be subject to applicable carry forward periods. Asof March 31, 2006, we had net operating loss carry forwards for Federaland state tax purposes of $7,806,000 and $1,862,000, respectively, which areavailable to offset taxable income through 2024 and 2014, respectively.

***Earnings (Loss) from ContinuingOperations/Loss from Discontinued Operations***

Loss from continuing operations was $207,000, or $.01per diluted share, for fiscal 2006. Earnings from continuing operations were$5,127,000, or $.26 per diluted share for fiscal 2005. Loss from continuingoperations was $7,115,000, or $.39 per diluted share, which included the abovementioned income tax expense of $6,244,000, or $.34 per diluted share, forfiscal 2004. Loss from discontinued operations was $2,441,000, or $.13 perdiluted share for fiscal 2004. The fiscal 2004 loss from discontinuedoperations comprises a loss from operations of $1,742,000 and a loss on thesale of DVDPlanet of $699,000.

***Consolidated Net Earnings (Loss)***

Net loss for fiscal 2006 was $207,000, or $.01 perdiluted share. Net earnings for fiscal 2005 were $5,127,000, or $.26 perdiluted share. Net loss for fiscal 2004 was $9,556,000, or $.52 per dilutedshare.

**RecentlyIssued Accounting Pronouncements**

On November 3,2005, the Financial Accounting Standards Board (“FASB”) issued FSP SFAS 115-1and SFAS 124-1, “The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments”. This FSP nullifies certain requirements ofEITF 03-1 and supersedes EITF Topic No. D-44 “Recognition ofOther-Than-Temporary Impairment upon the Planned Sale of a Security Whose CostExceeds Fair Value.” This FSP addresses (1) the determination of when aninvestment is considered impaired, (2) whether such impairment is otherthan temporary, and (3) the measurement of an impairment loss. This FSP alsoincludes accounting considerations subsequent to the recognition of another-than-temporary impairment and requires certain disclosures aboutunrealized losses that have not been recognized as other-than-temporaryimpairments. FSP SFAS 115-1 and SFAS 124-1 is effective for reportingperiods beginning after December 15, 2005, with earlier applicationpermitted. The application of FSP SFAS 115-1 and SFAS 124-1 did nothave a material effect on our results of operations or financial position.

In May 2005,the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections—areplacement of Accounting Principles Board (“APB”) Opinion No. 20 and FASBStatement No. 3”. This Statement replaces APB Opinion No. 20, *Accounting Changes,* and FASB Statement No. 3,*Reporting Accounting Changes in InterimFinancial Statements,* and changes the requirements for theaccounting for and reporting of a change in accounting principle.

SFAS No. 154applies to all voluntary changes in accounting principle. It also applies tochanges required by an accounting pronouncement in the unusual instance thatthe pronouncement does not include specific transition provisions. When apronouncement includes specific transition provisions, those provisions shouldbe followed. Opinion 20 previously required that most voluntary changes inaccounting principle be recognized by including the cumulative effect ofchanging to the new accounting principle within net income of the period of thechange.

SFAS No. 154requires retrospective application to prior periods’ financial statements ofchanges in accounting principle, unless it is impracticable to determine eitherthe period-specific effects or the cumulative effect of the change. When it isimpracticable to determine the period-specific effects of an accounting changeon one or more individual prior periods presented, SFAS No. 154 requiresthat the new accounting principle be applied to the balances of assets 

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and liabilities as of the beginning of the earliestperiod for which retrospective application is practicable and that acorresponding adjustment be made to the opening balance of retained earnings(or other appropriate components of equity or net assets in the statement offinancial position) for that period rather than being reported in an incomestatement. When it is impracticable to determine the cumulative effect ofapplying a change in accounting principle to all prior periods, this Statementrequires that the new accounting principle be applied as if it were adoptedprospectively from the earliest date practicable.

SFAS No. 154defines *retrospective application*as the application of a different accounting principle to prior accountingperiods as if that principle had always been used or as the adjustment ofpreviously issued financial statements to reflect a change in the reportingentity. This Statement also redefines *restatement*as the revising of previously issued financial statements to reflect thecorrection of an error. SFAS No. 154 requires that retrospectiveapplication of a change in accounting principle be limited to the directeffects of the change. Indirect effects of a change in accounting principle,such as a change in nondiscretionary profit-sharing payments resulting from anaccounting change, should be recognized in the period of the accounting change.

SFASNo. 154 also requires that a change in depreciation, amortization, ordepletion method for long-lived, nonfinancial assets be accounted for as achange in accounting estimate affected by a change in accounting principle. SFASNo. 154 carries forward without change the guidance contained in Opinion20 for reporting the correction of an error in previously issued financialstatements and a change in accounting estimate. SFAS No. 154 also carriesforward the guidance in Opinion 20 requiring justification of a change inaccounting principle on the basis of preferability. SFAS No. 154 iseffective for accounting changes made in fiscal years beginning after December 15,2005. We do not believe that this pronouncement will have a material effect onour consolidated financial statements.

InDecember 2004, the FASB issued FASB Staff Position No. FAS 109-1(FSP FAS 109-1), “Application of FASB Statement No. 109, Accountingfor Income Taxes, for the Tax Deduction on Qualified Production ActivitiesProvided by the American Jobs Creation Act of 2005.”  FSP FAS 109-1 clarifies that thededuction will be treated as a “special deduction” as described in SFAS No. 109,“Accounting for Income Taxes.”  As such,the special deduction has no effect on deferred tax assets and liabilitiesexisting at the date of enactment. The impact of the deduction will be reportedin the period in which the deduction is claimed. We do not believe that thispronouncement will have a material effect on our consolidated financialstatements.

InDecember 2004, the FASB issued the SFAS No. 153, “Exchange ofNonmonetary Assets, and An Amendment of APB Opinion No. 29.”  SFAS No 153 addresses the measurement ofexchanges of nonmonetary assets. SFAS No. 153 eliminates the exceptionfrom fair value measurement for nonmonetary exchanges of similar productiveassets in paragraph 21(b) of APB Opinion No. 29, *Accounting for Nonmonetary Transactions*,and replaces it with an exception for exchanges that do not have commercialsubstance. SFAS No. 153 specifies that a nonmonetary exchange hascommercial substance if the future cash flows of the entity are expected tochange significantly as a result of the exchange. The provisions of SFAS No. 153shall be effective for nonmonetary asset exchanges occurring in fiscal periodsbeginning after June 15, 2005. Earlier application is permitted fornonmonetary asset exchanges occurring in fiscal periods beginning after thedate this Statement is issued. The provisions of this Statement shall beapplied prospectively. We do not believe that this pronouncement will have amaterial effect on our consolidated financial statements.

In November 2004, the FASB issued SFAS No. 151,“Inventory Costs — an Amendment of ARB No. 43,” which is the result of itsefforts to converge U.S. accounting standards for inventories withInternational Accounting Standards. SFAS No. 151 requires idle facilityexpenses, freight, handling costs, and wasted material (spoilage) costs to berecognized as current-period charges. It also requires that allocation of fixedproduction overheads to the costs of conversion be based on the normal capacityof the production facilities. SFAS No. 151 will be effective for inventorycosts incurred during fiscal years beginning after June 15, 2005. We areevaluating the impact of this standard on our financial statements. We do notexpect that the adoption of SFAS No. 151 will have an impact on ourfinancial position, results of operations or cash flows.

**ITEM 7A.**           QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

**InterestRate Fluctuations.**At March 31, 2006, we had outstandingborrowings of $11,500,000 subject to variable interest rates. We do not usederivatives to manage interest rate risk. Our interest rate exposure is linkedto the prime rate and LIBOR. We believe that moderate changes in the prime rateor LIBOR would not materially affect our 

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operating results or financial condition. A 1%increase in the prime rate or LIBOR would increase our annual interest expenseby $115,000 based on the outstanding variable interest borrowings at March 31,2006.

**ForeignExchange Rate Fluctuations.**At March 31, 2006,approximately $28,000 of our accounts receivable related to internationaldistribution and were denominated in foreign currencies subject to futureforeign exchange rate risk. We distribute some of our licensed DVD and VHSprogramming internationally through subdistributors and sublicensees. Additionally,we exploit international broadcast rights to our licensed entertainmentprogramming. We believe that moderate changes in the foreign exchange rates forthose agreements denominated in foreign currencies will not materially affectour operating results or financial condition. For example, a 10% change inexchange rates would result in an approximate $3,000 impact on pretax income(loss) based upon those outstanding receivables at March 31, 2006. Althoughour Sony BMG and Digital Site sublicense agreements are U.S. Dollardenominated, with these parties reporting to us and paying us in U.S. Dollars,the underlying Sony BMG sales transactions are in Euros and the underlyingDigital Site sales transactions are in Yen. Should the U.S. Dollar strengthencompared to either the Euro or the Yen, our sublicensees’ reported royalties tous on a title-by-title basis and in the aggregate would decline, assumingconsistent unit sales, and thus reduce our revenues recognized. To date, wehave not entered into foreign currency exchange contracts.

 

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**ITEM 8.  FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

**INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**
|                                                                                                              | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|------------|------------|
| Report of Independent Registered Public Accounting  Firm                                                     |       |       |       |
| Report of Independent  Registered Public Accounting Firm                                                     |       |       |       |
| Consolidated  Balance Sheets at March 31, 2006 and 2005                                                 |       |       |       |
| Consolidated Statements of Operations for the years  ended March 31, 2006, 2005 and 2004                |       |       |       |
| Consolidated Statements of Shareholders’ Equity for  the years ended March 31, 2006, 2005 and 2004 |       |       |       |
| Consolidated Statements of Cash Flows for the years  ended March 31, 2006, 2005 and 2004                |       |       |       |
| Notes to Consolidated Financial Statements                                                                   |       |       |       |
| Schedule II — Valuation and Qualifying Accounts for  the years ended March 31, 2006, 2005 and 2004 |       |       |       |

 

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**Report ofIndependent Registered Public Accounting Firm**

Board of Directors and ShareholdersImage Entertainment, Inc.Chatsworth, California

We have auditedthe accompanying consolidated balance sheets of Image Entertainment, Inc.as of March 31, 2006 and 2005, and the related consolidated statements ofoperations, shareholders’ equity and cash flows for each of the years thenended. We also have audited the schedule as listed in the accompanying index. Theseconsolidated financial statements and schedule are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements and schedule based on our audits.

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements arefree of material misstatement. An audit included consideration of internal controlover financial reporting as a basis for designing audit procedures that areappropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Image Entertainment, Inc. asof March 31, 2006 and 2005, and the results of its operations and its cashflows for each of the years then ended in conformity with accounting principlesgenerally accepted in the United States of America.

Also, in our opinion, theschedule presents fairly, in all material respects, the information set forththerein.

/s/ BDO SEIDMAN LLP

Los Angeles, CaliforniaJune 27, 2006

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**Report of Independent Registered Public AccountingFirm**

The Board of Directors and ShareholdersImage Entertainment, Inc.:

We have auditedthe accompanying consolidated statements of operations, shareholders’ equity,and cash flows of Image Entertainment, Inc. and subsidiaries for the yearended March 31, 2004. In connection with our audit of the consolidatedfinancial statements, we also have audited the financial statement Schedule IIfor the year ended March 31, 2004. These consolidated financial statementsand financial statement schedule are the responsibility of the Company’s management.Our responsibility is to express an opinion on these consolidated financialstatements and financial statement schedule based on our audit.

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audit provides a reasonable basisfor our opinion.

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the results of operations and cash flows of ImageEntertainment, Inc. and subsidiaries for the year ended March 31,2004 in conformity with U.S. generally accepted accounting principles. Also, inour opinion, the related financial statement schedule, when considered inrelation to the basic consolidated financial statements taken as a whole,presents fairly, in all material respects, the information set forth therein.

(signed) KPMG LLP

Los Angeles, CaliforniaJune 25, 2004

 

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**CONSOLIDATEDBALANCE SHEETS**

**March 31,2006 and 2005**

**ASSETS**
| **(In thousands)**                                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Current assets:                                                                     |       |     |       |     |       |
| Cash and cash  equivalents                                                          |       | $        | 1,079      |     | $          | 6,339 |   |
| Accounts  receivable, net of allowances of  $9,172 — 2006;  $8,646 — 2005 |       | 17,162   |       | 22,993   |       |
| Inventories  (Notes 5 and 8)                                                        |       | 17,498   |       | 15,408   |       |
| Royalty and  distribution fee advances (Notes 3, 9 and 13)                          |       | 13,366   |       | 8,142    |       |
| Prepaid expenses  and other assets                                                  |       | 948      |       | 803      |       |
| Total current  assets                                                               |       | 50,053   |       | 53,685   |       |
| Noncurrent  inventories, principally production costs (Note 8)                      |       | 2,805    |       | 2,189    |       |
| Noncurrent  royalty and distribution advances (Notes 9 and 13)                      |       | 23,558   |       | 12,563   |       |
| Property,  equipment and improvements, net (Note 10)                                |       | 4,999    |       | 6,563    |       |
| Goodwill (Note  2)                                                                  |       | 5,715    |       | —   |       |
| Other assets                                                                        |       | 545      |       | 186      |       |
|                                                                                |       | $        | 87,675     |     | $          | 75,186 |   |

 

*Seeaccompanying notes to consolidated financial statements.*

 

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**CONSOLIDATEDBALANCE SHEETS**

**March 31,2006 and 2005**

**LIABILITIESAND SHAREHOLDERS’ EQUITY**
| **(In thousands, except share data)**                                                                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Current liabilities:                                                                                                                             |       |     |       |     |       |
| Accounts payable                                                                                                                                 |       | $        | 5,302      |     | $          | 6,175 |   |
| Accrued  liabilities                                                                                                                             |       | 4,234    |       | 3,300    |       |
| Accrued  royalties and distribution fees (Notes 3 and 13)                                                                                        |       | 13,355   |       | 12,423   |       |
| Accrued music  publishing fees (Note 13)                                                                                                         |       | 5,890    |       | 4,617    |       |
| Deferred revenue  (Note 7)                                                                                                                       |       | 5,751    |       | 5,392    |       |
| Revolving credit  facility (Note 11)                                                                                                             |       | 11,500   |       | —   |       |
| Subordinated  note payable — Ritek Taiwan (Note 12)                                                                                         |       | —   |       | 1,337    |       |
| Capital lease  obligations (Note 12)                                                                                                             |       | —   |       | 109      |       |
| Total  liabilities — all current                                                                                                            |       | 46,032   |       | 33,353   |       |
| Commitments and  Contingencies (Notes 11 and 13)                                                                                                 |       |     |       |     |       |
| Shareholders’  equity (Note 14):                                                                                                            |       |     |       |     |       |
| Preferred stock,  $.0001 par value, 25 million shares authorized; none issued and outstanding                                                    |       | —   |       | —   |       |
| Common stock,  $.0001 par value, 100 million shares authorized; 21,296,000 and 21,252,000  issued and outstanding in 2006 and 2005, respectively |       | 47,518   |       | 47,513   |       |
| Additional  paid-in capital                                                                                                                      |       | 3,790    |       | 3,774    |       |
| Accumulated  other comprehensive loss                                                                                                            |       | (4       | )          | —   |       |
| Accumulated  deficit                                                                                                                             |       | (9,661   | )          | (9,454   | )          |
| Net  shareholders’ equity                                                                                                                   |       | 41,643   |       | 41,833   |       |
|                                                                                                                                             |       | $        | 87,675     |     | $          | 75,186 |   |

 

*Seeaccompanying notes to consolidated financial statements.*

 

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**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**For the YearsEnded March 31, 2006, 2005 and 2004**

 
| **(In thousands, except per share data)** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| NET REVENUES                                                       |       | $        | 111,902    |     | $          | 118,383  |       | $ | 84,840 |   |
| OPERATING COSTS AND  EXPENSES:                                     |       |     |       |     |       |     |       |
| Cost of sales  (Note 17)                                           |       | 84,168   |       | 88,435   |       | 66,595   |       |
| Selling expenses                                                   |       | 10,750   |       | 9,853    |       | 6,086    |       |
| General and  administrative expenses (Note 4)                      |       | 16,460   |       | 14,092   |       | 12,425   |       |
|                                                               |       | 111,378  |       | 112,380  |       | 85,106   |       |
| EARNINGS (LOSS) FROM  OPERATIONS                                   |       | 524      |       | 6,003    |       | (266     | )          |
| OTHER EXPENSES  (INCOME):                                          |       |     |       |     |       |     |       |
| Interest  expense, net                                             |       | 707      |       | 665      |       | 818      |       |
| Other                                                              |       | (3       | )          | 49       |       | (213     | )          |
|                                                               |       | 704      |       | 714      |       | 605      |       |
| EARNINGS (LOSS) FROM  CONTINUING OPERATIONS BEFORE INCOME TAXES    |       | (180     | )          | 5,289    |       | (871     | )          |
| INCOME TAX EXPENSE  (Note 16)                                      |       | 27       |       | 162      |       | 6,244    |       |
| EARNINGS (LOSS) FROM  CONTINUING OPERATIONS                        |       | (207     | )          | 5,127    |       | (7,115   | )          |
| DISCONTINUED OPERATIONS  (Note 6)                                  |       |     |       |     |       |     |       |
| Loss from  operations of discontinued retail distribution segment  |       | —   |       | —   |       | (1,742   | )          |
| Loss on sale of  retail distribution segment                       |       | —   |       | —   |       | (699     | )          |
| LOSS FROM DISCONTINUED  OPERATIONS                                 |       | —   |       | —   |       | (2,441   | )          |
| NET EARNINGS (LOSS)                                                |       | $        | (207       | )        | $          | 5,127    |       | $ | (9,556 | ) |
| NET EARNINGS (LOSS) PER  SHARE:                                    |       |     |       |     |       |     |       |
| Continuing  operations — basic                                |       | $        | (.01       | )        | $          | .27      |       | $ | (.39 | ) |
| Continuing  operations —diluted                               |       | $        | (.01       | )        | $          | .26      |       | $ | (.39 | ) |
| Discontinued  operations — basic and diluted                  |       | —   |       | —   |       | (.13     | )          |
| Net earnings  (loss) — basic                                  |       | $        | (.01       | )        | $          | .27      |       | $ | (.52 | ) |
| Net earnings  (loss) — diluted                                |       | $        | (.01       | )        | $          | .26      |       | $ | (.52 | ) |
| WEIGHTED AVERAGE  COMMON SHARES OUTSTANDING:                       |       |     |       |     |       |     |       |
| Basic                                                              |       | 21,273   |       | 19,100   |       | 18,250   |       |
| Diluted                                                            |       | 21,273   |       | 19,912   |       | 18,250   |       |

 

*Seeaccompanying notes to consolidated financial statements.*

 

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**CONSOLIDATEDSTATEMENTS OF SHAREHOLDERS’ EQUITY (Note 14)**

**Forthe Years Ended March 31, 2006, 2005 and 2004**

 
| ** **                                | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**    | ** ** | **Other**       | ** ** | ** **  | ** ** |
|-------------------------------------------|------------|-----------------------|------------|-------------|------------|-------------------|------------|-----------------|------------|-------------|------------|
| ** **                                | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Comprehensive** | ** ** | **Accumulated** | ** ** |
| **(In thousands)**                   | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**       | ** ** | **Loss**        | ** ** | **Deficit** | ** ** |
| BALANCES,  March 31, 2003            |       | 18,225                |       | $           | 32,916     |              | $          | 3,774           |       | $           | —     |   | $ | (5,025 | ) |
| Issuance of  restricted stock units       |       | 20                    |       | 186         |       | —            |       | —          |       | —      |       |
| Exercise of  options                      |       | 23                    |       | 40          |       | —            |       | —          |       | —      |       |
| Net loss                                  |       | —                |       | —      |       | —            |       | —          |       | (9,556      | )          |
| BALANCES,  March 31, 2004            |       | 18,268                |       | 33,142      |       | 3,774             |       | —          |       | (14,581     | )          |
| Issuance of  common stock                 |       | 2,905                 |       | 14,198      |       | —            |       | —          |       | —      |       |
| Issuance of  restricted stock units       |       | 10                    |       | 87          |       | —            |       | —          |       | —      |       |
| Exercise of  options                      |       | 36                    |       | 96          |       | —            |       | —          |       | —      |       |
| Return of Aviva  investment to member     |       | —                |       | (10         | )          | —            |       | —          |       | —      |       |
| Exercise of  stock warrant                |       | 33                    |       | —      |       | —            |       | —          |       | —      |       |
| Net earnings                              |       | —                |       | —      |       | —            |       | —          |       | 5,127       |       |
| BALANCES,  March 31, 2005            |       | 21,252                |       | 47,513      |       | 3,774             |       | —          |       | (9,454      | )          |
| Exercise of  options                      |       | 2                     |       | 5           |       | —            |       | —          |       | —      |       |
| Exercise of  stock warrant                |       | 42                    |       | —      |       | —            |       | —          |       | —      |       |
| Acceleration of  vesting of stock options |       | —                |       | —      |       | 16                |       | —          |       | —      |       |
| Foreign currency  translation loss        |       | —                |       | —      |       | —            |       | (4              | )          | —      |       |
| Net loss                                  |       | —                |       | —      |       | —            |       | —          |       | (207        | )          |
| BALANCES, March 31, 2006             |       | 21,296                |       | $           | 47,518     |              | $          | 3,790           |       | $           | (4         | ) | $ | (9,661 | ) |

 

*Seeaccompanying notes to consolidated financial statements.*

 

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**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**For the YearsEnded March 31, 2006, 2005 and 2004**

 
| **(In thousands)**                                                                                           | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| CASH FLOWS FROM  CONTINUING OPERATING ACTIVITIES:                                                                 |       |     |       |     |       |     |       |
| Net earnings  (loss)                                                                                              |       | $        | (207       | )        | $          | 5,127    |       | $ | (9,556 | ) |
| Adjustments to reconcile  net earnings (loss) to net cash provided by (used in) continuing operating  activities: |       |     |       |     |       |     |       |
| Loss from  discontinued operations                                                                                |       | —   |       | —   |       | 1,742    |       |
| Loss on sale of  discontinued retail distribution segment                                                         |       | —   |       | —   |       | 699      |       |
| Amortization of  production costs                                                                                 |       | 4,537    |       | 4,070    |       | 3,957    |       |
| Depreciation and  other amortization                                                                              |       | 2,603    |       | 2,568    |       | 2,313    |       |
| Amortization of restricted  stock units                                                                           |       | —   |       | 25       |       | 132      |       |
| Provision for  lower of cost or market inventory write downs                                                      |       | 1,808    |       | 1,396    |       | 766      |       |
| Provision for  doubtful accounts, sales returns and other credits                                                 |       | 2,257    |       | 2,036    |       | 2,481    |       |
| Asset impairment  write-off                                                                                       |       | 248      |       | —   |       | —   |       |
| Loss on disposal  of assets                                                                                       |       | —   |       | 59       |       | 7        |       |
| Acceleration of  vesting of employee stock options                                                                |       | 16       |       | —   |       | —   |       |
| Deferred income  taxes — continuing operations                                                               |       | —   |       | —   |       | 6,244    |       |
| Changes in assets and  liabilities associated with continuing operating activities:                               |       |     |       |     |       |     |       |
| Accounts  receivable                                                                                              |       | 7,447    |       | (3,287   | )          | (3,769   | )          |
| Inventories                                                                                                       |       | (2,349   | )          | (2,909   | )          | (1,694   | )          |
| Royalty and  distribution fee advances                                                                            |       | (10,113  | )          | (2,128   | )          | 319      |       |
| Production cost  expenditures                                                                                     |       | (4,456   | )          | (3,827   | )          | (3,328   | )          |
| Prepaid expenses  and other assets                                                                                |       | 170      |       | 165      |       | (123     | )          |
| Accounts  payable, accrued royalties, fees and liabilities                                                        |       | (8,262   | )          | 1,531    |       | 2,204    |       |
| Deferred revenue                                                                                                  |       | 359      |       | 2,032    |       | (477     | )          |
| Net cash (used)  provided by continuing operating activities                                                      |       | (5,942   | )          | 6,858    |       | 1,917    |       |
| CASH FLOWS FROM  CONTINUING INVESTING ACTIVITIES:                                                                 |       |     |       |     |       |     |       |
| Capital  expenditures                                                                                             |       | (1,132   | )          | (3,408   | )          | (2,140   | )          |
| Acquisition of  business, net of cash acquired                                                                    |       | (8,241   | )          | —   |       | —   |       |
| Net cash used in  continuing investing activities                                                                 |       | (9,373   | )          | (3,408   | )          | (2,140   | )          |
|                                                                                                                   |            |          |            |          |            |          |            |  |  |  |

 

*Seeaccompanying notes to consolidated financial statements*

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**CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED**

**For the YearsEnded March 31, 2006, 2005 and 2004**

 
| **(In thousands)**                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| CASH FLOWS FROM  CONTINUING FINANCING ACTIVITIES:               |       |     |       |     |       |     |       |
| Borrowings under revolving credit facility                      |       | $        | 35,987     |     | $          | 84,960   |       | $ | 92,874 |   |
| Repayments of borrowings under revolving credit  facility       |       | (24,487  | )          | (95,178  | )          | (93,176  | )          |
| Repayments of long-term debt                                    |       | (1,337   | )          | (1,479   | )          | (1,591   | )          |
| Principal payments under capital lease obligations              |       | (109     | )          | (248     | )          | (569     | )          |
| Issuance of common stock                                        |       | —   |       | 14,198   |       | —   |       |
| Foreign currency translation                                    |       | (4       | )          | —   |       | —   |       |
| Exercise of employee stock option                               |       | 5        |       | 96       |       | 40       |       |
| Net cash provided by (used in) continuing financing  activities |       | 10,055   |       | 2,349    |       | (2,422   | )          |
| INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS:              |       | (5,260   | )          | 5,799    |       | (2,645   | )          |
| Cash provided by discontinued operations                        |       | —   |       | —   |       | 513      |       |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS:          |       | (5,260   | )          | 5,799    |       | (2,132   | )          |
| Cash and cash equivalents at beginning of year                  |       | 6,339    |       | 540      |       | 2,672    |       |
| Cash and cash equivalents at end of year                        |       | $        | 1,079      |     | $          | 6,339    |       | $ | 540 |   |
| SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION:             |       |     |       |     |       |     |       |
| Cash paid during the year for:                                  |       |     |       |     |       |     |       |
| Interest                                                        |       | $        | 667        |     | $          | 713      |       | $ | 833 |   |
| Income taxes                                                    |       | $        | 28         |     | $          | 175      |       | $ | 6 |   |

 

*Seeaccompanying notes to consolidated financial statements*

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**CONSOLIDATEDSTATEMENTS OF CASH FLOWS, CONTINUED**

**For the YearsEnded March 31, 2006, 2005 and 2004**

SUPPLEMENTALDISCLOSURES OF NONCASH OPERATING, INVESTING AND FINANCING ACTIVITIES:

On March 29,2006, our Compensation Committee of our Board of Directors and our full Boardapproved the acceleration of vesting for all outstanding unvested stock optionsgranted under our equity compensation plans. In connection with the vestingacceleration we recorded and based on an estimated 10% of employees withoptions who we estimate will terminate their employment prior to the end of theoriginal vesting periods, we accrued $16,100 to additional paid in capital at March 31,2006.

As of March 31,2006, we accrued approximately $3.8 million to accrued royalty advances anddistribution fees for committed unpaid royalty/production advances where futurepayment is based upon the release of the program or the passage of time.

As of March 31,2006, we have accrued approximately $1.6 million for music publishing fees foraudio programs that we believe have not been paid by one of our contentproviders as contractually required. We have also recorded a corresponding recoupablemusic publishing advance included as a component of royalty and distributionfee advances in the accompanying balance sheet, as of March 31, 2006. See “Note13. Commitments and Contingencies. - Distribution Agreement and Related MusicPublishing Liability”

During fiscal2006, a former financial consultant exercised their warrant to purchase 100,000shares issued in fiscal 2002 by surrendering approximately 58,000 shares in acashless exercise, an option in the original warrant agreement. The value ofthe original warrant was fully amortized by March 31, 2003.

On August 1,2005 we acquired Home Vision Entertainment for $8,000,000 in cash. See “Note 2.Acquisition and Consolidation of Home Vision Entertainment.”

 

| (In thousands)                                                                    | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------|------------|------------|------------|
| Fair value of  tangible assets acquired                                                |       | $          | 7,102      |   |
| Fair value of  intangible assets acquired                                              |       | 600        |       |
| Excess of  purchase price over fair value of net assets acquired, recorded as goodwill |       | 5,715      |       |
| Cash paid for  net assets acquired                                                     |       | (8,000     | )          |
| Expenses  incurred in connection with the acquisition                                  |       | (241       | )          |
| Liabilities assumed                                                                    |       | $          | 5,176      |   |

 

During fiscal2005, a former financial consultant exercised their warrant to purchase 50,000shares issued in fiscal 2002 by surrendering approximately 17,000 shares in acashless exercise, an option in the original warrant agreement. The value ofthe original warrant was fully amortized by March 31, 2003.

On July 1,2004, and June 30, 2003, we issued 9,524 and 19,577 shares, respectively,of common stock to officers (net of shares withheld for payment of relatedincome taxes) in connection with the vesting of restricted stock units. Weincreased common stock at July 1, 2004, and June 30, 2003, byapproximately $87,000 and $186,000, respectively, representing the value of thetotal vested shares as of the grant dates, less the value of shares withheldfor payment of related income taxes on the vesting dates.

*Seeaccompanying notes to consolidated financial statements*

 

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NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

**Note1.                   Basisof Presentation and Summary of Significant Accounting Policies.**

*Basis of Presentation and Principles of Consolidation.*The accompanying consolidated financial statements include the accounts of ImageEntertainment, Inc., its subsidiaries Egami Media, Inc., ImageEntertainment (UK), Inc., DVDPlanet, Inc. (which was dissolved as of December 31,2004) and Aviva International, LLC (which was dissolved as of December 31,2004) (collectively, “we,” “our” or “us”). All significant inter-companybalances and transactions have been eliminated in consolidation. AvivaInternational, LLC ceased active operations effective December 31, 2002. DVDPlanetceased operations for us in December 2003 subsequent to the sale ofsubstantially all of its assets in September 2003. See “Note 6Discontinued Operations — Sale of DVDPlanet in fiscal 2004.”

*Business.* We engage primarily in the domestic acquisition and wholesaledistribution of home entertainment content for release on DVD, and in otherhome entertainment formats, via exclusive license and distribution agreements. Wealso distribute our exclusive DVD programming internationally, primarily byrelying on sublicensees (particularly Sony BMG, Warner Music Group and DigitalSite), from whom we receive revenues in the form of royalty income.

*Use of Estimates in Preparation of Financial Statements.* The preparation of our consolidatedfinancial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe amounts reported in the financial statements. The significant areasrequiring the use of management estimates are related to provisions forlower-of-cost or market inventory write downs, doubtful accounts receivable,unrecouped royalty and distribution fee advances, valuation of deferred taxes,and sales returns. Although these estimates are based on management’s knowledgeof current events and actions management may undertake in the future, actualresults may ultimately differ from those estimates.

*Cash andCash Equivalents.* Cash and cash equivalents include allcash balances and highly liquid investments with an initial maturity of threemonths or less. We place our temporary cash investments with high creditquality financial institutions. At times our cash deposits may be in excess ofthe Federal Deposit Insurance Corporation (FDIC) insurance limit.

*Fair Value of Financial Instruments.* The carrying amount of our financialinstruments, which principally include cash, trade receivables, accountspayable and accrued expenses, approximates fair value due to the relativelyshort maturity of such instruments. The fair value of our debt instrumentsapproximate the amount of future cash flows associated with each instrument. Thecarrying value of all financial instruments was not materially different fromthe fair value.

*Revenue Recognition.* Revenue is recognized upon meeting the recognition requirementsof American Institute of Certified Public Accountants Statement of Position (“SOP”)00-2, *Accounting by Producers orDistributors of Films* andStaff Accounting Bulletin (“SAB”) No. 104, *Revenue Recognition*. Revenues from home videodistribution are recognized net of an allowance for estimated returns, as wellas related costs, in the period in which the product is available for sale byour customers (at the point that title and risk of loss transfer to thecustomer, which is generally upon receipt by the customer and in the case ofnew releases, after “street date” restrictions lapse). Revenues from domesticand international broadcast licensing and home video sublicensing, as well asassociated costs, are recognized when the programming is available to thelicensee and other recognition requirements of SOP 00-2 are met. Feesreceived in advance of availability, usually in the case of advances receivedfrom Sony BMG, Digital Site, other international home video sublicensees andfor broadcast programming, are deferred until earned and all revenuerecognition requirements have been satisfied. Provisions for uncollectibleaccounts receivable are provided at the time of sale. As of March 31,2006, and March 31, 2005, deferred revenue totaled $5,751,000 and$5,392,000, respectively.

*Inventories.* Inventories consist primarily of finished products for sale(which are stated at the lower-of-cost or market, with cost being determined onan average cost basis) and unamortized non-recoupable production costs (whichare stated at fair value).

*Non-Recoupable Production Costs.* The costs to produce licensed contentfor domestic and international distribution include the cost of converting filmprints or tapes into the optical disc format. Costs also include menu design,authoring, compression, subtitling, closed captioning, service charges relatedto disc manufacturing, ancillary

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material production, product packaging design andrelated services, and the overhead of our creative services and productiondepartments. A percentage of the capitalized production costs is amortized toexpense each month based upon:  (i) aprojected revenue stream resulting from distribution of new and previouslyreleased exclusive programming related to such production costs; and (ii) management’sestimate of the ultimate net realizable value of the production costs. Estimatesof future revenues are reviewed periodically and amortization of productioncosts is adjusted accordingly. If estimated future revenues are not sufficientto recover the unamortized balance of production costs, such costs are reducedto their estimated fair value.

*Royalty and Distribution Fee Advances, Recoupable Production Advances.* Royalty and distribution fee advancesrepresent fixed minimum payments made to program suppliers for exclusivecontent distribution rights. A program supplier’s share of exclusive programdistribution revenues is retained by us until the share equals the advance(s) paidto the program supplier plus recoupable production costs. Thereafter, anyexcess is paid to the program supplier. In the event of an excess, we record,as a cost of sales, an amount equal to the program supplier’s share of the netdistribution revenues. Royalty and distribution fee advances are charged tooperations as revenues are earned. Royalty distribution fee advances andrecoupable production costs are amortized to expense in the same ratio thatcurrent period revenue for a title or group of titles bears to the estimatedremaining unrecognized ultimate revenue for that title. Revenue and costforecasts are continually reviewed by management and revised when warranted bychanging conditions. When estimates of total revenues and costs indicate thatan individual title or group of cross-collateralized titles which we exploitvia home entertainment formats (such as home video, CD or broadcast) willresult in an ultimate loss, an impairment charge is recognized to the extentthat capitalized advance royalties and distribution fees and recoupableproduction costs exceed estimated fair value, based on discounted cash flows,in the period when estimated.

*Property, Equipment and Improvements.* Property, equipment and improvementsare stated at cost less accumulated depreciation and amortization. Majorrenewals and improvements are capitalized; minor replacements, maintenance andrepairs are charged to current operations. Some costs in developing internaluse software are capitalized pursuant to the SOP 98-1, *Accounting for Costs of Computer Software Developedor Obtained for Internal Use*. Depreciation and amortization arecomputed by applying the straight-line method over the estimated useful livesof the machinery, equipment and software (3-7 years). Leaseholdimprovements are amortized over the shorter of the useful life of theimprovement or the 10-year life of the related leases.

*Advertising Costs.* Our advertising expense comprises expenditures related toadvertising in trade and consumer publications, product brochures and catalogs,booklets for sales promotion, radio advertising and other promotional costs. Inaccordance with SOP 93-7, *Reporting onAdvertising Costs*, we expense advertising costs in the period inwhich the advertisement first takes place. Product brochures and catalogs andvarious other promotional costs are capitalized and amortized over the expectedperiod of future benefit, but generally not exceeding six months. Our co-opadvertising is expensed in accordance with Emerging Issues Task Force (“EITF”)01-09, *Accounting for ConsiderationGiven by a Vendor to a Customer or a Reseller of the Vendor’s Products*.At March 31, 2006, there were no prepaid advertising costs. At March 31,2005 and 2004, our prepaid advertising costs were $151,000 and $224,000,respectively. For fiscal 2006, 2005 and 2004, advertising and promotion expensewas $4,904,000, $4,632,000 and $2,445,000, respectively.

*Market Development Funds.* In accordance with EITF 01-09, *Accounting for Consideration Given by a Vendor to a Customer or aReseller of the Vendor’s Products*, market development funds,including funds for specific product positioning, taken as a deduction frompayment for purchases by customers are classified by us as a reduction torevenues. The following reductions to consolidated net revenues have been madein accordance with the guidelines of this issue:  $5,329,000 for 2006, $4,530,000 for 2005 and$2,437,000 for 2004.

*Allowances Received From Vendors.* In accordance with EITF 02-16, *Accounting by a Customer (Including a Reseller) forCertain Consideration Received from a Vendor*, we classifyconsideration received as a reduction in cost of sales in the accompanyingstatements of operations unless we receive an identifiable benefit in exchangefor the consideration, or the consideration represents reimbursement of aspecific, identifiable cost incurred by us in selling the vendor’s product.

*Shipping Income and Expenses.* In accordance with EITF 00-10, *Accounting for Shipping and Handling Fees and Costs*,we classify amounts billed to customers for shipping fees as revenues, andclassify costs related to shipping as cost of sales in the accompanyingstatements of operations.

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*Major Customers and Suppliers.* Anderson Merchandisers (who suppliesWal-Mart) accounted for 11% of our net revenues for the year ended March 31,2006. Anderson Merchandisers, Best Buy and AEC One Stop Group accounted forapproximately 17%, 12%, and 10%, respectively, of our net revenues for the yearended March 31, 2005. Best Buy and AEC One Stop accounted for 17% and 12%of fiscal 2004 sales, respectively.  Noother customers accounted for more than 10% of net revenues in fiscal 2006,2005 and 2004. At March 31, 2006, Anderson Merchandisers and AEC One Stopaccounted for 13% and 12%, respectively, of our gross accounts receivables. At March 31,2005, three customers accounted for more than 10% of our gross accountsreceivable, all totalling 42% of our total accounts receivable.

We currentlysource substantially all of our DVD replication from Deluxe. In June 2006,we reached an agreement in principle with Sonopress LLC for a five-yearreplication agreement to replace Deluxe as our exclusive manufacturer of DVDproduct. See Note 5. Subsequent Event -Agreement in Principle - New DiscReplication Agreement and Related Advance.

*Goodwill.* Goodwill is not amortized, but instead is tested for impairment at leastannually. Intangible assets continue to be amortized over their respectiveestimated useful lives ranging from three to five years. We have no intangibleassets with indefinite useful lives.

*Impairment of Long-Lived Assets.* We review for the impairment oflong-lived and specific, identifiable intangible assets whenever events orchanges in circumstances indicate the carrying amount of an asset may not berecoverable. An impairment loss would be recognized when estimated undiscountedfuture cash flows expected to result from the use of the asset and its eventualdisposition is less than its carrying amount. We incurred an impairment chargefor the cumulative cost of a third-party software program totaling $248,000during our quarter ended December 31, 2005. The third-party developer hasfailed to provide adequate resources necessary to cause the software tofunction as designed.  It is unclear asto whether they have the ability and resources to continue to support theprocess necessary to correct functionality to original design specificationsand provide adequate future maintenance should we ultimately go into liveproduction. As a result of increased uncertainty experienced by us during the December 2005quarter, we believe it was prudent to take the charge.

*Foreign Currency Transactions.* Foreign currency denominatedtransactions are recorded at the exchange rate in effect at the time ofoccurrence, and the gains or losses resulting from subsequent translation ofthe corresponding receivable or payable at current exchange rates are includedas a component of other income and expenses in the accompanying statements ofoperations. To date, we have not entered into foreign currency exchangecontracts.

*Income Taxes.* We account for income taxes pursuant to the provisions of SFAS No. 109,*Accounting for Income Taxes*,whereby deferred tax assets and liabilities are recognized for the future taxconsequences attributable to differences between the financial statementcarrying amount of existing assets and liabilities and their respective taxbases and the future tax benefits derived from operating loss and tax creditcarry forwards. We provide a valuation allowance on our deferred tax assetswhen it is more likely than not that such deferred tax assets will not berealized. We have a valuation allowance against 100% of our net deferred taxassets at March 31, 2006 and 2005.

*Earnings per Share.* Basic earnings per share are computed using the weighted averagenumber of common shares outstanding during the period. Diluted earnings pershare are computed using the combination of dilutive common share equivalentsand the weighted average shares outstanding during the period.

*Comprehensive Income (Loss).* Comprehensive income (loss) consistsof two components, net income (loss) and other comprehensive income (loss). Othercomprehensive income (loss) refers to revenue, expenses, gains and losses thatunder generally accepted accounting principles are recorded as an element ofstockholders’ equity but are excluded from net income (loss). Our othercomprehensive income (loss) is comprised of foreign currency translationadjustments arising from cash accounts maintained in England by our subsidiaryImage UK. Accumulated other comprehensive loss for the year ended March 31,2006 was $4,000. Our comprehensive loss was $211,000 for the year endedMarch 31, 2006. We did not have other comprehensive income (loss) for theyears ended March 31, 2005 and 2004.

*Stock Options.* In December 2004, the Financial Accounting Standards Board(FASB) issued revised Statement of Financial Accounting Standards (SFAS) No. 123(R) (123R)*“Share-Based Payment — an Amendment of*

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*SFAS No.’s 123 and 95.”*  SFAS 123(R) establishes standards withrespect to the accounting for transactions in which an entity exchanges itsequity instruments for goods or services, or incurs liabilities in exchange forgoods or services, that are based on the fair value of the entity’s equityinstruments, focusing primarily on accounting for transactions in which anentity obtains employee services in share-based payment transactions. SFAS No. 123(R) requirespublic entities to measure the cost of employee services received in exchangefor an award of equity instruments based on the grant-date fair value of theaward (with limited exceptions) and recognize the cost over the period duringwhich an employee is required to provide service in exchange for the award.  Through March 31, 2006, we accounted forstock options granted to employees in accordance with Accounting PrinciplesBoard Opinion (APB) No. 25, *Accounting for StockIssued to Employees*, and related interpretations.

On April 1,2006, we adopted SFAS No. 123R using the “modified prospective” method.Under this method, SFAS No. 123R requires that we measure the cost ofemployee services received in exchange for an award of equity instruments basedon the fair value of the award on the grant date for all awards granted after March 31,2006. Such cost will be recognized over the period during which an employee ofours is required to provide service in exchange for the award (i.e. the vestingperiod). Subsequent to our adoption of SFAS No. 123R, we have not grantedany stock-based compensation and are currently evaluating our future plans todo so, which at this time do not include issuing stock-based compensation inthe form of employee stock options.

On March 29,2006, the Compensation Committee of our Board of Directors approved, and ourfull Board ratified, the acceleration of vesting for all outstanding unvestedstock options granted under the our equity compensation plans. In connectionwith the vesting acceleration, the Compensation Committee and the Board alsoimposed a holding period on the shares underlying the accelerated options,which would prevent the sale or other transfer of such shares until the datethe shares would have vested under the original vesting schedule of therespective option, except that the holding period will end upon the close of achange in control transaction. Approximately 402,500 unvested stock optionswere accelerated with an exercise price below the closing price of $3.73 on March 29,2006 (i.e. in-the-money), and approximately 724,830 unvested stock options wereaccelerated with an exercise price above the closing price (i.e.out-of-the-money). The action to accelerate the vesting of unvested stockoptions enables us to minimize recognizing future compensation expenseassociated with our outstanding options upon our adoption of SFAS No. 123R.The fair value of such stock-based compensation that would have been recordedas compensation expense over the remaining vesting periods for the fiscal 2006-2011periods, had we not accelerated the vesting, totaled $1,883,000 (approximately$650,000 for our 2007 fiscal year, beginning April 1, 2006, andapproximately $1,233,000 over the remaining vesting period of the options). Thepro-forma compensation expense is reflected in the table below, whichillustrates the effect on net earnings (loss) and earnings (loss) per share forfiscal year 2006 as if Image had applied the fair value recognition provisionsof SFAS No. 123R to stock-based employee compensation. The weightedaverage difference between the exercise price of the 402,500 in-the-moneyoption shares and the closing stock price on March 29, 2006, was $0.40 pershare, and totaled $161,000 for all shares. Based on an estimated 10% ofemployees with options who we estimate will terminate their employment prior tothe end of the original vesting periods, we expensed $16,100 during the fourthquarter ended March 31, 2006.

As noted above,prior to April 1, 2006, we accounted for stock options granted toemployees in accordance with APB No. 25. Because the exercise price of alloptions granted by us was greater than or equal to the market price of theunderlying common stock on the date of the grant, no compensation expense wasrecognized.  If we had accounted forstock options issued to employees in accordance with SFAS No. 123R, ourpro forma net earnings (loss) and net earnings (loss) per share would have beenreported as follows:

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| **(In thousands, except per share data)**                                                                            | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Consolidated net  earnings (loss), as reported                                                                                                |       | $        | (207       | )        | $          | 5,127    |       | $ | (9,556 | ) |
| Add: Stock-based  employee compensation expense included in the reported consolidated net  earnings (loss), net of related tax effects        |       | 16       |       | —   |       | —   |       |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (1,861   | )          | (455     | )          | (536     | )          |
| Pro forma  consolidated net earnings (loss)                                                                                                   |       | $        | (2,052     | )        | $          | 4,672    |       | $ | (10,092 | ) |
| Consolidated net earnings (loss) per share:                                                                                                   |       |     |       |     |       |     |       |
| As reported                                                                                                                                   |       |     |       |     |       |     |       |
| Basic                                                                                                                                         |       | $        | (.01       | )        | $          | .27      |       | $ | (.52 | ) |
| Diluted                                                                                                                                       |       | $        | (.01       | )        | $          | .26      |       | $ | (.52 | ) |
| Pro forma                                                                                                                                     |       |     |       |     |       |     |       |
| Basic                                                                                                                                         |       | $        | (.10       | )        | $          | .24      |       | $ | (.55 | ) |
| Diluted                                                                                                                                       |       | $        | (.10       | )        | $          | .23      |       | $ | (.55 | ) |

 

The fair value ofthe options at the date of grant was estimated using the Black-Scholes modelwith the following assumption:
| ** **                                                      | ** ** | **2006**         | ** ** | **2005**         | ** ** | **2004**         | ** ** |
|-----------------------------------------------------------------|------------|------------------|------------|------------------|------------|------------------|------------|
| Expected life  (years)                                          |       | 2.5 – 5.0   |       | 2.5 – 5.0   |       | 5.0              |       |
| Interest rate                                                   |       | 2.76 – 4.39 | %          | 2.76 – 3.88 | %          | 3.03 – 3.52 | %          |
| Volatility                                                      |       | 60-67            | %          | 60-67            | %          | 74-79            | %          |
| Dividend yield                                                  |       | 0.00             | %          | 0.00             | %          | 0.00             | %          |
| Weighted-average fair  value of options granted during the year |       | $                | 1.8377     |             | $          | 1.9624           |       | $ | 1.7443 |   |
|                                                                 |            |                  |            |                  |            |                  |            |  |  |  |

 

*Recently Issued AccountingStandards.*

On November 3, 2005, the Financial AccountingStandards Board (“FASB”) issued FSP SFAS 115-1 and SFAS 124-1, “TheMeaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments”. This FSP nullifies certain requirements of EITF 03-1 andsupersedes EITF Topic No. D-44 “Recognition of Other-Than-TemporaryImpairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value.”This FSP addresses (1) the determination of when an investment is consideredimpaired, (2) whether such impairment is other than temporary, and (3) themeasurement of an impairment loss. This FSP also includes accountingconsiderations subsequent to the recognition of an other-than-temporaryimpairment and requires certain disclosures about unrealized losses that havenot been recognized as other-than-temporary impairments. FSP SFAS 115-1and SFAS 124-1 is effective for reporting periods beginning after December 15,2005, with earlier application permitted. The application of FSP SFAS 115-1and SFAS 124-1 did not have a material effect on our results ofoperations or financial position.

In May 2005,the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections—areplacement of Accounting Principles Board (“APB”) Opinion No. 20 and FASBStatement No. 3”. This Statement replaces APB Opinion No. 20, *Accounting Changes,* and FASB Statement No. 3,*Reporting Accounting Changes in InterimFinancial Statements,* and changes the requirements for theaccounting for and reporting of a change in accounting principle.

SFAS No. 154applies to all voluntary changes in accounting principle. It also applies tochanges required by an accounting pronouncement in the unusual instance thatthe pronouncement does not include specific transition provisions. When apronouncement includes specific transition provisions, those provisions shouldbe followed. Opinion 20 previously required that most voluntary changes inaccounting principle be recognized by including the cumulative effect ofchanging to the new accounting principle within net income of the period of thechange.

SFAS No. 154requires retrospective application to prior periods’ financial statements ofchanges in accounting principle, unless it is impracticable to determine eitherthe period-specific effects or the cumulative effect of the change. When it isimpracticable to determine the period-specific effects of an accounting changeon one or more individual prior periods presented, SFAS No. 154 requiresthat the new accounting principle be applied to the balances of assets andliabilities as of the beginning of the earliest period for which retrospectiveapplication is practicable and that a corresponding adjustment be made to theopening balance of retained earnings (or other appropriate components of equityor net assets in the statement of financial position) for that period ratherthan being reported in an income

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statement. When it is impracticable to determine thecumulative effect of applying a change in accounting principle to all priorperiods, this Statement requires that the new accounting principle be appliedas if it were adopted prospectively from the earliest date practicable.

SFAS No. 154defines *retrospective application*as the application of a different accounting principle to prior accountingperiods as if that principle had always been used or as the adjustment ofpreviously issued financial statements to reflect a change in the reportingentity. This Statement also redefines *restatement*as the revising of previously issued financial statements to reflect thecorrection of an error. SFAS No. 154 requires that retrospectiveapplication of a change in accounting principle be limited to the directeffects of the change. Indirect effects of a change in accounting principle,such as a change in nondiscretionary profit-sharing payments resulting from anaccounting change, should be recognized in the period of the accounting change.

SFAS No. 154also requires that a change in depreciation, amortization, or depletion methodfor long-lived, nonfinancial assets be accounted for as a change in accountingestimate affected by a change in accounting principle. SFAS No. 154carries forward without change the guidance contained in Opinion 20 for reportingthe correction of an error in previously issued financial statements and achange in accounting estimate. SFAS No. 154 also carries forward theguidance in Opinion 20 requiring justification of a change in accountingprinciple on the basis of preferability. SFAS No. 154 is effective foraccounting changes made in fiscal years beginning after December 15, 2005.We do not believe that this pronouncement will have a material effect on ourconsolidated financial statements.

In December 2004,the FASB issued FASB Staff Position No. FAS 109-1 (FSP FAS 109-1),“Application of FASB Statement No. 109, Accounting for Income Taxes, forthe Tax Deduction on Qualified Production Activities Provided by the AmericanJobs Creation Act of 2004.”  FSP FAS 109-1clarifies that the deduction will be treated as a “special deduction” asdescribed in SFAS No. 109, “Accounting for Income Taxes.”  As such, the special deduction has no effecton deferred tax assets and liabilities existing at the date of enactment. Theimpact of the deduction will be reported in the period in which the deductionis claimed. We do not believe that this pronouncement will have a materialeffect on our consolidated financial statements.

In December 2004,the FASB issued the SFAS No. 153, “Exchange of Nonmonetary Assets, and AnAmendment of APB Opinion No. 29.” SFAS No 153 addresses the measurement of exchanges of nonmonetary assets.SFAS No. 153 eliminates the exception from fair value measurement fornonmonetary exchanges of similar productive assets in paragraph 21(b) ofAPB Opinion No. 29, *Accounting for NonmonetaryTransactions*, and replaces it with an exception for exchanges thatdo not have commercial substance. SFAS No. 153 specifies that anonmonetary exchange has commercial substance if the future cash flows of theentity are expected to change significantly as a result of the exchange. Theprovisions of SFAS No. 153 shall be effective for nonmonetary assetexchanges occurring in fiscal periods beginning after June 15, 2005. Theprovisions of this Statement shall be applied prospectively. We do not believethat this pronouncement will have a material effect on our consolidatedfinancial statements.

In November 2004,the FASB issued SFAS No. 151, “Inventory Costs — an Amendment of ARB No. 43,”which is the result of its efforts to converge U.S. accounting standards forinventories with International Accounting Standards. SFAS No. 151 requiresidle facility expenses, freight, handling costs, and wasted material (spoilage)costs to be recognized as current-period charges. It also requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities. SFAS No. 151 will beeffective for inventory costs incurred during fiscal years beginning after June 15,2005. We are evaluating the impact of this standard on our financial statements.We do not expect that the adoption of SFAS No. 151 will have an impact onour financial position, results of operations or cash flows.

*Reclassifications.* Some fiscal 2005 and 2004 balances have been reclassified toconform to the fiscal 2006 presentation.

**Note 2.**                   **Acquisitionand****Consolidation of Home Vision Entertainment**

On August 1,2005, we acquired all of the outstanding capital stock of Public Media, Inc.,a Delaware corporation, d.b.a. Home Vision Entertainment, from Adrianne Furnissand Charles Benton for $8 million in cash, and changed its name to Home VisionEntertainment, Inc. We completed the consolidation of all of Home Vision’soperations into our existing facilities in Chatsworth and Las Vegas and closedtheir Chicago corporate headquarters and warehouse and distribution facility inOctober 2005.

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Home Vision was aprivately-held publisher and distributor of home entertainment programming,specializing in independent, foreign and fine art films. In addition toreleasing its own exclusive titles under the Home Vision label, it alsoco-distributed with us the special edition DVD library of The CriterionCollection.

The purchase wasfinanced by our existing revolving credit and term loan facility with WellsFargo Foothill, Inc. We acquired most of Home Vision’s assets and assumedmost of its liabilities, except outstanding bank and stockholder debt.

The acquisitionhas been accounted for under the purchase method of accounting in accordancewith Statement of Financial Accounting Standards No. 141, *Business Combinations* and Emerging Issues Task Force Issue (“EITF”)No. 95-3, *Recognition of Liabilitiesin Connection with a Purchase Business Combination*. Under thepurchase method of accounting, the total purchase price is allocated to the nettangible and intangible assets of Home Vision acquired, based on theirestimated fair values. Under EITF No. 95-3, the cost of a plan toexit an activity of an acquired company should be recognized as a liabilityassumed as of the consummation date of the acquisition, assuming requiredspecific criteria are met. Involuntary employee terminations, accruals forabandoned leased premises in Chicago, Illinois, write-downs of leaseholdimprovements, lease termination costs and other expenses were accrued andcharged against goodwill in accordance with EITF No. 95-3.

In conjunctionwith the acquisition, we entered into non-compete and consulting agreementswith Ms. Furniss, Home Vision’s former CEO, and an employment andconsulting agreement with Home Vision’s former CFO. The consulting agreementwith Ms. Furniss calls for $500,000 in payments over three years and theconsulting agreement with the former CFO calls for approximately $245,000 inpayments through July 31, 2006. We are accounting for these payments asseverance arrangements since both were only required to work full time for thecombined entity until the October 2005 closure of Home Vision and mayobtain employment elsewhere during the remaining term of their agreements.

Based upon anindependent appraisal, $600,000 of the purchase price was allocated tointangible assets, subject to amortization. We are amortizing the non-competeintangible asset to general and administrative expenses over the three-yearterm of the non-compete agreement, the customer relationships intangible assetto general and administrative expenses over five years and the Home Vision filmlibrary intangible asset to cost of sales over the average remaining lives ofthe Home Vision titles in the library acquired. Accumulated amortization forthe fiscal year ended March 31, 2006, was $96,000.

Totalconsideration was allocated based on estimated fair values as follows (inthousands):

| Purchase price                                                                                |   |   |   |
|-----------------------------------------------------------------------------------------------|--------|--------|--------|
| Cash (financed through the Company’s revolving  credit facility)                         |   | $      | 8,000  |   |
| Transaction fees and expenses                                                                 |   | 241    |   |
|                                                                                          |   | $      | 8,241  |   |
| Fair market value of net assets acquired:                                                     |   |   |   |
| Accounts receivable                                                                           |   | $      | 3,874  |   |
| Inventories                                                                                   |   | 1,186  |   |
| Inventories — production costs                                                           |   | 1,060  |   |
| Royalty advances                                                                              |   | 752    |   |
| Prepaid expenses and other assets                                                             |   | 75     |   |
| Property and equipment                                                                        |   | 155    |   |
| Tangible assets acquired                                                                      |   | 7,102  |   |
| Accounts payable and accrued liabilities assumed                                              |   | (3,397 | )      |
| Costs to exit Home Vision operations assumed:                                                 |   |   |   |
| Accrued severance to former Home Vision CEO and CFO                                           |   | (745   | )      |
| Other assumed liabilities (lease termination,  involuntary termination and integration costs) |   | (1,034 | )      |
| Liabilities assumed                                                                           |   | (5,176 | )      |
| Total net  tangible assets acquired                                                           |   | 1,926  |   |
| Identifiable intangible assets:                                                               |   |   |   |
| Non-compete agreement                                                                         |   | 180    |   |
| Customer relationships                                                                        |   | 140    |   |
| Film library                                                                                  |   | 280    |   |
| Total net  intangible assets acquired                                                         |   | 600    |   |
| Goodwill                                                                                      |   | 5,715  |   |
| Purchase price                                                                                |   | $      | 8,241  |   |

 

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The results ofoperations for Home Vision from the date of acquisition are included in ourconsolidated financial statements for the year ended March 31, 2006.

*Goodwill*

Approximately$5,715,000 has been allocated to goodwill. Goodwill represents the excess ofthe purchase price over the net assets acquired. Goodwill will not be amortizedbut instead will be tested for impairment at least annually. In the event thatwe determine that the value of goodwill has become impaired, we will incur anaccounting charge for the amount of impairment during the fiscal quarter inwhich the determination is made. The goodwill is not deductible for taxpurposes.

*Pro FormaResults of Operations*

The historicaloperating results of Home Vision have not been included in our historicalconsolidated operating results prior to its August 1, 2005 acquisitiondate. Pro forma data for the years ended March 31, 2006 and 2005, as ifthese acquisitions had been effective as of April 1, 2004, is as follows:

 

|                                                                    | ** ** | **Fiscal Years Ended March 31,** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| **(in thousands, except per share data)** | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Net revenues                                                       |       | $                                                    | 119,521    |   | $ | 146,032 |   |
| Net earnings  (loss)                                               |       | $                                                    | (682       | ) | $ | 5,839 |   |
| Net earnings (loss) per  share:                                    |       |                                                 |       |   |   |
| Basic                                                              |       | $                                                    | (.03       | ) | $ | . 31 |   |
| Diluted                                                            |       | $                                                    | (.03       | ) | $ | . 29 |   |
| Weighted average common  shares outstanding:                       |       |                                                 |       |   |   |
| Basic                                                              |       | 21,273                                               |       | 19,100 |   |
| Diluted                                                            |       | 21,273                                               |       | 19,912 |   |

 

These pro formaresults of operations are not necessarily indicative of future operatingresults.

**Note 3.                   ExclusiveDistribution Agreement with The Criterion Collection.**

On August 1, 2005, we also entered into anexclusive distribution agreement with The Criterion Collection, a Delawarecorporation, to exclusively distribute their DVD titles in North America.

The agreement formalized previous distributionarrangements with us and Home Vision whereby we exclusively supplied differentretailers with Criterion’s titles.

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We are payingCriterion a $1.5 million non-recoupable distribution fee, payable monthly overthe first twelve months of the term. Should we meet minimum purchase levelsover the initial three years, the term continues through December 31, 2010.We also have the option to extend the term through December 31, 2010, withthe payment of two additional $500,000 non-recoupable payments on January 1,2009 and 2010. If we suffer a major decline in purchases that cannot beattributed to a lack of titles, Criterion has the right to terminate theagreement in years four and five, but we believe this is unlikely. We haveaccrued the unpaid portion of the $1.5 million fee as a component of royaltyand distribution fee advances at March 31, 2006, and are amortizing thefee over the five-year term to cost of sales in accordance with Statement ofPosition No. 00-2. Amortization for the fiscal year ended March 31,2006 was $185,000.

**Note 4.                   Fiscal2006 Bad Debt Charge Due to Musicland Holding Corp. Bankruptcy Filing.**

On January 12,2006, Musicland Holding Corp. filed for Chapter 11 bankruptcy protection. Wehad approximately $2.6 million in trade receivables outstanding from Musiclandat December 31, 2005. We have recorded a bad debt charge of approximately$1.6 million to general and administrative expenses for the year ended March 31,2006. This charge reflects the net expense, after reversing royalties anddistribution fees otherwise payable by us had we expected to collect theMusicland trade receivable. We wrote off as uncollectible the entire Musiclandtrade receivable balance at March 31, 2006.

**Note 5.****                          Subsequent Event — Agreement in Principle - New DiscReplication Agreement and Related Advance.**

In June 2006,we reached an agreement in principle with Sonopress LLC, for a five-yearreplication agreement to act as our exclusive manufacturer of our DVDrequirements. This will include the HD-DVD and Blu-ray Disc® high-definitionformats. At our option, they may also manufacture our CD requirements. We willreceive an interest-free $10 million advance against future manufacturing fromSonopress, to be repaid at $0.20 per disc manufactured, plus payment of a$0.042 administrative fee per disc manufactured until the advance is repaid. Alloutstanding amounts under the advance are subordinated to all of ourobligations outstanding to Wells Fargo Foothill. Sonopress will take a securityinterest in all the Company’s assets in second position behind Foothill. Theproceeds from the advance will be used to reduce amounts outstanding under ourrevolving credit facility with Foothill. The replication prices under thisagreement are less than the current pricing under our replication agreementwith Deluxe. For future reporting periods, we will impute interest on theamounts outstanding under the advance during the periods and record such amountas interest expense with a corresponding reduction to cost of sales.

**Note6.                   DiscontinuedOperations — Sale of DVDPlanet in Fiscal 2004.**

On September 23,2003, our wholly-owned subsidiary DVDPlanet, Inc., sold substantially allof its assets to Planet Entertainment, Inc., a subsidiary of InfinityResources, Inc. (“Infinity”) for approximately $2,644,000 in net proceedsin connection with the sale: $1,655,000 from the sale of the net assets, and $989,000in accelerated payments for purchased inventory under the June 2003fulfillment agreement between DVDPlanet and I-Serve Direct Commerce Services, Inc.(also a subsidiary of Infinity). We received $2,354,000 on September 23,2003 ($1,424,000 of which was attributable to the asset sale), and $290,000 in October 2003($231,000 of which represented the remaining amount due on the sale). DVDPlanet’scash, accounts receivable, accounts payable and accrued expenses on the date ofsale were retained by us. We incurred a loss of approximately $699,000 on thesale of the assets. We expensed approximately $293,000 in remainingseverance-related compensation liability in connection with the sale during thequarter ended December 31, 2003, which is included as a component of theloss from discontinued operations for the year ended March 31, 2004.

The following issummary financial information for our discontinued retail distribution segmentfor the three years ended March 31, 2006:

 

| (In thousands)                                           | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net revenues                                                  |       | $        | —     |     | $          | —   |       | $ | 8,991 |   |
| Pretax loss from  discontinued operations                     |       | —   |       | —   |       | (1,742   | )          |
| Pretax loss from  the sale of the retail distribution segment |       | —   |       | —   |       | (699     | )          |
| Income tax  benefit                                           |       | —   |       | —   |       | —   |       |
| Net loss from  discontinued operations                        |       | $        | —     |     | $          | —   |       | $ | (2,441 | ) |

 

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**Note 7.                   Transition of International Sales to Sony BMG inFiscal 2004 and Royalty Advance.**

Duringfiscal 2004, we completed our transition from international distribution of ourexclusive DVD programming previously performed by a network of independentsubdistributors to BMG Music International Service, GmbH (now known as SonyBMG) under a January 2003 five-year sublicense agreement.

We received a $3.0 million initial royalty advanceunder the Sony BMG agreement in March 2003, fully recoupable from revenuesgenerated by Sony BMG against quarterly royalties due to us under the agreement.Based upon actual quarterly sales of our programming in the territories, SonyBMG recoups quarterly royalties from the $3.0 million previously advanced. SonyBMG provided additional quarterly royalty advances such that for the firstthree years of the agreement term (through December 31, 2005), the amount outstandingto us at any given time was maintained at $3.0 million. During the first threequarters of the fourth year of the term (the nine months ending September 30,2006), Sony BMG will reduce, through recoupment, the outstanding royaltyadvance to $1.5 million. Once the entire royalty advance is recouped, Sony BMGwill continue to pay quarterly royalties based on revenue generated. During thefourth quarter of the fourth year (the quarter ending December 31, 2006),Sony BMG may recoup the entire remaining balance of $1.5 million by notre-advancing royalties quarterly. The agreement contains a formula to pay anadditional lesser advance at the beginning of the fifth and final year of theterm (calendar 2007) which is to be recouped by Sony BMG during that year. Wemust repay any outstanding unrecouped royalty advance within 30 days followingthe final Sony BMG reporting at the conclusion of Sony BMG’s sell-off periodafter expiration of the five-year term. Royalty advances received from Sony BMGare recorded as deferred revenue until earned. At March 31, 2006,approximately $2.3 million of the last $3 million advance is classified as acomponent of deferred revenue in the accompanying balance sheet.

**Note8.                   Inventories.**

Inventories at March 31,2006 and 2005, are summarized as follows:

 

| (In thousands)                                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------------------------------------|------------|----------|------------|----------|------------|
| DVD                                                                  |       | $        | 11,446     |     | $          | 11,122 |   |
| Other                                                                |       | 3,011    |       | 1,616    |       |
|                                                                 |       | 14,457   |       | 12,728   |       |
| Production  costs, net                                               |       | 5,846    |       | 4,869    |       |
|                                                                 |       | 20,303   |       | 17,597   |       |
| Less current  portion of inventories                                 |       | 17,498   |       | 15,408   |       |
| Noncurrent inventories,  principally non-recoupable production costs |       | $        | 2,805      |     | $          | 2,189 |   |

 

Non-recoupableproduction costs are net of accumulated amortization of $11,485,000 and$12,364,000 at March 31, 2006 and 2005, respectively. We expect toamortize approximately 75% of the March 31, 2006 unamortized productioncosts by March 31, 2008.

**Note 9.                   Investment in FilmProduction.**

Investmentin film production at March 31, 2006 and 2005, are summarized as follows:

 

| (In thousands)         | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|
| Completed and  not released |       | $        | 801        |     | $          | — |   |
| In process                  |       | 3,607    |       | 468      |       |
| In development              |       | 98       |       | 50       |       |
|                        |       | $        | 4,506      |     | $          | 518 |   |

 

**Note 10.                 Property,Equipment and Improvements.**

Property,equipment and improvements at March 31, 2006 and 2005, are summarized asfollows:

 

| (In thousands)                             | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Machinery, equipment  and software              |       | $        | 17,473     |     | $          | 16,934 |   |
| Leasehold  improvements                         |       | 889      |       | 864      |       |
| Other                                           |       | 149      |       | 147      |       |
|                                            |       | 18,511   |       | 17,945   |       |
| Less accumulated  depreciation and amortization |       | 13,512   |       | 11,382   |       |
|                                            |       | $        | 4,999      |     | $          | 6,563 |   |

 

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Depreciation andamortization expense for the years ended March 31, 2006, 2005 and 2004,was $2,603,000, $2,568,000 and $2,313,000, respectively.

**Note11.                 RevolvingCredit and Term Loan Facilities.**

On August 10, 2005, we entered into an Amendedand Restated Loan and Security Agreement with Foothill. The agreement replacesthe existing Loan and Security Agreement, dated December 28, 1998, asamended. The more significant amended terms of the agreement are as follows,with other terms remaining generally unchanged:

·                  The maximumrevolving credit line limit was decreased to $21 million from $23 million(actual borrowing availability remains substantially based upon eligible tradeaccounts receivable levels);

·                  The agreementterm was extended two years through December 29, 2009;

·                  The prime andLIBOR interest rate options on borrowings were reduced from prime plus 0.75%(or LIBOR plus 3.5%) to (a) prime plus 0.50% (or LIBOR plus 3.0%) if ouraverage availability under the revolving line is less than $7.5 million and (b) primeplus 0.25% (or LIBOR plus 2.75%) for availability between $7.5 million and $15million. For availability greater than $15 million rates drop to prime (orLIBOR plus 2.50%);

·                  The unused linefee was reduced to 0.125% from 0.25%;

·                  The clearanceday charge and servicing fee were eliminated;

·                  Allowableaccounts receivable dilution, depending upon then-availability, and customerreceivable concentration limits were favorably increased;

·                  Earlytermination fees were increased;

·                  The tangible networth covenant was eliminated; and

·                  The minimum earningsbefore interest taxes depreciation and amortization (EBITDA) covenant wasrevised beginning with the quarter ended June 30, 2005, and a provision tothe EBITDA covenant was also added, such that we may not incur two consecutivefiscal quarters of EBITDA losses, beginning with the quarter ending September 30,2005.

On November 4,2005, at our request, Foothill further amended the credit facility to providefor a higher maximum revolving credit limit during each monthly period from October 31through April 15. During this period each year, the maximum borrowinglimit under our revolving credit line will be increased from $21 million to $25million (actual borrowing availability remains substantially based uponeligible trade accounts receivable levels).

On June 23, 2006, at our request, Foothillfurther amended the credit facility to:

·                  waive ourrequired compliance with the minimum EBITDA requirement for the twelve monthsended March 31, 2006

·                  reduce theminimum EBITDA covenant on a go forward basis. The required minimum EBITDA isnow $3.5 million for the twelve months ending June 30, 2006, $3.75 millionfor the twelve months ending September 30, 2006, $4.25 million for thetwelve months ending December 31, 2006 and March 31, 2007 and $5million of each twelve month-ended quarterly measurement period thereafter

·                  amend theprovision that we may not incur two consecutive fiscal quarters of EBITDAlosses, beginning with the quarter ended September 30, 2005, to alsoexclude the period ended March 31, 2006 and period ending June 30,2006

·                  consent allowingus to enter the new replication agreement with Sonopress, receive the relatedadvance as well as allow Sonopress to take a subordinated security interest inour assets

·                  increase ourearly termination fees to 1.5%  on themaximum revolving credit amount (either $21 million or $25 million as notedabove) and any outstanding borrowings under the capital expenditures lineamount through June 30, 2007 and to 1% through June 30, 2008. Theearly termination fee was 0.75% through September 30, 2006 and 0.50%thereafter.

 

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At March 31, 2006, we had cash of $1,079,000 andborrowing availability of $6.6 million and $1 million, respectively, under ourrevolving credit and term loan facilities with Foothill. Comparatively, at March 31,2005, we had cash of $6,339,000 and borrowing availability of $17.3 million,and $1 million, respectively, under our revolving credit and term loanfacilities. At March 31, 2006, we had $11.5 million borrowed under theline with $1.5 million borrowed at prime plus 0.25% (8% at March 31, 2006)and $10.0 million borrowed at LIBOR plus 3.00% (ranging from 7.69 to 7.87% at March 31,2006).

We were not in compliance with the covenantestablishing a minimum EBITDA, as defined by Foothill, of $4,250,000 for thetwelve months ended March 31, 2006. Our EBITDA, as defined by Foothill,was $3,506,000, or $744,000 short of the required minimum. At our request,Foothill has waived this minimum EBITDA requirement for the 12 monthmeasurement period ended March 31, 2006 and reduced the EBITDA covenantminimums on a go-forward basis. We were in compliance with all financial andoperating covenants at March 31, 2006, and expect to be in compliance withall covenants for the next twelve months.

**Note 12.                 Repayment of Long-Term Debt andCapital Lease Obligations.**

*Subordinated Note Payable — Ritek Taiwan.*  InMarch 2006, we repaid our note payable with Ritek Corporation, a TaiwaneseCorporation and former parent of Ritek Global Media (now Deluxe Media Services,our exclusive DVD manufacturer) in accordance with its terms. There was nolong-term debt as of March 31, 2006. At March 31, 2005, $1,337,000 wasoutstanding under the note.

Our July 2001 capital lease agreement with General ElectricCapital Corporation bore interest at a fixed rate of 7.58% per annum, payablemonthly, and expired in September 2005, fully repaid in accordance withits terms.

**Note 13.                 Commitments and Contingencies.**

**Operating Leases**

*CorporateOffices*  On January 7,2004, we entered into a corporate office lease starting July 1, 2004, forapproximately 62,000 square feet in a multi-tenant building in Chatsworth,California. The cost of the office space is $1.27 per square foot on a grossbasis and increases approximately 3% annually. The lease has an initial 10-yearterm with two five-year options.

We also lease our 76,000 square foot warehouse and distributionfacility located in Las Vegas, Nevada. The monthly rent is approximately$39,000, subject to annual adjustment based on increases in the consumer priceindex, and the lease will terminate on November 4, 2012. In addition, welease approximately 4.07 acres of adjacent vacant land in the event we need toexpand our current warehouse and distribution facility. The monthly rent isapproximately $9,000 and the lease will terminate on November 4, 2007. Beginningin January 2004, we leased an additional 10,000 square foot warehousestorage space in Las Vegas, Nevada for a monthly rent of approximately $6,000 throughApril 30, 2007. Beginning in October 2005, we leased an additional5,000 square foot warehouse storage space in Las Vegas, Nevada for a monthlyrent of approximately $3,000 on a month to month basis.

Image UK leasesapproximately 500 square feet of business space in London inside the offices ofContentFilm plc. Image UK currently pays £7,500 (approximately $14,000) perquarter. We have mutually agreed with ContentFilm to terminate the lease as ofthe end of August 2006, and we have recently signed a new, one-year lease withMWB Business Exchange Centres for office space at 77 Oxford Street, London W1D2ES, commencing August 28, 2006, at a rate of approximately £4,750(approximately $8,662) per month, which rate includes VAT, utilities, cleaning,security, insurance and other fees.

Future minimum annual rental payments by year under operating leases atMarch 31, 2006, are approximately as follows:

 

| Fiscal     | ** ** | **Amount**              | ** ** |
|------------|------------|-------------------------|------------|
| ** ** | ** ** | **(In thousands)** | ** ** |
| 2007       |       | $                       | 1,689      |   |
| 2008       |       | 1,656                   |       |
| 2009       |       | 1,658                   |       |
| 2010       |       | 1,702                   |       |
| 2011       |       | 1,745                   |       |
| Thereafter |       | 4,653                   |       |
|       |       | $                       | 13,103     |   |

 

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Rent expense was$1,553,000, $1,455,000 and $911,000 for fiscal 2006, 2005, and 2004,respectively.

*LeaseGuarantee*  Inconnection with the fiscal 2004 asset sale of DVDPlanet, Planet Entertainmentassumed the obligations under DVDPlanet’s leases for its retail store andvarious other liabilities related to the assets being acquired and its parentInfinity Resources guaranteed Planet Entertainment’s obligations. We remain aguarantor in the event that Planet Entertainment and Infinity default on theirfinancial obligations under the lease. The remaining payments under the leasetotal approximately $268,000 through December 2007.

*Distribution Agreement and Related Music Publishing Liability* As of March 31, 2006, we haveaccrued approximately $1.6 million for mechanical licensing fees for audioprograms that we believe have not been paid by one of our content providers ascontractually required. We have also recorded a corresponding music publishingrecoupable advance for anticipated payments by us, included as a component ofroyalty and distribution fee advances in the accompanying balance sheet, as of March 31,2006. On February 8, 2006, we entered into an amended agreement with thecontent provider, which grants us the exclusive right to distribute as manyadditional content provider-branded titles as necessary to fully recoup anyoutstanding unpaid mechanical licensing and other unrecouped costs. We willcontinue to receive our standard distribution fee on all units sold. Theamended agreement gives us the right but not the obligation to discharge anyunpaid music publishing fees required. All related litigation and arbitrationproceedings have been dismissed. We believe we will recover all of the $1.6million receivable through profit participations from future titles and futuresales of previously released titles from this content provider.

*Employment Contracts*   Future**contractualobligations under employment contracts totaled $2,398,000 and $2,415,000 forfiscal years ending March 31, 2007 and 2008, respectively.

*Other*   At March 31,2006, our future obligations by year for royalty advances, minimum royaltyguarantees and exclusive distribution fee guarantees under the terms of ourexisting licenses and exclusive distribution agreements, respectively, are asfollows:

 

| Fiscal     | ** ** | **Amount**              | ** ** |
|------------|------------|-------------------------|------------|
| ** ** | ** ** | **(in thousands)** | ** ** |
| 2007       |       | $                       | 12,444     |   |
| 2008       |       | 2,839                   |       |
|       |       | $                       | 15,283     |   |

 

Includedin the table above are approximately $3.8 million in royalty, distribution feeand production advances which were accrued as a component of accrued royaltyand distribution fee advances in the accompanying balance sheet at March 31,2006.

*Legal Proceedings*  In the normal course of business, we aresubject to proceedings, lawsuits and other claims, including proceedings undergovernment laws and regulations relating to employment and tax matters. Whileit is not possible to predict the outcome of these matters, it is the opinionof management, based on consultations with legal counsel, that the ultimatedisposition of known proceedings will not have a material adverse impact on ourfinancial position, results of operations or liquidity.

**Note 14.                 Shareholders’ Equity.**

*Fiscal 2005Private Placement of Image Common Stock*

On December 20,2004, we sold 2,904,763 shares of our common stock at $5.25 per share for grossproceeds of $15.25 million, in a private placement. We also issued three-yearwarrants to the investors to purchase up to 726,189 shares at $6.56 per share. Thewarrants are now exercisable. The expenses of the private placement wereapproximately $1,052,000, which includes the cash fee paid to our exclusiveplacement agent, and legal, accounting and other related expenses. We alsoissued the placement agent a three-year warrant to purchase up to 58,095 sharesof common stock on the same terms as the investors, except this warrantincludes a cashless exercise provision. We used the net proceeds of thetransaction to pay down outstanding obligations under our credit facility withWells Fargo Foothill, Inc. The remaining proceeds were used for workingcapital and general corporate purposes, including content acquisition.

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*StockAwards, Options and Warrants*

In September 2004,our shareholders approved an incentive compensation plan (the “2004 Plan”)pursuant to which an additional 1,000,000 shares of our common stock were madeavailable for annual incentive and specific performance awards, includingoptions. The 2004 Plan provides for awards to our employees and directors. Options(incentive as well as non-qualified), restricted stock units, stockappreciation rights, performance share awards, stock bonuses and stock unitscan be awarded under the 2004 Plan. The limitation on overall number of sharesof stock reserved and available for delivery in connection with awards underthe 2004 Plan shall be the sum of 1,000,000 shares above, plus the number ofshares with respect to awards previously granted under the 2004 Plan that terminatewithout being exercised, expire, are forfeited or canceled, and the number ofshares of stock that are surrendered in payment of any awards, or any taxwithholding with regard thereto. The 2004 Plan requires that the exercise pricefor any incentive or non-qualified option be at least 100% of the closing priceof our common stock on the date such option is granted. The maximum termallowed for an option is 10 years and a stock unit shall either vest or beforfeited not more than 10 years from the date of grant.

In July 1999and 1998, an aggregate of 91,662 and 88,359 shares, respectively, of restrictedstock units were granted to our officers under our 1998 incentive plan. Thesegrants vested annually in increments of 20% over the five-year periodcommencing June 30, 2000 and 1999, respectively. There were no restrictedstock units granted to officers during fiscal 2001 through 2006. Theserestricted stock units were payable solely in shares. We amortized the totalvalue of the restricted stock units on the date of grant ($622,000 for thefiscal 2000 grant and $592,000 for the fiscal 1999 grant) ratably over thefive-year vesting period as compensation expense. Compensation expense relatingto these stock units for fiscal 2005 and 2004 was approximately $25,000 and$132,000, respectively.

See “Note 1.Basis of Presentation and Summary of Significant Accounting Policies—StockOptions” regarding our acceleration of vesting of all outstanding unvestedstock options on March 29, 2006.

Stock option transactions,including our former plans, for the three years ended March 31, 2006, areas follows:

 
| **(In thousands, except per share data)** | ** ** | **Shares** | ** ** | **Per Share  Price Range** | ** ** | **Weighted Average  Price Per Share** | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|--------------------------------------|------------|------------------------------------------------------|------------|
| Outstanding,  March 31, 2003                                  |       | 1,759      |       | 1.68-8.75                            |       | 4.806                                                |       |
| Granted                                                            |       | 45         |       | 2.256-2.96                           |       | 2.655                                                |       |
| Exercised                                                          |       | (23        | )          | 1.75                                 |       | 1.750                                                |       |
| Canceled                                                           |       | (184       | )          | 1.68-7.94                            |       | 5.143                                                |       |
| Outstanding,  March 31, 2004                                  |       | 1,597      |       | 1.68-8.75                            |       | 4.752                                                |       |
| Granted                                                            |       | 1,156      |       | 3.74-5.43                            |       | 3.980                                                |       |
| Exercised                                                          |       | (36        | )          | 1.68-3.75                            |       | 2.640                                                |       |
| Canceled                                                           |       | (273       | )          | 1.75-8.75                            |       | 6.880                                                |       |
| Outstanding,  March 31, 2005                                  |       | 2,444      |       | 1.68-7.94                            |       | 4.180                                                |       |
| Granted                                                            |       | 403        |       | 2.94-5.36                            |       | 3.362                                                |       |
| Exercised                                                          |       | (3         | )          | 1.75                                 |       | 1.750                                                |       |
| Canceled                                                           |       | (198       | )          | 3.80-7.75                            |       | 7.099                                                |       |
| Outstanding,  March 31, 2006                                  |       | 2,646      |       | 1.68-7.94                            |       | 3.782                                                |       |

 

Of the optionsreflected as outstanding on March 31, 2006, options to purchaseapproximately 2,646,000 shares of common stock were exercisable. At March 31,2006, there were approximately 105,000 shares of common stock available for newawards, including stock options, to our directors and employees.

The followingtable summarized significant ranges of outstanding and exercisable options at March 31,2006:

 

 

|                                         | ** ** | **Options Outstanding and Exercisable** | ** **   |
|-----------------------------------------|------------|--------------------------------------------------------|--------------|
| **Range of  Exercise Prices** | ** ** | **Shares**                                             | *** *** | **Weighted  Average  Remaining  Life (Years)** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| ** **                              | ** ** | **(In thousands)**                                | ** **   | ** ** | ** ** | ** ** | ** ** |
| Under $2.00                             |       | 450                                                    |         | 6.0 |   | $ | 1.758 |   |
| $2.01 to $4.00                          |       | 1,701                                                  |         | 7.9 |   | 3.644 |   |
| $4.01 to $6.00                          |       | 205                                                    |         | 7.9 |   | 5.079 |   |
| $6.01 to $8.00                          |       | 290                                                    |         | 1.7 |   | 6.840 |   |
|                                    |       | 2,646                                                  |         |   |   |   |   |
|                                         |            |                                                        |              |  |  |  |  |  |

 

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The followingtable summarized significant ranges of outstanding and exercisable warrants at March 31,2006:

 

|                                         | ** ** | **Warrants Outstanding and Exercisable** | ** **   |
|-----------------------------------------|------------|---------------------------------------------------------|--------------|
| **Range of  Exercise Prices** | ** ** | **Shares**                                              | *** *** | **Weighted  Average  Remaining  Life (Years)** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| ** **                              | ** ** | **(In thousands)**                                 | ** **   | ** ** | ** ** | ** ** | ** ** |
| $1.22                                   |       | 270                                                     |         | 1.50 |   | $ | 1.22 |   |
| $2.04                                   |       | 100                                                     |         | 2.00 |   | 2.04 |   |
| $6.56                                   |       | 784                                                     |         | 1.72 |   | 6.56 |   |
|                                    |       | 1,154                                                   |         |   |   |   |   |
|                                         |            |                                                         |              |  |  |  |  |  |

 

*Lions Gate Proposal*

On August 30, 2005, we received an unsolicited proposal from Lions Gate Entertainment Corp. to acquire all of our outstanding shares. Our board of directors formed a special committee to consider and evaluate the proposal. After entering into a confidentiality agreement, we provided Lions Gate with extensive information (with competitive information redacted) to assist in its due diligence process, and Lions Gate made a revised proposal. On October 31, 2005, the final proposal was rejected on the grounds that it was substantially below what the special committee would find acceptable for stockholders.

Lions Gate has nominated a complete slate of potential Board members to compete for the six board seats up for election at our next annual meeting of stockholders scheduled for October 10, 2006.

*Stockholder Rights Plan*

On October 31,2005, we adopted a stockholder rights plan. The plan is intended to protect theinterests of the stockholders from coercive, abusive or unfair takeover tactics.We believe the rights plan represents a sound and reasonable means ofaddressing the complex issues of corporate policies. Issuance of the rightsdoes not in any way adversely affect our financial strength or interfere withour business plan. The issuance of the rights has no dilutive effect, will notaffect reported earnings per share, is not taxable to the company or tostockholders, and will not change the way in which stockholders can trade ourshares. The rights will only become exercisable upon the occurrence of certaintriggering events, and are then intended to operate to protect stockholdersagainst being deprived of their rights so they can share in the full measure ofour long-term potential.

*Shelf Registrations*

Wecontinue to seek out viable acquisition targets to enhance our library ofexclusive programming, distribution channels and sources of revenue. On September 23,2005, we filed a shelf registration statement that gives us the ability to sellour common stock in one or more offerings to raise cash for acquisitions, debtrepayment or working capital and other general corporate purposes. We alsofiled an acquisition shelf registration statement with the Securities andExchange Commission to ensure that registered shares of our common stock areavailable to use as consideration in connection with our acquisition of theassets, businesses or securities of other companies, whether by purchase, mergeror other form of business combination. The shares may be offered in separatetransactions or, in the aggregate, in a single transaction.

**Note 15.                 Net Earnings (Loss) per Share Data.**

Thefollowing is a reconciliation of the numerators and denominators used incomputing basic and diluted net earnings (loss) per share for the three yearsended March 31, 2006:

 
| **(In thousands, except per share data)**     | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Earnings (loss)  from continuing operations                            |       | $        | (207       | )        | $          | 5,127    |       | $ | (7,115 | ) |
| Loss from discontinued  operations                                     |       | —   |       | —   |       | (2,441   | )          |
| Net earnings  (loss) — basic and diluted numerator                |       | $        | (207       | )        | $          | 5,127    |       | $ | (9,556 | ) |
| Weighted average  common shares outstanding — basic denominator   |       | 21,273   |       | 19,100   |       | 18,250   |       |
| Effect of  dilutive securities                                         |       | —   |       | 812      |       | —   |       |
| Weighted average  common shares outstanding — diluted denominator |       | 21,273   |       | 19,912   |       | 18,250   |       |
| Basic and  diluted net earnings (loss) per share:                      |       |     |       |     |       |     |       |
| Continuing operations                                                  |       | $        | (.01       | )        | $          | .27      |       | $ | (.39 | ) |
| Discontinued operations                                                |       | —   |       | —   |       | (.13     | )          |
| Basic net  earnings (loss) per share                                   |       | (.01     | )          | .27      |       | (.52     | )          |
| Diluted net earnings  (loss) per share                                 |       | $        | (.01       | )        | $          | .26      |       | $ | (.52 | ) |

 

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Outstanding commonstock options and warrants not included in the computation of diluted netearnings (loss) per share totaled 2,538,000, 1,443,000 and 1,079,000,respectively, for the years ended March 31, 2006, 2005 and 2004 as theireffect would be antidilutive.

**Note 16.                 Income Taxes.**

Income tax expense(benefit) for the years ended March 31, 2006, 2005 and 2004, aresummarized as follows:

 

| (In thousands)          | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current                      |       |     |       |     |       |     |       |
| Federal                      |       | $        | (39        | )        | $          | 54       |       | $ | — |   |
| State                        |       | 5        |       | 30       |       | —   |       |
| Foreign                      |       | 61       |       | 78       |       | —   |       |
|                         |       | 27       |       | 162      |       | —   |       |
| Deferred                     |       |     |       |     |       |     |       |
| Federal                      |       | —   |       | —   |       | 5,593    |       |
| State                        |       | —   |       | —   |       | 651      |       |
|                         |       | —   |       | —   |       | 6,244    |       |
|                         |       |     |       |     |       |     |       |
| Total Tax Expense  (Benefit) |       | $        | 27         |     | $          | 162      |       | $ | 6,244 |   |

 

The tax effects oftemporary differences that give rise to a significant portion of the netdeferred tax assets at March 31, 2006 and 2005, are presented below:

 

| (In thousands)                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax  assets:                                        |       |     |       |     |       |
| Provision for  lower of cost or market inventory write downs |       | $        | 1,159      |     | $          | 797 |   |
| Net operating  loss carry forwards                           |       | 2,763    |       | 2,369    |       |
| Allowance for  sales returns                                 |       | 1,692    |       | 1,055    |       |
| Allowance for  doubtful accounts receivable                  |       | 64       |       | 121      |       |
| Tax credits                                                  |       | 945      |       | 1005     |       |
| Other                                                        |       | 526      |       | 547      |       |
| Deferred tax  assets                                         |       | 7,149    |       | 5,894    |       |
| Less valuation  allowance                                    |       | (5,991   | )          | (5,406   | )          |
| Deferred tax  assets                                         |       | 1,158    |       | 488      |       |
|                                                         |       |     |       |     |       |
| Deferred tax  liabilities:                                   |       |     |       |     |       |
| Depreciation and  amortization                               |       | (742     | )          | 235      |       |
| Write downs of  royalty advances                             |       | (400     | )          | 253      |       |
| Other                                                        |       | (16      | )          | —   |       |
| Deferred tax  liabilities                                    |       | 1,158    |       | 488      |       |
| Net deferred tax assets                                      |       | $        | —     |     | $          | — |   |

 

SFAS No. 109requires that we assess the likelihood that our deferred tax assets are realizable,and to the extent that it is more likely than not that all, or a portion, ofsuch deferred tax assets will not be realized, a valuation allowance,increasing tax expense for the year, must be established.

*Continuation of Valuation Allowance on Net DeferredTax Assets in Fiscal 2006, established in Fiscal 2004.*  In assessing the realizability of a deferredtax asset, Statement of Financial Accounting Standards (SFAS) No. 109requires that all available evidence, both positive and negative, be consideredto determine whether, based on the weight of that evidence, a valuationallowance is needed. SFAS No. 109 further provides that “cumulative lossesin recent years” are significant pieces of negative evidence to overcome whendetermining whether it is “more likely than not” that the recorded deferred taxassets will be realized in the future by reducing future income taxes payable. Suchcumulative losses from prior years must be considered on a pretax consolidatedbasis from all operations. In addition to fiscal 2004 pretax losses for bothcontinuing and discontinued operations, we also incurred aggregate net pretaxlosses for fiscal years 2003 and 2002. Accordingly, during fiscal 2004 weestablished a valuation allowance against 100% of our net deferred tax assets,which were composed primarily of operating loss carry forwards, resulting in afiscal 2004 tax expense of $6,244,000. The valuation allowance was recorded inthe third quarter of fiscal 2004 primarily as a 

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result of operating losses sustained during ournormally seasonally strong third quarter as well as its then-expected impact onthe full fiscal year results of operations.

Although in fiscal 2005 we had pretax earnings of $5,289,000, we didnot possess a strong earnings history. We enjoyed the benefits of a strongschedule of new DVD and CD releases during fiscal 2005 which we rightfullybelieved that we would be challenged to duplicate or exceed in fiscal 2006. Wecontinue to maintain a 100% valuation allowance against our net deferred taxassets at March 31, 2006, due to the following factors:

(1)       We had a pretax loss for fiscal 2006 and2004

(2)       We had an accumulated deficit at March 31,2006

(3)                    A significantportion (approximately 21%) of our robust fiscal 2005 revenues, and by extension,fiscal 2005 profitability, was generated by five titles

Even though wehave fully reserved our net deferred tax assets, we would still be able toutilize them to reduce future income taxes payable should we have futureearnings. To the extent such deferred tax assets relate to NOL carry forwards,the ability to use such NOL carry forwards against future earnings will besubject to applicable carry forward periods.

As of March 31,2006, we had net operating loss carry forwards for Federal and state income taxpurposes of $7,806,000 and $1,862,000, respectively, which are available tooffset future taxable income through 2024 and 2014, respectively.

Expected incometax expense (benefit) based on Federal statutory rates for the three yearsended March 31, 2006 differed from actual tax expense (benefit) asfollows:

 
| **(In thousands, except per share data)** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected income  tax benefit                                       |       | $        | (61        | )        | $          | 1,798    |       | $ | (1,126 | ) |
| State income  taxes, net of Federal benefit                        |       | 14       |       | 128      |       | 2        |       |
| Change in  valuation allowance                                     |       | 17       |       | (1,894   | )          | 7,422    |       |
| Non-deductible  expenses                                           |       | 49       |       | 51       |       | 26       |       |
| Other                                                              |       | 8        |       | 79       |       | (80      | )          |
|                                                               |       | $        | 27         |     | $          | 162      |       | $ | 6,244 |   |

 

**Note 17.                 Other Items — Statements of Operations.**

**Fourth Quarter Adjustments**

Fiscal2006  During the fourthquarter we reversed an overaccrual of music publishing liabilities on a DVDseries. During the fourth quarter we were notified by a content holder that theactual negotiated music publishing rate for DVD titles licensed from thiscontent supplier was lower than the estimated rate at which we accrued. Withoutthe actual rate known at the time of release of the related DVDs, we accruemusic publishing liability at the estimated maximum rate as we sell theprograms.  Accordingly, we reversedapproximately $562,000 in accrued music publishing as a credit to cost of salesduring the fourth quarter to reflect the comparably lower actual negotiatedmusic publishing rate.

Fiscal2005  During the fourthquarter we reduced estimated publishing liabilities relating to ourinternational distribution of DVDs through subdistributors. Approximately$499,000 was recorded as non-recurring, noncash, pretax credit to cost of salesin the accompanying consolidated statement of operations for fiscal 2006. Ourjoint venture Aviva International, LLC dissolved and Sony BMG was responsiblefor publishing for the European territories under our sublicense agreement.

Fiscal2004  None

**Note 18.                 Employee Benefit Plan.**

We have a 401(k) savingsplan covering substantially all of our employees. Eligible employees maycontribute through payroll deductions. We match employees’ contributions at therate of 50% of the first 4% of salary contributed.

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Our 401(k) savings plan matching expenses forfiscal 2006, 2005 and 2004 were $120,000, $143,000 and $149,000, respectively.

**Note 19.                 SegmentInformation.**

In accordance withthe requirements of SFAS No. 131, *Disclosuresabout Segments of and Enterprises and Related Information*, selectedfinancial information regarding our reportable business segments, domestic andinternational, are presented below. Domestic wholesale distribution of homeentertainment programming on DVD accounted for approximately 87% of our netrevenue for fiscal 2006, 85% for fiscal 2005 and 84% for fiscal 2004. Managementcurrently evaluates segment performance based primarily on net revenues,operation costs and expenses and income (loss) before income taxes. Interestincome and expense is evaluated on a consolidated basis and not allocated toour business segments.

For the Year EndedMarch 31, 2006:

 
| ** **                                                      | ** ** | **2006**     | ** ** |
|-----------------------------------------------------------------|------------|--------------|------------|
| **(In thousands)**                                         | ** ** | **Domestic** | ** ** | **International** | ** ** | **Inter-segment  Eliminations** | ** ** | **Consolidated** | ** ** |
| NET REVENUES                                                    |       | $            | 108,667    |   | $ | 3,235 |   | $ | — |   | $ | 111,902 |   |
| OPERATING COSTS  AND EXPENSES                                   |       | 108,409      |       | 2,969 |   | — |   | 111,378 |   |
| EARNINGS FROM  OPERATIONS                                       |       | 258          |       | 266 |   | — |   | 524 |   |
| OTHER EXPENSES                                                  |       | 704          |       | — |   | — |   | 704 |   |
| EARNINGS (LOSS) FROM  CONTINUING OPERATIONS BEFORE INCOME TAXES |       | $            | (446       | ) | $ | 266 |   | $ | — |   | $ | (180 | ) |

 

For the Year EndedMarch 31, 2005:

 
| ** **                                               | ** ** | **2005**     | ** ** |
|----------------------------------------------------------|------------|--------------|------------|
| **(In thousands)**                                  | ** ** | **Domestic** | ** ** | **International** | ** ** | **Inter-segment  Eliminations** | ** ** | **Consolidated** | ** ** |
| NET REVENUES                                             |       | $            | 113,219    |   | $ | 5,164 |   | $ | — |   | $ | 118,383 |   |
| OPERATING COSTS  AND EXPENSES                            |       | 108,274      |       | 4,106 |   | — |   | 112,380 |   |
| EARNINGS FROM  OPERATIONS                                |       | 4,945        |       | 1,058 |   | — |   | 6,003 |   |
| OTHER EXPENSES  (INCOME)                                 |       | 735          |       | 15 |   | (36 | ) | 714 |   |
| EARNINGS FROM  CONTINUING OPERATIONS BEFORE INCOME TAXES |       | $            | 4,210      |   | $ | 1,043 |   | $ | 36 |   | $ | 5,289 |   |

 

For the Year EndedMarch 31, 2004:

 
| ** **                                                      | ** ** | **2004**     | ** ** |
|-----------------------------------------------------------------|------------|--------------|------------|
| **(In thousands)**                                         | ** ** | **Domestic** | ** ** | **International** | ** ** | **Inter-segment  Eliminations** | ** ** | **Consolidated** | ** ** |
| NET REVENUES                                                    |       | $            | 78,370     |   | $ | 6,470 |   | $ | — |   | $ | 84,840 |   |
| OPERATING COSTS  AND EXPENSES                                   |       | 79,169       |       | 5,937 |   | — |   | 85,106 |   |
| EARNINGS (LOSS)  FROM OPERATIONS                                |       | (799         | )          | 533 |   | — |   | (266 | ) |
| OTHER EXPENSES  (INCOME)                                        |       | 818          |       | (67 | ) | (146 | ) | 605 |   |
| EARNINGS (LOSS) FROM  CONTINUING OPERATIONS BEFORE INCOME TAXES |       | $            | (1,617     | ) | $ | 600 |   | $ | 146 |   | $ | (871 | ) |

 
| ** **                 | ** ** | **As of March 31,** | ** ** |
|----------------------------|------------|------------------------------------|------------|
| **(In thousands)**    | ** ** | **2006**                           | ** ** | **2005** | ** ** |
| TOTAL ASSETS:              |       |                               |       |   |   |
| DOMESTIC                   |       | $                                  | 86,950     |   | $ | 74,431 |   |
| INTERNATIONAL              |       | 725                                |       | 755 |   |
| CONSOLIDATED  TOTAL ASSETS |       | $                                  | 87,675     |   | $ | 75,186 |   |

 

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**Note20.                 Quarterly FinancialData. (Unaudited)**

Summarizedquarterly consolidated financial data for fiscal 2006 and 2005 is as follows:

 
| ** **                                                                           | ** ** | **Quarter Ended** | ** ** |
|--------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                           | ** ** | **June 30,**      | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
| **(In thousands, except per share data)**                   | ** ** | **2005**               | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net revenues                                                                         |       | $                      | 18,586     |   | $ | 26,541 |   | $ | 23,737 |   | $ | 28,556 |   | $ | 39,171 |   | $ | 34,391 |   | $ | 30,408 |   | $ | 28,895 |   |
| Earnings (loss)  before income tax                                                   |       | (1,652                 | )          | 911 |   | (613 | ) | 1,244 |   | 2,357 |   | 2,001 |   | (272 | )(3) | 1,133 | (2) |
| Net earnings  (loss)                                                                 |       | $                      | (1,652     | ) | $ | 890 |   | $ | (613 | ) | $ | 1,215 |   | $ | 2,341 |   | $ | 1,955 |   | $ | (283 | ) | $ | 1,067 |   |
| Net earnings  (loss) per share(1) —                                             |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                                |       | $                      | (.08       | ) | $ | .05 |   | $ | (.03 | ) | $ | .07 |   | $ | .11 |   | $ | .10 |   | $ | (.01 | ) | $ | .05 |   |
| Diluted                                                                              |       | $                      | (.08       | ) | $ | .05 |   | $ | (.03 | ) | $ | .06 |   | $ | .11 |   | $ | .10 |   | $ | (.01 | ) | $ | .05 |   |
| Weighted average  common shares used in computation of net earnings (loss) per share |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                                |       | 21,252                 |       | 18,268 |   | 21,252 |   | 18,278 |   | 21,290 |   | 18,642 |   | 21,296 |   | 21,244 |   |
| Diluted                                                                              |       | 21,252                 |       | 18,588 |   | 21,252 |   | 18,697 |   | 21,763 |   | 19,746 |   | 21,296 |   | 22,373 |   |

----

(1)             Net earnings (loss)per share are computed independently for each of the quarters represented inaccordance with SFAS No. 128. Therefore, the sum of the quarterly netearnings (loss) per share may not equal the total computed for the fiscal yearor any cumulative interim period.

(2)             Includes $499,000 ina non-recurring noncash credits relating to the discontinuation of ourinternational distribution of DVDs through subdistributors.

(3)             Includes a $562,000credit to cost of sales from the reversal of an overaccrual for musicpublishing liabilities associated with a DVD series.

 

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**ITEM 9.****                                                     CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

None.

**ITEM 9A.****                                            CONTROLSAND PROCEDURES**

Asof the end of the period covered by this report, we carried out an evaluation,under the supervision and with the participation of our Chief Executive Officerand Chief Financial Officer, of the effectiveness of the design and operationof our disclosure controls and procedures. Based on this evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective in timely alerting them to materialinformation required to be included in our periodic SEC reports.

Therehave been no significant changes in our internal controls or in other factorsthat could significantly affect those controls subsequent to the date of thismost recent evaluation.

**ITEM 9B.               OTHER INFORMATION**

None.

**PART III**

Theinformation required by Items 10 through 14 of Part III is incorporated byreference from Item 1 of this report and from our proxy statement that will bemailed to shareholders in connection with our 2006 annual meetingof shareholders.

OurCode of Ethics Policy which is applicable to all employees including ourprincipal executive officer, principal financial officer and principalaccounting officer, as well as our Insider Trading Policy, Corporate GovernanceGuidelines, the written Charters for our Audit, Compensation, and Nominationsand Governance Committees, as well as periodic and current reports filed withthe SEC are available on our website, www.image-entertainment.com, and areavailable in print to any shareholder upon request. Such information isincorporated herein by reference.

 

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**PART IV**

**ITEM 15.               EXHIBITSAND FINANCIAL STATEMENT SCHEDULES**
| (a)    |   | THE FOLLOWING DOCUMENTS  ARE FILED AS A PART OF THIS REPORT. |   |
|--------|--------|-------------------------------------------------------------------|--------|
|   |   |                                                              |   |
|   |   | 1.                                                                |   | Financial Statements: |   |
|   |   |                                                              |   | Report of Independent  Registered Public Accounting Firm |   |
|   |   |                                                              |   | Report of Independent  Registered Public Accounting Firm |   |
|   |   |                                                              |   | Consolidated Balance  Sheets at March 31, 2006 and 2005 |   |
|   |   |                                                              |   | Consolidated Statements  of Operations for the years ended  March 31, 2006, 2005 and 2004 |   |
|   |   |                                                              |   | Consolidated Statements  of Shareholders’ Equity for the years ended  March 31, 2006, 2005 and 2004 |   |
|   |   |                                                              |   | Consolidated Statements  of Cash Flows for the years ended  March 31, 2006, 2005 and 2004 |   |
|   |   |                                                              |   | Notes to Consolidated  Financial Statements |   |
|   |   |                                                              |   |   |   |
|   |   | 2.                                                                |   | Financial  Statement Schedule: |   |
|   |   |                                                              |   | Schedule II —  Valuation and Qualifying Accounts |   |
|   |   |                                                              |   |   |   |
|   |   | 3.                                                                |   | Exhibits: |   |

 

3.1                                                                                 Certificateof Incorporation. Filed as Exhibit B of Appendix B of Image’s ProxyStatement dated July 29, 2005, as amended by certificate of correction asreflected in Current Report on Form 8-K filed on May 15, 2005,each incorporated by reference herein.

3.2                                                                                 Bylaws.Filed as Exhibit C of Appendix B of Image’s Proxy Statement dated July 29,2005, and incorporated by reference herein.

4.1                                                                                 SpecimenCommon Stock certificate. Filed as Exhibit 4.1 to Image’s RegistrationStatement on Form S-3 (No. 333-128487), effective October 21,2005, and incorporated by reference herein.

4.3                                                                                 RightsAgreement dated as of October 31, 2005 and amended on November 2,2005, by and between Image and Computershare Trust Company, Inc. Filed as Exhibit toForm 8-K/A on November 2, 2005 and Image’s Form 10-Qfor the quarter ended December 31, 2005, and incorporated herein byreference.

10.1                                                                           Amendedand Restated Loan and Security Agreement, dated as of August 10, 2005, byand between Image and Wells Fargo Foothill, Inc. Filed as Exhibit 10.1to Image’s Form 10-Q for the quarter ended June 30, 2005, andincorporated by reference herein.

10.2                                                                           AmendmentNo. 1, effective as of November 3, 2005, to Amended and Restated Loanand Security Agreement, dated as of August 10, 2005, by and between Imageand Wells Fargo Foothill, Inc. Filed as Exhibit 10.1 to Image’s Form 10-Qfor the quarter ended September 30, 2005, and incorporated by referenceherein.

10.3*                                                                    AmendmentNo. 2, effective as of June 23, 2006, to Amended and Restated Loan and SecurityAgreement, dated as of August 10, 2005, by and between Image and Wells FargoFoothill, Inc.

10.4                                                                           Form ofWarrant, dated March 24, 2003, between Image and Image Investors Co. Filedas Exhibit 99.2 to Image’s Form 8-K dated March 24, 2003,and incorporated by reference herein.

10.5**†**                                                                      EmploymentAgreement, dated as of April 1, 2004, between Image and Martin W.Greenwald. Filed as Exhibit 10.42 to Image’s Form 10-K for thefiscal year ended March 31, 2004, and incorporated by reference herein.

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10.6**†**                                                                      Amendment No. 1, dated as of June 1,2004, to Employment Agreement, dated as of April 1, 2004, by and betweenImage and Martin W. Greenwald. Filed as Exhibit 10.42(a) toImage’s Form 10-K for the fiscal year ended March 31, 2004, andincorporated by reference herein.

10.7**†**                                                                      EmploymentAgreement, dated as of April 1, 2004, between Image and David A. Borshell.Filed as Exhibit 10.43 to Image’s Form 10-K for the fiscal yearended March 31, 2004, and incorporated by reference herein.

10.8**†**                                                                      EmploymentAgreement, dated as of April 1, 2004, between Image and Jeff M. Framer. Filedas Exhibit 10.44 to Image’s Form 10-K for the fiscal year endedMarch 31, 2004, and incorporated by reference herein.

10.9                                                                           Form ofPurchase Agreement, dated December 20, 2004, between Image and investors.Filed as Exhibit 99.1 to Image’s Form 8-K dated December 21,2004, and incorporated by reference herein.

10.10                                                                     Form ofWarrant, dated December 20, 2004, between Image and investors. Filed as Exhibit 99.2to Image’s Form 8-K dated December 21, 2004, and incorporatedby reference herein.

10.11**†**                                                                Image’s2004 Incentive Compensation Plan. Filed as Exhibit A to Image’s Notice ofAnnual Meeting and Proxy Statement dated July 29, 2004, and incorporatedherein by this reference.

10.12**†**                                                                2005Incentive Compensation Plan of Egami Media, Inc. Filed as Exhibit 10.14to Image’s Form 10-K for the fiscal year ended March 31, 2005, and incorporatedherein by this reference.

10.13**†**                                                                Form ofIndemnification Agreement, between Image and its directors and officers. Filedas Exhibit 10.1 to Image’s Form 8-K dated October 18,2005, and incorporated by reference herein.

10.14                                                                     Form ofOption Agreement Amendment, between Image and its optionees. Filed as Exhibit 10.1to Image’s Form 8-K dated March 29, 2006, and incorporated byreference herein.

14.1                                                                           Codeof Ethics Policy, dated November 1, 2003. Filed as Exhibit 10.45 toImage’s Form 10-K for the fiscal year ended March 31, 2004, andincorporated by reference herein.

16.1                                                                           Letterfrom KPMG, LLP dated October 12, 2004. Filed as Exhibit 16.1 to Image’sForm 8-K dated October 12, 2004, and incorporated by referenceherein.

21*                                                                             Subsidiariesof the Registrant.

23.1*                                                                    ConsentLetter of BDO Seidman LLP, Independent Registered Public Accounting Firm.

23.2*                                                                    ConsentLetter of KPMG LLP, Independent Registered Public Accounting Firm.

31.1*                                                                    Certificationby the Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, asadopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2*                                                                    Certificationby the Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, asadopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1*                                                                    Certificationby the Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, asadopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2*                                                                    Certificationby the Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, asadopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

***  Exhibit(s) not previously filed with the Securities and ExchangeCommission.†   Management Contracts, CompensatoryPlans or Arrangements.**

 

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**SCHEDULE II— Valuation and Qualifying Accounts —For the Years Ended March 31, 2006, 2005 and 2004**

 
| ** **                               | ** ** | **Allowance for Doubtful Accounts**          | ** ** |
|------------------------------------------|------------|----------------------------------------------|------------|
| **(In thousands)**                  | ** ** | **Balance at  Beginning  of Year** | ** ** | **Additions  Charged to  Costs and  Expenses** | ** ** | **Amounts  Written-Off** | ** ** | **Balance at  End of Year** | ** ** |
| For the Year Ended  March 31, 2006: |       | $                                            | 240        |   | $ | 1,605 |   | $ | (1,668 | ) | $ | 177 |   |
| For the Year Ended  March 31, 2005: |       | $                                            | 1,002      |   | $ | 41 |   | $ | (803 | ) | $ | 240 |   |
| For the Year Ended March 31, 2004   |       | $                                            | 1,020      |   | $ | 72 |   | $ | (90 | ) | $ | 1,002 |   |

 
| ** **                               | ** ** | **Allowance for Sales Returns**              | ** ** |
|------------------------------------------|------------|----------------------------------------------|------------|
| **(In thousands)**                  | ** ** | **Balance at  Beginning  of Year** | ** ** | **Additions  Charged to  Costs and  Expenses** | ** ** | **Amounts  Written-Off** | ** ** | **Balance at  End of Year** | ** ** |
| For the Year Ended  March 31, 2006: |       | $                                            | 8,406      |   | $ | 31,715 |   | $ | (31,126 | ) | $ | 8,995 |   |
| For the Year Ended  March 31, 2005: |       | $                                            | 6,411      |   | $ | 30,457 |   | $ | (28,462 | ) | $ | 8,406 |   |
| For the Year Ended March 31, 2004   |       | $                                            | 5,050      |   | $ | 20,091 |   | $ | (18,730 | ) | $ | 6,411 |   |

 

Reconciliation toConsolidated Balance Sheets

 
| ** **                        | ** ** | **At March 31,** | ** ** |
|-----------------------------------|------------|-----------------------|------------|
| **(In thousands)**           | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Allowance for Doubtful  Accounts: |       |                  |       |   |   |
| Balance at End  of Year           |       | $                     | 177        |   | $ | 240 |   |
| Allowance for Sales  Returns:     |       |                  |       |   |   |
| Balance at End  of Year           |       | 8,995                 |       | 8,406 |   |
| Allowances                        |       | $                     | 9,172      |   | $ | 8,646 |   |

 

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.
|                           | * * | IMAGE ENTERTAINMENT, INC.  A Delaware corporation                                 |
|---------------------------|----------|-----------------------------------------------------------------------------------|
| Dated: June 29, 2006 | * * | */s/ MARTIN W. GREENWALD*                                                         |
|                      |     | MARTIN W. GREENWALD  Chairman of the Board, President and Chief Executive Officer |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.
| Dated: June 29, 2006  | * * | */s/ MARTIN W. GREENWALD*                                                                                            |
|----------------------------|----------|----------------------------------------------------------------------------------------------------------------------|
|                       |     | MARTIN W. GREENWALD Chairman of the Board, President and  Chief Executive Officer (Principal Executive Officer) |
| Dated: June 29,  2006 |     | */s/  JEFF M. FRAMER*                                                                                                |
|                       |     | JEFF M. FRAMER  Chief Financial Officer (Principal Financial and Accounting Officer)                                 |
| Dated: June 29,  2006 |     | */s/  DAVID CORIAT*                                                                                                  |
|                       |     | DAVID CORIAT  Director                                                                                               |
| Dated: June 29,  2006 |     | */s/  IRA EPSTEIN*                                                                                                   |
|                       |     | IRA EPSTEIN  Director                                                                                                |
| Dated: June 29,  2006 |     | */s/  GARY HABER*                                                                                                    |
|                       |     | GARY HABER  Director                                                                                                 |
| Dated: June 29,  2006 |     | */s/  M. TREVENEN HUXLEY*                                                                                            |
|                       |     | M. TREVENEN HUXLEY  Director                                                                                         |
| Dated: June 29,  2006 |     | */s/ ROBERT  J. MCCLOSKEY*                                                                                           |
|                       |     | ROBERT J. MCCLOSKEY                                                                                                  |
|                       |     | Director                                                                                                             |

 

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